Beat the Press

Beat the press por Dean Baker

Beat the Press is Dean Baker's commentary on economic reporting. He is a Senior Economist at the Center for Economic and Policy Research (CEPR). To never miss a post, subscribe to a weekly email roundup of Beat the Press. Please also consider supporting the blog on Patreon.

I have to say that I was surprised and disappointed by the data in the January Consumer Price Index. I expected to see evidence that some of the sharp runups in the prices of items like cars, clothes, and appliances were starting to be reversed. The idea was that the main factor in these runups was not higher costs of production, but shipping problems, which were being alleviated.

The basis for the belief that shipping problems were being fixed was both anecdotal accounts in the media and also the big increases in retail inventories reported for December. It seems stores had ordered (and received) lots of stuff they couldn’t sell. This is a context in which we might normally expect prices to fall, or at least not rise further.

That turned out not to be the case. The price index for appliances rose 1.5 percent in January and is now 8.5 percent above its year ago level. The index for apparel rose 1.1 percent in the month putting it 5.3 percent above its year ago level. And, used vehicle prices rose 1.5 percent in January, and are now 40.5 percent above year ago levels. So, there is not much of a story of a turnaround there.

There was also a lot of inflation in items not directly connected to the supply chain. Prescription drug prices jumped 1.3 percent, after being pretty much flat the prior year.[1] The health care insurance index, which measures the operating costs and profits of the industry, rose 2.7 percent, the fourth consecutive month with a rise in excess of 1.0 percent. This follows thirteen consecutive months of declines. And rental inflation appears to be accelerating, with the rent proper index rising 0.5 percent and owners’ equivalent rent going up 0.4 percent in the month.

All in all, this is not a good story. Still there were some positive signs. New car prices were flat in January, suggesting that supply may finally have caught up with demand in the sector. They are still up 12.2 percent over the year. The index for rental cars fell 7.0 percent in January, following a 2.7 percent drop the prior month. This indicates that rental companies have managed to rebuild their fleets and will not be an outsized source of demand for new cars going forward. The index still has a way to drop, it is 29.3 percent above its year ago level.

Also, television prices, which I have treated as a canary in the coal mine, fell another 1.4 percent, their fifth consecutive monthly decline. This mostly reverses a 12.0 percent run-up in television prices between March and August, although they are still 2.4 percent above year ago levels. My expectation is that the price of cars, and many other items, in the months ahead will look a lot like television prices, dropping back to levels that are comparable to where they were before the pandemic.

I’ve been saying that for several months now and it has not yet happened. I still think it will, but we shall see. In the meantime, I want to make three points about the inflation we have been seeing to date:

  • Most people are almost certainly enjoying better living standards than they did before the pandemic, ignoring of course the pandemic itself. In other words, the tales of serious deprivation being seen in the media, while undoubtedly true for many families, are not worse or more frequent than what they would have found in 2019, if they had chosen to look.
  • This inflation, unlike the 1970s inflation, is clearly profit driven, not wage driven. While we could end up with the sort of wage-price spiral we saw in the 1970s, we are not there presently. Businesses have raised prices in response to temporary (hopefully) shortages, which has led to higher profits. These profits can fall back if workers regain their income share.
  • There has been an uptick in productivity growth in the last few years. This is in contrast to the 1970s which saw a sharp slowing in productivity growth. This can allow for both higher real wages and higher profits.

 

Have Living Standards Improved?

Most people get most of their income through wages. This would seem to imply that we just need to look at the pattern in real wages over the last year to determine whether people are better off. However, the circumstances of the pandemic make this more difficult than would usually be the case.

The data for the last year are distorted by two factors directly attributable to the pandemic. The first is a composition effect. In 2020 millions of people lost their jobs. The job losers were concentrated at the lower end of the pay scale, which meant that average wages rose simply due to a composition effect. The average wage of the people who still had jobs in 2020 was higher than the average wage of people who were working in 2019.

In 2021 this composition effect was reversed, with most lower-paid workers getting their jobs back. This lowered the average wage in 2021.

There was also a pandemic price effect. The price of many items, most notably gasoline, fell in 2020 as the recession led to a drop in demand. This was reversed in 2021 as the U.S. and world economy grew rapidly.

