We need clarity about what’s causing inflation, why it’s a problem, and what should be done about it.
We need clarity about what’s causing inflation, why it’s a problem, and what should be done about it.
T he inflation levels of the last year are stuck around President Biden’s neck like a tight noose and, if the current polling is any indication, will likely be a major problem for Democrats in the 2022 midterms. The politicization of inflation is normal, unavoidable, and has a great tradition in 20th-century political economy.
Some conservative economists (present company included) have been cautious of the inflation narrative, believing that more is at play than the easy narrative to which many have understandably subscribed. Several facts on the ground are indisputable and ought to be conceded:
- Prices are broadly higher right now (i.e., inflation) than they were in 2019 and 2020. Using 2019 is an important barometer so as to avoid the potential of comparing prices to Covid-influenced price deterioration. In much of 2021, the “base effect” of 2020 comparisons were distortive, but we now can see indisputably that prices in goods, services, food, and energy are not just higher than Covid 2020 levels but pre-Covid “normal” levels of 2019, too.
- In 2020 and 2021, the government spent an unfathomable amount of money to combat Covid, with a $1.9 trillion pile-on bill signed into the law by President Biden in March of 2021.
- In 2020 and 2021, the Federal Reserve responded to the Covid moment with hyper-accommodative monetary policy that was intended to aid the economy despite government shutdowns and a wide assortment of stressors in the financial system. The 0 percent federal-funds target rate that was implemented in March 2020 stayed in place for two calendar years (and even now is only at 0.25 percent). Additionally, the Fed’s use of its own balance sheet as a policy tool (the process of quantitative-easing whereby the Fed purchases bonds with money that does not exist) was re-initiated after several years of such activity being dormant.
What we have right now, then, is an overwhelming consensus that No. 2 and No. 3 are the cause of No. 1 — that President Biden’s big spending and the Fed’s hyper-accommodative monetary policy gave rise to the current inflation levels. The “post hoc” support for this assumption is fair enough, and other anecdotal evidence make it reasonable, if not compelling.
The biggest impediment to making a case for a more nuanced and longer-term view of this economic complexity is that the guiding agenda for most who have differences with consensus thinking has been to defend the Federal Reserve or to defend the Biden administration. The Biden administration has understandably been on the defensive, and talk of blaming supply-chain woes, or greedy companies, or Vladimir Putin all serve the purpose of seeing consensus opinion-holders dig in their heels, understandably aghast at the silliness of these explanations. My agenda in pursuing a more long-term and informed understanding of inflation, government spending, and monetary policy is not to defend governmental actions but rather to more exhaustively and rigorously critique them. That is the fundamental point I would ask readers to understand: My views on monetary policy and excessive governmental spending are more critical than even those of the consensus inflation camp.
The following five contentions are intended to clarify my own perspective but also to offer nuance for those who desire a more holistic understanding of these economic issues. Inflation is a potent topic in both political and economic circles, and if all I cared about was the upcoming election cycles, I would pile on the current narrative for the obvious political benefits they provide a conservative Republican such as myself. But as a steward of capital managing close to $4 billion of client assets, and as an economist focused on the visible and invisible effects in both short- and long-term contexts (per Bastiat), I am writing with a different agenda on the subject.
Indeed, many decades of those on the right getting inflation talk wrong has left me deeply passionate about this issue. I do not want us to make the same mistake again, and I hope these five contentions will offer some clarity toward that desired outcome.
1. The Fed’s Role in our Modern Economy Is Excessive, Distortive, and Dangerous
Federal Reserve policy has been problematic for a long time, as excessive interventions and use of discretion have distorted markets, created malinvestment, exacerbated a boom–bust cycle, and created fragility in financial markets. Too much focus in our financial economy has gone into “financialization” — front-running the Fed — predicting what it would do, or what other financial actors would guess it is going to do — and not nearly enough focus has gone into productive activities. An accompaniment to this criticism of Fed policy is that it has sustained “zombie” companies — i.e., allowing companies that would otherwise not live to fight another day to survive merely by their continued access to a low cost of capital and needed liquidity, apart from their ability to ever pay back their debt, let alone profit. The CPR given to these zombie companies is not benevolent but cannibalistic of resources that otherwise could be allocated more efficiently elsewhere. This compresses growth and facilitates stagnation by not allowing capital to migrate to its most efficient use. In short, the Fed as a “stop-gap” in our economy has been highly problematic for growth, for resource allocation, and for economic optimization. This modern Fed is out of control and requires thoughtful policy prescriptions to rein it in.
