I'll take a stab at answering the question posed in the subject line of this post and offer my quick take on the issue.
You may have noticed that Krugman and Stiglitz more or less congratulated themselves recently for heading early to "camp transitory" -- in other words holding the belief that we were not heading into a 1970s redux and were never likely to face year after year of anything like Carter-era inflation.
I didn't think we would, either, but for entirely different reasons than those offered by the aforementioned left-wing economics. Stiglitz, in particular, spent much effort on deflecting attention from the ginormous over-the-top spending packages of 2021-22, instead assigning most of the blame to supply disruptions. Although the latter certainly contributed, I beg to differ about the main driver of the 2021-2022 inflation surge.
Note that JP Morgan Chase analysts reported in midyear 2021 that "excess savings" in household accounts amounted to nearly $2.4 trillion. (That was about 10% of GDP!) That is; the amount of additional cash in household accounts, relative to what would have existed if the pandemic had never occurred and therefore all the covid relief/stimulus measures of 2020-2021 had not been passed, was approximately $2.4 trillion.
Also recall that even Larry Summers, a partisan Democrat (but apparently a lot wiser than Krugman and Stiglitz), said at the time that the March 2021 American Rescue Plan was the most irresponsible fiscal policy in decades. Of course, the aforementioned far-left economists were loathe to criticize any of this, since they're generally in favor of big-spending initiatives and large government interventions in response to almost any perceived economic ill.
My view is that notwithstanding changes in Fed policy, inflation was bound to recede as the excess savings in household accounts winds down. That's been happening for some time now, though the process is not complete. Still, to a greater extent virtually every month, a larger percentage of the remaining "excess savings" is in the hands of higher-income households with a lower marginal propensity to consume.
For those interested in taking a much deeper dive into the issue of the fiscal policy/inflation relationship, I highly recommend John Cochrane's excellent book The Fiscal Theory of the Price Level It was easily one of my 5 or 10 favorite reads of the last year.
For those with some interest in the issue, but not so much as to be inclined to take the time to read this book, there was an excellent concise rundown of a number of key points in a WSJ article from February 2022.
(See following post)
wsj.com
Opinion | How Government Spending Fuels Inflation
Tunku Varadarajan
11–14 minutes
Annual inflation in the U.S. rose to 7.5% in January, the highest it’s been since February 1982, when it was 7.6% and declining. This current crisis, economist John Cochrane says, came as “a complete surprise” to the Federal Reserve. “All of the governors who reported forecasts, all of the staff, missed it.” When he calls this an “institutional failure,” he sounds almost kind.
Mr. Cochrane, 64, parses the present inflation in a conversation by Zoom from his house in Palo Alto, Calif., near Stanford University, where he’s a senior fellow at the Hoover Institution. His tone is wry, and it’s obvious he doesn’t hold this Fed in the greatest esteem. “They’re leading us in the dark,” he says, “with a great pretense of knowing exactly what the map is in front of us.”
He traces the present inflation to the pandemic and the government’s response. Starting in March 2020, “the Treasury issued $3 trillion of new debt, which the Fed quickly bought in return for $3 trillion of new reserves.” The Treasury then sent checks to people and businesses, later borrowing another $2 trillion and sending more checks. Overall federal debt rose nearly 30%. “Is it at all a surprise,” Mr. Cochrane asks, “that a year later inflation breaks out?”
He likens this $5 trillion in checks to a “classic parable” of Milton Friedman (1912-2006), the great monetarist at the University of Chicago, where Mr. Cochrane was a professor for 30 years before moving to Stanford in 2015. “Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community,” Friedman wrote in “The Optimum Quantity of Money” (1969). If they spent the money, inflation would result.
The Covid checks, Mr. Cochrane says, were “an immense fiscal helicopter drop. People are spending the money, driving prices up.”