For these reasons, taking real wage growth in 2021 in isolation gives a misleading picture of wage growth. The more honest route would be to combine the two years and compare real wages today to where they were two years ago. (I know this overlaps presidential terms, but such is life.)

The real average hourly wage has risen by 2.1 percent compared to its January, 2020 level. (It fell 1.7 percent in the last year.) This means that a typical worker’s pay will go 2.1 percent further now than it did in 2020. If most workers were not suffering severe deprivation at the start of 2020, it is not reasonable to claim that they are today.

 

Source: Bureau of Labor Statistics.

Furthermore, the wage gains look better at points lower down the wage ladder. If we look at the average hourly wage for production and non-supervisory workers, a group that excludes most professionals and managers, it rose by 2.5 over the last two years, after adjusting for inflation. For production and non-supervisory workers in retail, the gain in real wage was 3.2 percent over the last two years.

If we look at the lowest paying sectors, workers secured real wage gains even in 2021. Production and non-supervisory workers in convenience stores had a 10.6 gain in real wages during 2021. In hotels workers had a real wage increase of 8.2 percent over the year, and in restaurants the gain was 9.0 percent.

In short, workers at the lower end of the pay scale have generally been doing well the last two years, in spite of the uptick in inflation. It is also worth noting that many have seen their income increase over the last two years due to the various government payments over this period.

In 2020 and 2021, the government sent out a total of $3,200 per person in pandemic checks to the vast majority of adults, with additional payments for dependent children. Unemployed workers received $600 supplements to their unemployment checks for the months from April of 2020 to August of 2020. They then got supplements of $300 per week from January of 2021 until September of last year. As a result of these supplements, many lower paid workers were receiving as much or more in unemployment benefits as they did when they were working.

The American Recovery Act also included an increase in the child tax credit to $3,000 per child and $3,500 for children under age six. Also, unlike the prior tax credit, this benefit was fully refundable, so even the lowest income family could receive the full benefit of the tax credit. While this program expired at the end of 2021, it did put additional money in the pockets of the families who most needed it.

The general structure of the pandemic relief programs was quite progressive. A $1,200 check means much more to someone earning $20,000 a year, than to someone earning $100,000. The same is the case for the expansion of the child tax credit. As a result of these benefits, and the sharp rise in real wages for those at the bottom, lower income households had far more money in their bank accounts during the pandemic than they had previously. 

While middle and higher-income households may have benefitted less from these pandemic payments, and seen smaller gains in real wages, they are also likely doing better in most cases than before the pandemic. Close to ten million people have taken advantage in the plunge in mortgage interest rates to refinance their mortgages, saving an average of more than $2,800 a year in interest payments. This is a substantial savings for a family earning $100,000 a year.

In addition, higher income households were much more likely to benefit from increased opportunities to work from home. The increase in remote work has allowed for tens of billions of in savings from lower commuting costs, dry-cleaning bills, and other work-related expenses. These savings do not appear in the data as a decrease in the cost of living, but if a worker saves $100 a month from not having to pay commuting costs, it is same thing to their budget as if the cost of commuting fell by $100, although in the case of working from home, they also save the time spent commuting.

In short, the data indicate that most people are far better off financially today than they were before the pandemic. This doesn’t mean that tens of millions of people are not struggling. If a family was at the poverty line in 2019, they would still be struggling today even if their income was 10 percent higher.

However, what we can say is that the data does not give us any reason to believe that more people are struggling now than was the case before the pandemic hit. If we are hearing more stories of struggling families, it is because the media have chosen to give us more stories of struggling families, not because of an actual increase in the number of families who can’t make ends meet. 

The Return of the Seventies: Is It a Wage Price Spiral?

The big fear of those of us old enough to remember the 1970s inflation is that we are on a path to a wage-price spiral. This is a story where higher inflation leads workers to demand (and receive) higher wages, which in turn get passed on in still higher prices. This would be a real problem, since it implies a story of ever higher inflation that is likely only broken by a recession, and possibly a very severe recession, like the ones we saw in 1980-82.