2. There Has Been a Huge Lack of Inflation for a Long, Long Time in Places That Did Try Excessive Monetary Policy
Point No. 1 notwithstanding, the Fed’s own monetary policy over the last 25 years has favored the coddling of financial assets, no doubt, and yet has not been inflationary. In fact, until 2021, over two decades of Fed favoritism for accommodation has not resulted in reaching their inflation target, let alone exceeding it. The greatest example of modern times is Japan, a nation once believed to be so ascendant that a prominent New York real-estate developer named Donald J. Trump spent $100,000 running an ad in the New York Times to criticize American economic policy with the country. As is now well known, the spectacular bubble of Japanese real estate and stocks in the 1980s ended disastrously. The nation has pushed debt up to 250 percent of GDP and thrown the kitchen sink at fiscal and monetary interventions to address their vulnerabilities. The goal to “inflate” away this nasty debt level has not worked: Consider that, despite a zero-interest-rate policy, unprecedented money creation, and massive government spending, they have been stuck at 0 percent inflation (and basically 0 percent real-GDP growth) for 30 years.
The empirical facts are that huge quantitative-easing and nearly a decade of zero-interest-rate policy did not create inflation in the United States after the financial crisis, either. Much like those in Japan, central bankers in the U.S. instead scratched their heads as to why they were not meeting their desired inflation targets. The United Kingdom and the European Union have followed a similar path. There have been all sorts of economic problems in these four major geographical economies, but inflation has not been one of them despite the best efforts of central bankers and politicians.
Economically, how significant money-supply growth can somehow avoid creating significant inflation is explained by the corresponding decline in velocity of that money growth. The quantity theory of money taught us that MV=PT, where M is money supply, V velocity, P the price level, and T some capture of economic output (goods and services). A secular decline in velocity corresponded with a secular decline in loan growth and led to deflation in Japan and disinflation in the United States.
The cause of this collapsing velocity and loan demand is best explained by contention No. 3.
3. What We Have Struggled with Is Economic Stagnation
For reasons I believe are specifically explained by the fiscal and monetary policy of the countries being discussed, the developed world has been struggling with economic stagnation for a long time. Sub-par growth in the U.S. began with the deflationary impact of the Great Recession, yet unlike every other recession the U.S. has ever come out of since World War II, no resumption of trendline growth was found. This “Japanifcation” has its roots in the same deleterious policies that Japan has tried — namely, excessive indebtedness.
High levels of debt pull forward future growth into the present — meaning, high levels of debt limit future expectations for growth. As all government spending is fundamentally an extraction of wealth from the private sector (either in current taxation or borrowing, which is future taxation), and as the private sector represents the most efficient allocation of capital and resources in free enterprise, high government spending puts downward pressure on growth. This is a non-controversial assertion and one that is enthusiastically embraced in conservative circles.
Where hyper-accommodative monetary policy and aggressive fiscal policy fail to create growth is in the law of diminishing returns. The marginal-revenue product of debt has collapsed over time, and in the private sector, an under-levered actor becoming properly levered can happen only once. Once optimally levered, a low cost of capital does not serve a productive purpose for a good borrower. What it does do, though, is encourage bad borrowers. It distorts investment decisions. It allows zombie companies to stay alive. It misallocates financial and human capital away from their best use. And it does all this, over time.
4. Where We Have Had Indefensible and Known Inflation Was a By-Product of Bad Government Policy
We know of three areas that have bucked the trend of mostly moderate inflation over the last few decades — housing, college tuition, and health care. These three domains have experienced inexcusable price inflation with only the most egregious of explanations: government subsidy. The basic lesson that “if you subsidize something you will get more of it” has come to bear as the subsidies available to the highly levered class of housing via Fannie Mae and Freddie Mac have helped push prices up to extreme levels of unaffordability despite very low interest rates.
College administrators have had carte blanche to raise prices knowing that there is infinite loan money available from the government-monopolized world of student loans. This government intrusion has made non-price-sensitive actors of everyone; it has enabled sub-par universities to raise prices knowing that access to debt capital has made competitive advantages nearly obsolete. It has manipulated demand, pushing more people into the college world, without a competitive price decrease, because of government-subsidized debt.
