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Climate Change = Stagflation

A couple of weeks ago in 'Supply Chain Massacre,' it was argued that supply chain issues tend to take a life of their own and that the current ones would last until 2023. Additional readings since then suggest that supply chain issues could become a recurring theme for the following decades, with negative implications for both growth and inflation.

In 'Fairness as a Constraint on Profit Seeking: Entitlement in the Market' (1986), a report co-written by Daniel Kahneman, the authors observe that prices often fail to bring supply and demand into a new equilibrium. Specifically, instead of driving up prices, a supply shock may, in many cases, result in delayed delivery or output. In other words, supply shocks can disproportionately lead to lower economic growth rather than inflation.

Take the recent fuel shortage in the UK: In a textbook environment, fuel prices would have increased until queues had disappeared. What prevented this adjustment was the notion of fairness. If suppliers had deviated from a recent 'reference transaction' which set a precedent and morally bound them to their customers, their actions would have been considered unfair. Such behavior would have had negative implications for their reputation and the future demand for their services. The outcome: wait time and lost economic output rather than higher prices at the petrol station.

Now consider the impact of climate change on supply chains. In 'Climate Change and the Macro Economy' (2020), published by the ECB, the economists expect climate change to have adverse implications for the economy's supply potential while changing demand conditions.

In particular, they note that productivity will be negatively affected by rising temperatures and more frequent extreme weathers (labor productivity, migration, transportation); agricultural output will falter in many regions; and natural disasters will damage capital stock. Social welfare, including healthcare costs, will rise. Consumers will be inclined to save more and spend less, with preferences changing rapidly. In turn, demand uncertainty will weigh on capex and lead to underinvestment.

In this new environment, wide, unexpected mismatches between supply and demand are likely to become a recurring phenomenon across economic sectors, long after the resolution of the current post-COVID logistical challenges.

If supply chain issues have an uncertain impact on both growth and inflation at the microeconomic level, they have the potential to simultaneously drive up inflation and slow down GDP growth at the aggregate, macroeconomic level. It is therefore not unreasonable to speculate about stagflation.

In that context, many fret about the direction of nominal interest rates. I would suggest a convenient shortcut to a more relevant variable, namely the long-term real interest rates. These rates have been on a downward trend for decades for various reasons, including declining productivity and demographics. The anticipated impact of climate change on the economy will likely put further pressure on them.

At the corporate level, leadership teams will feel compelled to adopt increasingly conservative practices with respect to net working capital (via inventories) and capital structure. To what extent? A giant learning process has just begun.

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