There are reasons for believing that this is not the situation we are now seeing. First, our labor market is very different today than in the 1970s, most obviously because it is far less unionized. In the 1970s, close to 30 percent of the private sector workforce belonged to a union.[2] Today the private sector unionization rate is just over 6.0 percent. For this reason, it is not clear that workers would have the bargaining power to sustain a wage-price spiral.

Many of us don’t consider the decline in unionization rates a good thing, but it is the reality. And, it has consequences. We cannot assume that the labor market of 2022 will respond to higher inflation in the same way as the labor market of the 1970s.

The second reason for believing that we are not seeing the beginnings of a 1970 wage-price spiral is that the current inflation is clearly not wage driven. In the 1970s, we were arguably seeing a real profit squeeze, with corporations having difficulty maintaining their profit margins.

That is not the problem we are seeing today. The capital share (profits plus interest) of net corporate income rose from 24.1 percent in the fourth quarter of 2019 to 26.7 percent in the third quarter of 2021, the most recent quarter for which we have data.[3]

This means that businesses can absorb higher labor costs, without passing them on in higher prices, by simply allowing their profit share to return to its pre-pandemic level. There are shortages of many items at present, which allow for price increases. If we think that these shortages will be overcome as supply chain conditions return to normal, then we should expect profit shares to return to something close to their pre-pandemic levels.

This would be true, unless we think that the pandemic has changed conditions of competition in the economy in some fundamental way that favors capital. This is of course a possibility, but it would be necessary to present an argument as to why it would be the case. Otherwise, we should assume that profit shares in a post-pandemic world won’t be very different than profit shares in a pre-pandemic world. This would allow for a substantial increase in wages that is not passed on in higher prices.

The Uptick in Productivity Growth

An important aspect to the 1970s wage-price spiral was a sharp slowdown in productivity growth. For more than a quarter century, from 1947 to 1973, productivity growth averaged almost 2.5 percent annually. From 1973 to 1980 it averaged less than 1.3 percent annually.[4] The rapid productivity growth in the earlier period allowed for annual increases in real wages of more than 2.0 percent.

This pace of wage growth could not be sustained in a context where productivity was only rising 1.3 percent annually. This meant that if workers sought to secure real wage gains that were close to what they had been seeing over the prior quarter century, it had to lead to either higher inflation or a profit squeeze, or both.

We are currently seeing the opposite situation. Productivity growth averaged less than 0.8 percent annually from the fourth quarter of 2010 to the fourth quarter of 2018. In the last three years, it averaged almost 2.3 percent. This allows for considerable room for real wage gains, without leading to higher inflation. The pace of productivity growth over the last four years means that real wages can be almost 7.0 percent higher now than in the fourth quarter of 2018, without leading to either a profit squeeze or an inflationary spiral.

Given economists’ track record in forecasting productivity growth (the 1973 slowdown was almost entirely unforeseen, as have been subsequent changes in trend growth), it would be foolish to predict the future pace of productivity growth, but there are reasons for believing that a more rapid pace of productivity growth could be sustained.

Specifically, the pandemic has forced many businesses to adopt more efficient ways of operating to deal with both fears of contagion and also the difficulty of finding workers. For example, many restaurants rely much more on on-line ordering, which requires less staff time to process orders. If pandemic-induced efficiencies become adopted more widely, it can mean further gains in productivity.

There also will be gains that affect living standards, that will not be picked up in productivity. At the top of this list would be the savings, noted earlier, in commuting expenses from the increase in the number of jobs where people can work from home. However, there have been other efficiencies, such as increased use of telemedicine or other ways in which people can substitute Internet exchanges for in-person contacts.

Whether or not the more rapid pace of productivity growth of the last three years can be sustained going forward, the jump in productivity over this period provides substantial room for wage gains that need not result in higher prices. This is the opposite of the situation we saw in the 1970s, when productivity growth was not fast enough to sustain the rate of wage growth workers to which workers had become accustomed. This difference doesn’t guarantee that we won’t see wage-price spiral, but it is a reason for believing it’s less likely.