Why didn’t the Fed see that this massive stimulus would cause inflation? Mr. Cochrane sees a “big blind spot” in the institution and its “large circle of policy commentators.” The Fed’s “modeling and understanding of ‘supply’ constraints is very simplistic,” he says. It focuses only on unemployment “as a measure of slack in the economy. There is no group of analysts at the Fed measuring how many containers can get through the ports.” More deeply, he says, “the Fed and its larger intellectual circle don’t think about supply at all. All variation in the economy is more or less demand.”
This “intellectual failing” showed up first in the recession that followed Covid. “The economy didn’t need demand-side stimulus,” Mr. Cochrane says. “It’s not 1933 again and again. A pandemic is, to the economy, like a huge snowstorm. Sending people money won’t get them out to closed bars, restaurants, airlines and businesses.”
The government did have to act “as a sort of insurer, making sure there wasn’t a wave of bankruptcy and helping people really hurt by the recession.” But it should have been obvious that supply constraints would lead to inflation after the recession ended. “The Fed being surprised by supply shocks is as excusable as the Army losing a battle because its leaders are surprised the enemy might attack,” Mr. Cochrane says.
He notes that even Lawrence Summers, who served as Bill Clinton’s Treasury secretary and Barack Obama’s director of the National Economic Council, foresaw inflation as early as February 2021 (in a column in the Washington Post). “Summers, who’d argued for big deficits and loose monetary policy to combat low inflation and ‘secular stagnation’ for a decade, saw inflation coming, and saw its source in the massive fiscal stimulus of the Covid recession. So why didn’t the Fed?”
I invite Mr. Cochrane to give the current inflation a name to distinguish it from previous episodes. “Naming it sounds like a fun project,” he says. “Our partisan world will likely call it the Biden Inflation, given that it started pretty much on Inauguration Day. But there was a lot of needless stimulus under Trump as well.” The administration may wish to call it the “It’s Not Our Fault Supply-Shock Inflation,” he says. “I’d like to call it the Fiscal Theory of the Price Level Inflation.”
“The Fiscal Theory of the Price Level” is the title of Mr. Cochrane’s next book, to be published in the fall. It’s a challenge to monetarism, the theory of controlling money as the chief method of stabilizing the economy. The new theory holds that when the overall amount of government debt is more than people expect the government to repay, we see inflation. The price of everything goes up, and the value of the dollar declines.
How does this work? “The U.S. government has $20 trillion of debt outstanding,” Mr. Cochrane says. “That means, over the long run, people must expect taxes to exceed spending by $20 trillion to repay the debt.” But if they think the government will be able to pay back only $10 trillion in today’s money, “people will try to get rid of their government debt fast, before it is worth less. They try to sell it in order to buy other things,” driving up the price of everything else. “That keeps going until all prices have doubled—until the $20 trillion promise is only worth $10 trillion at today’s prices.”
Why hasn’t “fiscal inflation” of this kind happened sooner? After all, the government has been borrowing money, as Mr. Cochrane puts it, “like the proverbial sailor”—the drunken one—for decades.
“Inflation comes when government debt increases relative to people’s expectations of what government will repay,” Mr. Cochrane says. “If the Treasury borrows but everyone understands it will later raise tax revenues or cut spending to repay the debt, that debt doesn’t cause inflation.” The borrowing and money-printing in 2020-21 was different: “It came without a corresponding increase in expectations that the government would someday raise surpluses by $5 trillion in present value to repay the debt.”
The failure of the Democrats’ Build Back Better bill “may augur well for budget seriousness,” Mr. Cochrane allows. But the “troublesome question” remains: “Do people, having decided that at least some of our government’s new debt will not be repaid—leading them to spend it now and inflate it away—also think that the government is less likely to repay its existing debts, or future borrowing? If so, even more inflation can break out seemingly—as always—out of nowhere.”
Mr. Cochrane believes that “we overstate the Fed’s power” to respond: “The Fed likes to say it has ‘the tools’ to contain inflation, but never dares to say just what those tools are.” In recent historical experience, “its tool is to replay 1980,” the year when inflation peaked at 14.8%. That means “20% interest rates, a bruising recession that hurts the disadvantaged, with the medicine applied for as long as it takes. Will our Fed really do that? Will our Congress let our Fed do that?”
