In early 2021, there was intense debate among economists about the likely consequences of the US bailout, the $1.9 trillion package promulgated by a new Democratic president and a (barely) democratic Congress. Some warned the package would be dangerously inflationary; others were fairly relaxed. I was Team Relaxed. As it turned out, that was of course a very bad decision.
But what exactly did I do wrong? Both the initial debate and the way things turned out were more complicated than I suspect most people realize.
You see, this was not a debate between opposing economic ideologies. Just about all the prominent players, from Larry Summers to Dean Baker, were Keynesian economists, with more or less center-left political leanings. And we all had similar views, at least in a qualitative sense, about how economic policy works. Everyone in the debate agreed that spending in deficit would boost demand; everyone agreed that a stronger economy with a lower unemployment rate would, incidentally, have higher inflation.
What we had instead was a fight about greats. The bailout was huge in dollar terms, and as Team Inflation warned, if it had a normal “multiplier” (the increase in gross domestic product caused by a dollar of extra government spending), it would lead to a highly overheated economy — that is. , to a temporary rise in employment and gross domestic product well above their sustainable levels, and thus high inflation.
However, those of us on Team Relaxed argued that the structure of the plan would lead to a much smaller increase in GDP than the headline number would suggest. A big part of the plan were one-time checks to taxpayers, which we claimed would largely be saved rather than spent; another important element was the aid to state and local governments, which we thought would only be spent gradually, over several years.
We also argued that if there were a temporary overrun in GDP and employment, it would not increase inflation significantly, as historical experience suggested that the relationship between employment and inflation was quite flat – i.e. there was a lot of overheating. would be to produce a large increase in inflation.
So here’s the odd thing: the multiplier on the rescue plan actually seems to have been relatively low. Many consumers have kept those checks; state and local government spending grew by less than one percent of GDP. Employment is still below prepandemic levels and real GDP, although it has recovered to roughly the prepandemic trend, has not risen above it.
Nevertheless, inflation rose anyway. Why?
Much, but not all, of the rise in inflation appears to reflect disruptions related to the pandemic. Fears of infection and changes in the way we live caused major shifts in the mix of spending: people spent less on services and more on goods, leading to shortages of shipping containers, overloaded port capacity, and so on. These distortions help explain why inflation has risen in many countries, not just the United States.
But while inflation was initially confined mainly to a relatively narrow part of the economy, in line with the disruption story, it has broadened. And many indicators, such as the number of unfilled vacancies, seem to indicate that an economy is running hotter than figures such as GDP or the unemployment rate suggest. A combination of factors — early retirement, reduced immigration, lack of childcare — appears to have reduced the productive capacity of the economy compared to the previous trend.
However, historical experience would not have led us to expect so much inflation due to overheating. So there was something wrong with my inflation model – again, a model shared by many others, including those who were rightly concerned in early 2021. I know it sounds stupid to say that Team Inflation was right for all the wrong reasons, but it’s also arguably true.
One possibility is that historical experience was misleading because until recently, the economy was almost always cold — producing less than it could — and inflation didn’t depend much on just how cold it was. Perhaps in a hot economy, the relationship between GDP and inflation gets a lot steeper.
Disruptions related to adaptation to the pandemic and its aftermath may also still play a major role. And of course, both Russia’s invasion of Ukraine and China’s lockdown of major cities have added a whole new level of disruption.
Looking ahead, the economy is currently cooling – the decline in GDP in the first quarter was probably an oddity, but overall growth appears to be below trend. And private sector economists I speak to usually believe that inflation has either already peaked or will peak soon. So in a few months it may seem less puzzling.
In any case, the whole experience has been a lesson in humility. No one will believe this, but in the wake of the 2008 crisis, the standard economic models performed quite well, and I felt comfortable adopting those models in 2021. But in retrospect, I should have realized that, given the new world created by Covid-19, that kind of extrapolation was not a safe bet.
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