Conclusion: Keep the Anti-Inflation Powder Dry

The Federal Reserve Board has indicated that it will soon begin to raise interest rates. It has already started to reverse course on its quantitative easing. These policies make sense in an economy that is both seeing rapid inflation and relatively low unemployment. At present, it does not need a strong boost from the Fed to reach something close to full employment.

However, there is little basis for the inflation-panic that some have been pushing. There are good reasons to believe that inflation is more likely heading lower than higher. This means the Fed should be cautious in its moves and wait to get a clearer picture of the problem it is facing.

[1] It is important to note that the CPI index misses most of the source of the increase in drug costs since it tracks the prices of drugs already on the market. If a new treatment for heart disease or cancer comes on the market at a very high price, it is not picked up in the index.

[2] The private sector unionization rate is the most relevant variable for the wage-price spiral story. Public sector unions are more constrained in their ability to negotiate over wages, and in any case, their wage increases don’t get directly passed on into price increases.

[3] This calculation excludes indirect business taxes, so it refers to the capital share of the income divided between labor and capital.

[4] The link between productivity growth and wage growth is somewhat more complicated, but productivity growth for the nonfarm business sector is a useful first approximation.

I have to say that I was surprised and disappointed by the data in the January Consumer Price Index. I expected to see evidence that some of the sharp runups in the prices of items like cars, clothes, and appliances were starting to be reversed. The idea was that the main factor in these runups was not higher costs of production, but shipping problems, which were being alleviated.

The basis for the belief that shipping problems were being fixed was both anecdotal accounts in the media and also the big increases in retail inventories reported for December. It seems stores had ordered (and received) lots of stuff they couldn’t sell. This is a context in which we might normally expect prices to fall, or at least not rise further.

That turned out not to be the case. The price index for appliances rose 1.5 percent in January and is now 8.5 percent above its year ago level. The index for apparel rose 1.1 percent in the month putting it 5.3 percent above its year ago level. And, used vehicle prices rose 1.5 percent in January, and are now 40.5 percent above year ago levels. So, there is not much of a story of a turnaround there.

There was also a lot of inflation in items not directly connected to the supply chain. Prescription drug prices jumped 1.3 percent, after being pretty much flat the prior year.[1] The health care insurance index, which measures the operating costs and profits of the industry, rose 2.7 percent, the fourth consecutive month with a rise in excess of 1.0 percent. This follows thirteen consecutive months of declines. And rental inflation appears to be accelerating, with the rent proper index rising 0.5 percent and owners’ equivalent rent going up 0.4 percent in the month.

All in all, this is not a good story. Still there were some positive signs. New car prices were flat in January, suggesting that supply may finally have caught up with demand in the sector. They are still up 12.2 percent over the year. The index for rental cars fell 7.0 percent in January, following a 2.7 percent drop the prior month. This indicates that rental companies have managed to rebuild their fleets and will not be an outsized source of demand for new cars going forward. The index still has a way to drop, it is 29.3 percent above its year ago level.

Also, television prices, which I have treated as a canary in the coal mine, fell another 1.4 percent, their fifth consecutive monthly decline. This mostly reverses a 12.0 percent run-up in television prices between March and August, although they are still 2.4 percent above year ago levels. My expectation is that the price of cars, and many other items, in the months ahead will look a lot like television prices, dropping back to levels that are comparable to where they were before the pandemic.

I’ve been saying that for several months now and it has not yet happened. I still think it will, but we shall see. In the meantime, I want to make three points about the inflation we have been seeing to date:

  • Most people are almost certainly enjoying better living standards than they did before the pandemic, ignoring of course the pandemic itself. In other words, the tales of serious deprivation being seen in the media, while undoubtedly true for many families, are not worse or more frequent than what they would have found in 2019, if they had chosen to look.
  • This inflation, unlike the 1970s inflation, is clearly profit driven, not wage driven. While we could end up with the sort of wage-price spiral we saw in the 1970s, we are not there presently. Businesses have raised prices in response to temporary (hopefully) shortages, which has led to higher profits. These profits can fall back if workers regain their income share.
  • There has been an uptick in productivity growth in the last few years. This is in contrast to the 1970s which saw a sharp slowing in productivity growth. This can allow for both higher real wages and higher profits.