In any case, Mr. Cochrane says, raising rates is a “crude tool to fight inflation, especially when the source is fiscal policy.” He likens the situation to a car going too fast. “Fiscal policy is the accelerator; monetary policy controls the oil. OK, if fiscal policy has floored it, you can slow the car down by draining oil, but that’s not a terribly good way to drive.” Fiscal policy sends checks, stoking inflation; monetary policy raises interest rates to discourage borrowing or encourage savers to hold the extra Treasury debt. To change the analogy slightly, the driver is accelerating and braking at the same time.
To overcome inflation, fiscal constraints on monetary policy will need to play a large role, Mr. Cochrane says: “The Fed is merely a copilot.” He notes that in 1980, the ratio of debt to gross domestic product was 25%. Today it is 100% and rising: “Fiscal constraints on monetary policy are four times larger today.” So for a rise in interest rates to lower inflation, “fiscal policy must tighten as well. Without that fiscal cooperation, monetary policy cannot lower inflation.”
An additional complication is that any increase in interest rates raises interest costs of servicing the debt. “The government must pay those higher interest costs by raising tax revenues and cutting spending, or by credibly promising to do so in the future.” At 100% debt to GDP, he says, “5% higher interest rates mean an additional deficit of 5% of GDP, or $1 trillion, for every year that high interest rates continue.” This consideration is especially relevant if fiscal policy is at the root of the inflation.
“If we’re having an inflation because people don’t believe the government can pay off the deficits it’s running to send people checks, and it will not reform the looming larger entitlement promises, then people won’t believe the government can pay off the additional $1 trillion deficit to pay off interest costs.” Result: “The central bank raises rates to fight inflation, which raises the deficit via interest costs, which only makes inflation worse.”
What kind of policy path would it take to stabilize inflation? Mr. Cochrane relies on history as well as theory. “Inflations do not happen to happily growing economies, whose governments run things well and with flush treasuries.” Historically, inflations have always come “to countries in trouble, primarily fiscal trouble, but fiscal trouble caused by bad macroeconomic policies.”
When people fundamentally distrust the government to repay debt, interest-rate policies and quantitative easing have limited power. So “the bottom line” is to ensure that people have faith in the government as debtor, and that comes “from solid growth, and transparent, responsible, durable institutions.” There’s no way out without “regulatory reform, tax reform, entitlement reform, as well as clear-eyed monetary policy that works on the narrow things it actually understands.”
Mr. Cochrane wants Americans to grasp that ending inflation “isn’t just technocrats at the Federal Reserve fiddling with interest rates.” Healthy economies don’t have inflation “no matter what the central banks do,” while dysfunctional ones have inflation even with “heroic central bank presidents.”
Mr. Cochrane calls himself a free-market economist who’s always “trying to find a better phrase than ‘free market’ or ‘supply side’ or ‘neoclassical’ ” to describe himself. He likes the word “incentivist,” because his understanding of economics is “really not so much about markets, but about paying attention to people’s incentives.”
He’s been this way since he had a “wake-up moment” in 1969, when he was 12 and lived in Italy. (His father was a professor of Florentine history.) Reading the newspaper, he learned that Tuscany had an infestation of vipers, so the authorities had offered a bounty of 1,500 lire per snake, about $1 at the time. “You can guess what happened next,” he says. “It didn’t take long for enterprising Tuscan farmers to figure out how to breed and raise vipers. Unintended consequences!”
That last phrase, Mr. Cochrane says in a follow-up email, could describe the outcome of those Covid stimulus checks. Yet a bout of inflation, he says, “may be useful to our body politic.” Inflation is where “dreams of costless fiscal expansion, flooding the country with borrowed money to address every perceived problem, hit a hard brick wall of reality.”