The government’s hand in health care takes on too many forms to count, but between Medicare and Obamacare, heavy subsidization of health care has not led to declining costs. Rather, it has eliminated price discovery, allowing runaway inflation in what is nearly 20 percent of the economy.
Differing inflation levels in different aspects of the economy is the norm and allows us to highlight the economic truth that competition brings prices down while government intervention pushes prices up. There is a reason that unlimited movies are available for $11 per month, whereas the government trifecta of housing, health care, and college has gone the other direction. Recognizing that there are different inflation levels at different times in different silos of the economy is a fundamental part of economic wisdom. The idea that there is such thing as an aggregate price level in the society is highly problematic. For one, if it were true, it would be of no use. The example I have often used is the idea of “national weather” — as if an “average temperature” across the country tells a golfer in Florida what to wear. But furthermore, no such thing exists. Different “time and place” circumstances influence prices in different ways at different times. The greatest inflation we have suffered this generation has come because of the government policy to subsidize that which needs no subsidy. To miss this in one’s analysis is to miss the forest for the trees.
5. The Price Escalations of 2021 Have Many Causes
There is truth to the fact that supply-chain disruptions have been responsible for much of the recent inflation. The fact that President Biden has said it does not make it untrue. But blaming all of the current inflation on the supply chain is just as silly as blaming none of it. Consider just a few of other causes, from pent-up demand that surged in the Covid re-opening to a secular shortage of semiconductor chips to deficiencies in China’s exporting vital products to a labor shortage that caught America by storm to the initial wave of spending post-government payment checks to challenges with American ports and American truck drivers to the 2020 shutdown of rigs in the American shale sector, etc., etc.
All of these things are true, and while I tend to believe the zero-interest-rate policy has had less to do with current inflation, I already acknowledge in contentions No. 1, 2, and 3 where I do take exception to current Fed policy. When the Fed keeps emergency measures on in times of non-emergency, it leaves them with an unloaded gun when a real emergency does surface. I want the Fed to get off the zero-bound, to normalize their balance sheet, and to signal an intention to be less interventionist in the years ahead. I want markets to know that the Fed is not going to distort markets or tilt scales in a way that skews normal production factors. Our primary problem is not an inflation-creating Fed but a market-distorting Fed. This is the point I want to make: not that the Fed should make no changes or that they have done no harm, but rather, that the impetus to change ought to be something far more systemic than even current inflation levels.
I understand the argument that the 2021 spending bill was equivalent to “helicopter money” in the economy. I believe it exacerbated labor shortages by disincentivizing people to work, but I do not believe it is the primary cause of the current inflation. That said, I do believe it will hamper growth for years to come. In other words, I want to get the critique right, and I suggest to readers that the great damage of excessive spending and debt is generational sub-par growth.
* * *
The challenges we face in our economy are made worse by current inflation. We are hearing pleas for the Fed to do something and for the government to do something. We would do well to remember that the same calls will come when a recession surfaces (which it inevitably will). Once we accept that monetary and fiscal policy caused this inflation, it will not be a big stretch to argue that monetary and fiscal policies ought to be the cure for contractionary times as well. We have been in this negative feedback loop for decades, and the result has been a continual boom–bust cycle that is the envy of no one. The Fed’s role as smoother of the business cycle is doing more harm than good. The Keynesian notion that excessive government spending can cure our cyclical problems has run its course. We have an economy in need of a detox.
I see two major economic agendas in front of conservatives: (1) ridding ourselves of the excessive fiscal and monetary interventions that have done so much harm to the economy, and (2) solving for the stagnant economic growth that is exacerbating social divides in our country and suppressing opportunities for today’s middle class, not to mention the generation ahead.
Inflation has been an undesirable and unwelcome entry to this conversation over the last year. Its damage is disproportionately felt by lower-income Americans. It punishes savers. It erodes purchasing power whether it happens quickly or slowly, over time.
Let us not allow the present inflation discussion to blind us to the two agenda items above. What we say now will be used against the cause of real reform in a different economic context. We have structural challenges that must be addressed. I fear too many on the right are so focused on finding the 1970s in present conditions that they may miss out on the chance to really move the needle on the 2020s. If the first couple of years of this decade are any indication, our ideas are going to be needed.