 

Have Living Standards Improved?

Most people get most of their income through wages. This would seem to imply that we just need to look at the pattern in real wages over the last year to determine whether people are better off. However, the circumstances of the pandemic make this more difficult than would usually be the case.

The data for the last year are distorted by two factors directly attributable to the pandemic. The first is a composition effect. In 2020 millions of people lost their jobs. The job losers were concentrated at the lower end of the pay scale, which meant that average wages rose simply due to a composition effect. The average wage of the people who still had jobs in 2020 was higher than the average wage of people who were working in 2019.

In 2021 this composition effect was reversed, with most lower-paid workers getting their jobs back. This lowered the average wage in 2021.

There was also a pandemic price effect. The price of many items, most notably gasoline, fell in 2020 as the recession led to a drop in demand. This was reversed in 2021 as the U.S. and world economy grew rapidly.

For these reasons, taking real wage growth in 2021 in isolation gives a misleading picture of wage growth. The more honest route would be to combine the two years and compare real wages today to where they were two years ago. (I know this overlaps presidential terms, but such is life.)

The real average hourly wage has risen by 2.1 percent compared to its January, 2020 level. (It fell 1.7 percent in the last year.) This means that a typical worker’s pay will go 2.1 percent further now than it did in 2020. If most workers were not suffering severe deprivation at the start of 2020, it is not reasonable to claim that they are today.

 

Source: Bureau of Labor Statistics.

Furthermore, the wage gains look better at points lower down the wage ladder. If we look at the average hourly wage for production and non-supervisory workers, a group that excludes most professionals and managers, it rose by 2.5 over the last two years, after adjusting for inflation. For production and non-supervisory workers in retail, the gain in real wage was 3.2 percent over the last two years.

If we look at the lowest paying sectors, workers secured real wage gains even in 2021. Production and non-supervisory workers in convenience stores had a 10.6 gain in real wages during 2021. In hotels workers had a real wage increase of 8.2 percent over the year, and in restaurants the gain was 9.0 percent.

In short, workers at the lower end of the pay scale have generally been doing well the last two years, in spite of the uptick in inflation. It is also worth noting that many have seen their income increase over the last two years due to the various government payments over this period.

In 2020 and 2021, the government sent out a total of $3,200 per person in pandemic checks to the vast majority of adults, with additional payments for dependent children. Unemployed workers received $600 supplements to their unemployment checks for the months from April of 2020 to August of 2020. They then got supplements of $300 per week from January of 2021 until September of last year. As a result of these supplements, many lower paid workers were receiving as much or more in unemployment benefits as they did when they were working.

The American Recovery Act also included an increase in the child tax credit to $3,000 per child and $3,500 for children under age six. Also, unlike the prior tax credit, this benefit was fully refundable, so even the lowest income family could receive the full benefit of the tax credit. While this program expired at the end of 2021, it did put additional money in the pockets of the families who most needed it.

The general structure of the pandemic relief programs was quite progressive. A $1,200 check means much more to someone earning $20,000 a year, than to someone earning $100,000. The same is the case for the expansion of the child tax credit. As a result of these benefits, and the sharp rise in real wages for those at the bottom, lower income households had far more money in their bank accounts during the pandemic than they had previously. 

While middle and higher-income households may have benefitted less from these pandemic payments, and seen smaller gains in real wages, they are also likely doing better in most cases than before the pandemic. Close to ten million people have taken advantage in the plunge in mortgage interest rates to refinance their mortgages, saving an average of more than $2,800 a year in interest payments. This is a substantial savings for a family earning $100,000 a year.

In addition, higher income households were much more likely to benefit from increased opportunities to work from home. The increase in remote work has allowed for tens of billions of in savings from lower commuting costs, dry-cleaning bills, and other work-related expenses. These savings do not appear in the data as a decrease in the cost of living, but if a worker saves $100 a month from not having to pay commuting costs, it is same thing to their budget as if the cost of commuting fell by $100, although in the case of working from home, they also save the time spent commuting.

