Many still blame today’s inflation on obstacles to global supply chains. The main proposed solution is to undo decades of globalization and bring production home. Some have also pushed for measures to offset inflation, including strong child subsidies and tax rebates for gas and food.
The proposals stem from a misunderstanding of the real cause of inflation: government-induced demand. Therefore, more spending will only fuel inflationary fires.
During the pandemic, the U.S. Treasury issued about $6 trillion, of which $2.7 trillion was monetized by the Federal Reserve. Americans received $5.1 trillion through various programs, including personal checks and unemployment bonuses. Since then, total federal debt has increased by about $6 trillion.
This response assumes that the 2020 recession is triggered by a demand shock that causes aggregate demand to fall, rather than aggregate supply stifled by the pandemic and lockdowns. In this case, sending money to individuals and companies never affects output. Instead, it greatly inflates demand for durable goods that are still being produced.
Even by the Keynesian economic standards that prompted this fiscal response, COVID-19 relief is greater than any “output gap”—the difference between what an economy produces and what it produces at its most. In March 2020, the shortfall was $2.3 trillion, and that year alone, the government spent $3 trillion through various relief bills.
In March 2021, Democrats passed a $1.9 trillion US rescue package. At the time, the output gap was projected to be $700 billion by 2023 — a period in which most spending will occur. As a result, the bill is two to three times too large, especially given that the economy is mostly reopened and growing, with unemployment falling rapidly to 6% from 14.8% the year before.
Some center-left economists, as well as Sen. Joe Manchin (DW.Va.), have sounded the alarm that the outsized injection of new spending will overheat the growing economy and drive inflation. They were ignored, if not mocked. As a result, almost everyone from Fed chairs to monetary experts will spend much of 2021 explaining inflation without mentioning the role of fiscal and monetary policy.
Today, several new studies confirm that this bout of inflation is rooted in demand, not supply. That’s not to say that supply chain chokepoints, which were initially caused by government-imposed global shutdowns and a sudden shift from services to goods, didn’t play a role.
But without the shutdowns and the aforementioned government-driven demand growth for durable goods, we wouldn’t have a supply chain problem of this magnitude. According to the World Trade Organization’s Robert Koopman, artificially inflated demand accounts for two-thirds of the supply shortage.
Second, global supply chains are clearly global. If inflation is really the product of supply chain problems, we will see roughly the same inflation rate across the industrialized world. But we don’t. Inflation levels in most industrialized countries are lower than in the United States. These other countries have also implemented significantly reduced COVID-19 spending.
For example, inflation rates in France, South Korea and Norway are all below 4%. Their governments are spending less than 10% of GDP on fiscal stimulus to combat the pandemic, compared with about 26% in the US.
One also needs to distinguish between supply constraints, where the price of some goods rises relative to others, and inflation, which happens when the price of everything, including labor, rises. Supply shocks and constraints do not lead to the same broad-based pattern of price increases as true inflation. Furthermore, price level increases due to supply-side shocks generally do not persist month-to-month; they are one-time jumps that gradually dissipate when the supply shock ends.
Today, all prices are rising, including wages (albeit at low levels at the moment), and inflation persists. This is because of overblown fiscal and monetary policy. Addressing this problem will require strong action from the Federal Reserve and significant fiscal restraint from Congress. Both are inseparable, and inflation will persist for longer, disproportionately hurting the most economically vulnerable.
It also means that recent calls to offset inflation by subsidizing gas, housing, childcare and more will require borrowing money. Since fiscal generosity is the source of the problem, and because these efforts make affected markets more inefficient, this approach increases the risk of a severe stagnation spiral.
Copyright 2022 Creator Network.