Deglobalization, Digitalization & Demographics – Competing forces on inflation

Is inflation coming? Part II: Drivers of inflation in the long run

Last week, we showed that the corona pandemic is responsible for the high inflation rates in Europe and the U.S. in fall 2021. When the effects of the corona pandemic fade out, lower inflation rates can be expected again.

But will that be the end of our inflation problems? No, because global demographic trends and the climate crisis could cause consumer prices to rise again in the coming years and decades. However, advances in innovation and productivity can mitigate these inflationary trends.

#1 Global demographic development

The world’s population continues to grow, and more people will need more consumer goods. According to United Nations estimates, the number of people living in the world is expected to increase from around 7.7 billion to 9.7 billion between 2019 and 2050.

As the natural limits of available resources do not permit unlimited expansion of supply, there will be excess demand and inflationary tendencies. Above all, this applies to land – and by extension to the production of food and the provision of housing.

In addition, global demographic change, the aging of the population, means that the ratio of people of working age to people who are no longer working due to their age will decline in the future. Taken in isolation, this will mean fewer people in the production process and more people who consume but no longer produce.

The result: a tendency toward excess demand on the goods market, leading to higher inflation rates. This is particularly true in those regions of the world that are aging particularly rapidly – i.e., first and foremost in Europe.

However, the global decline in the share of the labor force in the total population has another consequence: a labor shortage, including excess demand in the labor market. The latter causes wages to rise, which increases production costs – and so the prices that consumers have to pay. At the same time, a labor shortage means that an economy’s production capacities are reduced, causing consumer prices to rise.

#2 Climate change and decarbonization

Higher prices can also result from our strategies to reduce greenhouse gas emissions.

One of the ways to reduce them is to charge higher prices for these emissions, making emission-containing products and activities more expensive. This, too, has an inflationary effect – at least as long as emission-free production technologies do not exist.

Higher inflationary pressure also arises when there is an increased shift to biofuels to reduce the use of fossil energy materials, resulting in higher global demand for cereals, soybeans, corn, and other agricultural raw materials. At the same time, this reduces the supply of food from agricultural production.

In addition, we need land for cultivation, such as reforestation to store CO2. Both of these climate-protecting measures take up farmland, which is then no longer available for growing food. Combined with a growing world population, this can lead to rising food prices.

Meanwhile, climate change will negatively affect food production. The expected increase in weather extremes such as heatwaves, droughts, storms, and floods will lead to harvest losses. The supply of food products will be reduced in response. The excess demand for these products is then exacerbated, and food prices increase.

#3 Deglobalization

In recent decades, the international division of labor has had an anti-inflationary effect. Companies have been able to import cheaper inputs and components from abroad and reduce their production costs, causing a dampening of supply-side price levels. Consumers replace domestic consumer goods with cheaper products from abroad, directly lowering consumer prices.

However, if higher emissions prices are levied for climate protection, transport costs of physical products become more expensive. As a result, some forms of international division of labor lose their economic advantages.

If the increase in transport costs is greater than the price difference between the cheaper foreign product and the more expensive domestic product, there is no cost and price advantage in the international division of labor. The result is higher prices for consumer goods.

A further deglobalization push may result from the disruption of global supply chains in the wake of the corona pandemic. The absence of inputs and end products from abroad is prompting increasing calls in the sociopolitical debate to reduce dependence on imports of essential products (e.g., medicines and medical devices).

One proposal is to shift production from low-wage countries back to Europe. If these proposals were to become a reality, production would be renationalized – and in turn, lead to a trend toward deglobalization with the inflationary implications mentioned above.

Nor should we forget the disruptions to international trade caused by protectionist measures. They also have the effect of foregoing the price advantages of the international division of labor. It is to be feared that the major economies – above all the USA and China – will increasingly use trade policy instruments in the future to achieve (foreign) policy goals.

The arsenal of measures extends beyond tariffs and non-tariff barriers to trade and includes sanctions, export restrictions, and export bans.

Digitalization as an anti-inflationary factor

The increased use of digital technologies is an effective way to counteract the inflation-increasing effects outlined above. There are three main inflation-dampening effects to be considered here:

1. The use of digital technologies results in a general optimization of business processes and thus reduces production costs. Digital technologies consequently lead to higher resource productivity. This also reduces dependence on fossil fuels, and emissions-based inputs – the higher prices for greenhouse gas emissions required for climate protection are less of an issue.
2. The increased use of machines, robots, and digital technologies is one way to counter the aging-related labor shortage. If missing workers can be replaced in this way, excess demand on the labor market is reduced. It puts the brakes on wage increases, which lead to higher consumer prices via rising production costs.
3. When digital technologies and machines replace human workers, this cushions the inflation-increasing effects of deglobalization. Digitalization lowers production costs in Europe and thus reduces the price disadvantage that European high-wage countries have compared with low-wage countries.

Outlook

Rising prices are ultimately an expression of real shortages, i.e., the demand for goods, raw materials, or production factors is greater than the available supply.

If central banks boost aggregate demand by extending credit at low-interest rates, a more restrictive monetary policy can combat the resulting inflation. Moreover, a restrictive monetary policy is in principle also capable of mitigating price level increases that are not due to a prior expansionary monetary policy. However, the higher interest rates required for this mean a reduction in investment, which has a negative impact on output and employment.

However, if prices for goods rise even in the absence of loose monetary policy by central banks, the gap between demand for and supply of goods can be closed by increasing efficiency and productivity through innovation – a successful innovation and productivity policy is then simultaneously an anti-inflation policy.

Note: This and last week’s post are based on the German-language policy brief “Kommt nun die Inflation?”.

Read Part I: Inflation is coming. It’s corona’s fault.

Read more on the impact of an aging population:

Demographic change and Decarbonization – the Dual Challenge for Europe

Aging Societies, Old Societies, and International Competitiveness