In short, the data indicate that most people are far better off financially today than they were before the pandemic. This doesn’t mean that tens of millions of people are not struggling. If a family was at the poverty line in 2019, they would still be struggling today even if their income was 10 percent higher.

However, what we can say is that the data does not give us any reason to believe that more people are struggling now than was the case before the pandemic hit. If we are hearing more stories of struggling families, it is because the media have chosen to give us more stories of struggling families, not because of an actual increase in the number of families who can’t make ends meet. 

The Return of the Seventies: Is It a Wage Price Spiral?

The big fear of those of us old enough to remember the 1970s inflation is that we are on a path to a wage-price spiral. This is a story where higher inflation leads workers to demand (and receive) higher wages, which in turn get passed on in still higher prices. This would be a real problem, since it implies a story of ever higher inflation that is likely only broken by a recession, and possibly a very severe recession, like the ones we saw in 1980-82.

There are reasons for believing that this is not the situation we are now seeing. First, our labor market is very different today than in the 1970s, most obviously because it is far less unionized. In the 1970s, close to 30 percent of the private sector workforce belonged to a union.[2] Today the private sector unionization rate is just over 6.0 percent. For this reason, it is not clear that workers would have the bargaining power to sustain a wage-price spiral.

Many of us don’t consider the decline in unionization rates a good thing, but it is the reality. And, it has consequences. We cannot assume that the labor market of 2022 will respond to higher inflation in the same way as the labor market of the 1970s.

The second reason for believing that we are not seeing the beginnings of a 1970 wage-price spiral is that the current inflation is clearly not wage driven. In the 1970s, we were arguably seeing a real profit squeeze, with corporations having difficulty maintaining their profit margins.

That is not the problem we are seeing today. The capital share (profits plus interest) of net corporate income rose from 24.1 percent in the fourth quarter of 2019 to 26.7 percent in the third quarter of 2021, the most recent quarter for which we have data.[3]

This means that businesses can absorb higher labor costs, without passing them on in higher prices, by simply allowing their profit share to return to its pre-pandemic level. There are shortages of many items at present, which allow for price increases. If we think that these shortages will be overcome as supply chain conditions return to normal, then we should expect profit shares to return to something close to their pre-pandemic levels.

This would be true, unless we think that the pandemic has changed conditions of competition in the economy in some fundamental way that favors capital. This is of course a possibility, but it would be necessary to present an argument as to why it would be the case. Otherwise, we should assume that profit shares in a post-pandemic world won’t be very different than profit shares in a pre-pandemic world. This would allow for a substantial increase in wages that is not passed on in higher prices.

The Uptick in Productivity Growth

An important aspect to the 1970s wage-price spiral was a sharp slowdown in productivity growth. For more than a quarter century, from 1947 to 1973, productivity growth averaged almost 2.5 percent annually. From 1973 to 1980 it averaged less than 1.3 percent annually.[4] The rapid productivity growth in the earlier period allowed for annual increases in real wages of more than 2.0 percent.

This pace of wage growth could not be sustained in a context where productivity was only rising 1.3 percent annually. This meant that if workers sought to secure real wage gains that were close to what they had been seeing over the prior quarter century, it had to lead to either higher inflation or a profit squeeze, or both.

We are currently seeing the opposite situation. Productivity growth averaged less than 0.8 percent annually from the fourth quarter of 2010 to the fourth quarter of 2018. In the last three years, it averaged almost 2.3 percent. This allows for considerable room for real wage gains, without leading to higher inflation. The pace of productivity growth over the last four years means that real wages can be almost 7.0 percent higher now than in the fourth quarter of 2018, without leading to either a profit squeeze or an inflationary spiral.

Given economists’ track record in forecasting productivity growth (the 1973 slowdown was almost entirely unforeseen, as have been subsequent changes in trend growth), it would be foolish to predict the future pace of productivity growth, but there are reasons for believing that a more rapid pace of productivity growth could be sustained.

Specifically, the pandemic has forced many businesses to adopt more efficient ways of operating to deal with both fears of contagion and also the difficulty of finding workers. For example, many restaurants rely much more on on-line ordering, which requires less staff time to process orders. If pandemic-induced efficiencies become adopted more widely, it can mean further gains in productivity.