The present crisis may “reteach our politicians, officials and commentariat the classic lessons that there are fiscal limits, that fiscal and monetary [policy] are intertwined.” It may also teach them, Mr. Cochrane says, “that a country with solid long-term institutions can borrow, but a country without them is in trouble.”
Mr. Varadarajan, a Journal contributor, is a fellow at the American Enterprise Institute and at Columbia University’s Center on Capitalism and Society.
Copyright ©2023 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cde b8
Appeared in the February 19, 2022, print edition as 'How Government Spending Fuels Inflation'.
The part about the Treasury selling large quantities of securities to the Federal Reserve, to fund stimulus spending, was interesting. Looking at this graph, it looks like the Fed was buying treasuries all the way up to April, 2022.
https://fred.stlouisfed.org/series/TREAST
At that point in time, CPI inflation was running 8.5%, M2 (money supply) was up 40% over pre-COVID levels, and the Fed Funds rate was 0.33%. To a layman like me, that looks really crazy, like central banker malpractice. Any thoughts?
Originally Posted by Tiny
Yeah, it sure looked like central bank malpractice to me, too!
Of course, the Powell Fed has been blasted right and left for keeping interest rates pegged near the ZLB far too long. But I think at least as damaging (if not more so) to the 2021-2022 inflation outlook was the explicit promise to accommodate the 2021 spending binges with continued bond-buying. Note from the graph linked above that the Fed's balance sheet continued to expand by roughly another $1 trillion before peaking. So the egregiously irresponsible fiscal surge pushed by Biden and passed by Congress was abetted by the Fed.
Instead, an independent and responsible central bank should have at least implicitly said "Enough!," and forced the Treasury to sell securities into a "normalizing" market, in which case cooler heads might have been reticent to run up quite as much debt. (When it seems that there's almost limitless low-cost money available, the parties supplying it tend to find quite a few takers -- in the public sector as well as the private sector!)
Also what do you think about Cochrane's belief that recent inflation resulted from the market's belief that the government can't or won't raise enough taxes to pay back debt? I don't think he means that literally, but rather he's saying the value of money will have to depreciate through inflation so the government can make good on its debt. I believe this is certainly true for places like Venezuela and Zimbabwe, but do you buy that explanation for the USA? The culprit wasn't an excess of demand over supply (except to the extent people think they'd rather own things instead of dollars, because the value of the dollars will depreciate), or large amounts of stimulus money being pumped into people's pockets creating excess savings, or logistical hang ups and the like. But rather it's from recognition that the USA can't pay back its debt.
Originally Posted by Tiny
A very interesting question. My take:
I suspect that one reason the inflation panic took off so quickly in 2021-early 2022 is that there was a fear then that the spending binges would be virtually unceasing and would total trillions of dollars more, with gigantic "Build Back Better" and "Green New Deal" proposals that would have dwarfed even the unprecedentedly over-the-top stuff we actually got. But for Joe Manchin and a few others, the Bernie/AOC alliances might have gotten their way.
Then Republicans won the House majority, although by the thinnest of margins. But that's enough to put the kibosh on progressives' dreams of additional multitrillion-dollar binges.
Still, it looks like deficit spending at the moment is roaring along at about a $2.3 trillion annual run rate.
Interestingly, though, the bond market has been absorbing this much better than many expected. Note that 10-year UST yields, after peaking at about 5% two months ago have been steadily slipping into sub-4% territory. An anticipated slow-growth or possibly recessionary 2024 will likely send yields lower, especially if the Fed cuts the target rate by more than 100 bips over the next nine months, which I believe is more likely than not. In fact, I think it's likely that we'll see cuts in the funds target rate of about 200 bips over the next 12-15 months as inflation melts and growth slows.
Nothing delivers quite the beatdown to inflation than very slow growth or even a mild recession is likely to do under the present circumstances.
I won't be surprised if the M/M CPI trajectory quickly trends into sub-2% territory by Q2 2024 and stays there for a while.
