Earlier this year, some prominent economists warned that President Biden’s US bailout – the bill that sent those $ 1,400 checks – could be inflationary. People like Larry Summers, who was Barack Obama’s top economist, and Olivier Blanchard, a former chief economist at the International Monetary Fund, are not reckless deficit hawks. On the contrary, before the Covid coup, Summers advocated sustained deficit spending to combat economic weakness, and Blanchard was a prominent critic of fiscal austerity in the aftermath of the 2008 financial crisis.
But Summers, Blanchard and others argued that the bailout, which would represent around 8% of gross domestic product, was too big, that it would cause aggregate demand to grow much faster than supply and therefore soaring prices. And of course, inflation is at its highest level since 1990. It’s understandable that Team Inflation wants a winning lap.
However, when you look past the headline number, you see a quite different story than what Summers, Blanchard et al. predicted. And given the real history of inflation, calls for the Federal Reserve to raise interest rates to cool the economy seem premature at best.
First, aggregate demand has not grown so quickly. Real final domestic demand (“final” means excluding changes in inventories) is 3.8% higher than it was two years ago, in an economy whose capacity normally grows by around 2% per year:
It is true that the Great Resignation – the reluctance of many Americans slowed down by Covid-19 to return to the workforce – means that labor markets appear very tight, with high quit rates and rising wages, even though GDP is still below its pre-pandemic trend. Supply is therefore lower than most economists (including Team Inflation) expected, and the economy may indeed be overheating.
But everything we thought we knew from the past indicated that while the overheating economy causes inflation to rise, the effect is small, at least in the short term. As the jargon says, the slope of the Phillips curve is small. And these rising wages are not the main driver of inflation; if they were, average wages would not be lower than consumer prices.
So what’s up? The Bank for International Settlements – a Switzerland-based institution that is sort of the banker to the world’s bankers and has a formidable research team – argues that these are largely the bottlenecks, now famous supply chain grunts that push ships back and past Los Angeles and factories shut down for lack of chips.
What is causing these bottlenecks? Aggregate demand is still not that high, but demand has been skewed: in the era of the pandemic, people consumed fewer services but bought a lot of durable goods – household appliances, exercise equipment, etc. . :
This increased demand for durable goods has overloaded the ports, trucking and warehouses that deliver durable goods to consumers, leading to rapid increases in the prices of products whose prices normally fall over time as technology advances:
In other words, it appears that pandemic demand bias, not overspending at all levels, is driving current inflation.
Once you realize it, it has major implications both for our understanding of the recent past and for future politics.
First, because inflation reflects the huge increase in demand for durable goods, and not the much slower growth in aggregate demand, a smaller Biden spending plan wouldn’t have made much of a difference. Even if demand had been one or two points lower, the rush to buy products rather than services would still have exceeded our logistics capacity.
Second, because inflation reflects bottlenecks rather than a general problem of too much money for too few goods, it should come down as the economy adjusts. Inflation has not been as transient as we had hoped, but there is growing evidence that supply chains are warping, which should eventually bring some relief to consumers.
Finally, even if inflation remains high for a while, do we really want to slow the whole economy down because bottlenecks drive up some prices? One way to describe the inflation hawks’ argument is that they say we should cut hundreds of thousands, if not millions of jobs because the docks in the Port of Los Angeles are crowded. Does this make sense?
But things would be quite different if we saw the signs of a 1970s-style wage-price spiral. But so far, we haven’t. And for now, at least, policymakers should have the courage to bring this inflation under control.