There also will be gains that affect living standards, that will not be picked up in productivity. At the top of this list would be the savings, noted earlier, in commuting expenses from the increase in the number of jobs where people can work from home. However, there have been other efficiencies, such as increased use of telemedicine or other ways in which people can substitute Internet exchanges for in-person contacts.

Whether or not the more rapid pace of productivity growth of the last three years can be sustained going forward, the jump in productivity over this period provides substantial room for wage gains that need not result in higher prices. This is the opposite of the situation we saw in the 1970s, when productivity growth was not fast enough to sustain the rate of wage growth workers to which workers had become accustomed. This difference doesn’t guarantee that we won’t see wage-price spiral, but it is a reason for believing it’s less likely.

Conclusion: Keep the Anti-Inflation Powder Dry

The Federal Reserve Board has indicated that it will soon begin to raise interest rates. It has already started to reverse course on its quantitative easing. These policies make sense in an economy that is both seeing rapid inflation and relatively low unemployment. At present, it does not need a strong boost from the Fed to reach something close to full employment.

However, there is little basis for the inflation-panic that some have been pushing. There are good reasons to believe that inflation is more likely heading lower than higher. This means the Fed should be cautious in its moves and wait to get a clearer picture of the problem it is facing.

[1] It is important to note that the CPI index misses most of the source of the increase in drug costs since it tracks the prices of drugs already on the market. If a new treatment for heart disease or cancer comes on the market at a very high price, it is not picked up in the index.

[2] The private sector unionization rate is the most relevant variable for the wage-price spiral story. Public sector unions are more constrained in their ability to negotiate over wages, and in any case, their wage increases don’t get directly passed on into price increases.

[3] This calculation excludes indirect business taxes, so it refers to the capital share of the income divided between labor and capital.

[4] The link between productivity growth and wage growth is somewhat more complicated, but productivity growth for the nonfarm business sector is a useful first approximation.

We all know about the Trumpers’ big lie: somehow millions of votes were stolen from their hero, but the liberals were so smart in their steal that Trump’s team can’t produce any evidence. That one rightly draws contempt from anyone not in the cult, but what about the big lie that the vast majority of intellectuals seem to accept?

Regular readers know what I am talking about. The big lie is that the massive rise in inequality over the last four decades was somehow the result of the natural workings of the market. The standard position among policy types is that the rise in inequality was simply the result of the development of technology and the process of globalization.

We saw this view on full display in a generally interesting column in today’s NYT by Thomas Edsall. The piece looks at the growth in support for Trump, and right-wing populism more generally, among non-college educated white workers. It cites a number of academics who identify this development as a result of being left behind by economic developments, while Blacks and other minorities are perceived as having increased opportunities.

The key point, that is repeatedly misrepresented in this piece, is that the harm to the working-class in the last four decades was the result of deliberate policy, not something that just happened. For example, the first quote from an academic tells readers:

Education has emerged as a clear cleavage in addition to more traditional indicators of social class. The highly educated fare better in a more globalized world that puts a premium on human capital.”

Note that we are told as a matter of fact that a globalized world leads to a larger wage premium for more educated workers. This is undoubtedly true when the people designing the course of globalization deliberately structured it to put less-educated workers in rich countries in direct competition with low-paid workers in the developing world.

It would likely not be true if globalization had been designed to put doctors, dentists, lawyers, and other highly paid professionals in direct competition with their lower paid counterparts in the developing world. (Yes, we can have testing requirements to ensure they meet rich countries’ standards. Even elites are smart enough to design mechanisms for accomplishing this task.)[1] In other words, we are given as a fact that globalization had to hurt less-educated workers, as opposed to this outcome being a policy choice by the people who crafted trade agreements over the last four decades.

We get another repetition of the big lie a little further down when Edsall discusses the work of Lee Hartwich, Julia C. Becker, and S. Alexander Haslam which finds that neoliberalism can “reduce well-being by promoting a sense of social disconnection, competition, and loneliness.”

It warns of these harms from exposure to neoliberal ideology, which according to Edsall, “they describe as the belief that ‘economies and societies should be organized along the principles of the free market.’”

Edsall is writing this in the middle of a pandemic which has created dozens of billionaires because of government-granted patent monopolies on vaccines, treatments, and other items needed to combat the pandemic, even as millions lost their jobs and struggled with illness.  

These government-granted monopolies are antithetical to a free market. They are a government policy to promote innovation, and arguably a very poor one in the case of the pandemic. But the more basic point is that it is a lie to claim that the neoliberal ideology described by Hartwich, Becker, and Haslam is one that holds that economies and societies should be organized along the principles of the free market. In fact, the ideology is consistent with all sorts of government interventions that have the effect of redistributing income upward.

On the whole, Edsall’s piece does a very good job laying out evidence that US trade policy has been a major factor in breeding the resentments that have led to the rise of Trump and support for racist and authoritarian policies more generally. But a key feature missing from this discussion is the fact that the worsening of the plight of non-college educated workers, to the benefit of more educated workers, was by design. There was nothing inherent to the logic of globalization or development of technology that led to this outcome.

Perhaps one factor in the resentment of white non-college educated workers is that they are repeatedly lied to about the causes of their relative decline in well-being. It might be good if it was more generally acknowledged that they are faring more poorly because we structured policy so that they would fare more poorly. In other words, it was not something that just happened, it was something the elites did to them.

[1] To preempt an obvious complaint, this need not be a brain drain story where the most educated workers leave developing countries. We can design mechanisms where rich countries share their gains by paying to educate two or three professionals for every one that arrives from a developing country. As it stands, many professionals from developing countries already move to rich countries, but there is no compensation.

We all know about the Trumpers’ big lie: somehow millions of votes were stolen from their hero, but the liberals were so smart in their steal that Trump’s team can’t produce any evidence. That one rightly draws contempt from anyone not in the cult, but what about the big lie that the vast majority of intellectuals seem to accept?

Regular readers know what I am talking about. The big lie is that the massive rise in inequality over the last four decades was somehow the result of the natural workings of the market. The standard position among policy types is that the rise in inequality was simply the result of the development of technology and the process of globalization.

We saw this view on full display in a generally interesting column in today’s NYT by Thomas Edsall. The piece looks at the growth in support for Trump, and right-wing populism more generally, among non-college educated white workers. It cites a number of academics who identify this development as a result of being left behind by economic developments, while Blacks and other minorities are perceived as having increased opportunities.

The key point, that is repeatedly misrepresented in this piece, is that the harm to the working-class in the last four decades was the result of deliberate policy, not something that just happened. For example, the first quote from an academic tells readers:

Education has emerged as a clear cleavage in addition to more traditional indicators of social class. The highly educated fare better in a more globalized world that puts a premium on human capital.”

Note that we are told as a matter of fact that a globalized world leads to a larger wage premium for more educated workers. This is undoubtedly true when the people designing the course of globalization deliberately structured it to put less-educated workers in rich countries in direct competition with low-paid workers in the developing world.

It would likely not be true if globalization had been designed to put doctors, dentists, lawyers, and other highly paid professionals in direct competition with their lower paid counterparts in the developing world. (Yes, we can have testing requirements to ensure they meet rich countries’ standards. Even elites are smart enough to design mechanisms for accomplishing this task.)[1] In other words, we are given as a fact that globalization had to hurt less-educated workers, as opposed to this outcome being a policy choice by the people who crafted trade agreements over the last four decades.

We get another repetition of the big lie a little further down when Edsall discusses the work of Lee Hartwich, Julia C. Becker, and S. Alexander Haslam which finds that neoliberalism can “reduce well-being by promoting a sense of social disconnection, competition, and loneliness.”

It warns of these harms from exposure to neoliberal ideology, which according to Edsall, “they describe as the belief that ‘economies and societies should be organized along the principles of the free market.’”

Edsall is writing this in the middle of a pandemic which has created dozens of billionaires because of government-granted patent monopolies on vaccines, treatments, and other items needed to combat the pandemic, even as millions lost their jobs and struggled with illness.  

These government-granted monopolies are antithetical to a free market. They are a government policy to promote innovation, and arguably a very poor one in the case of the pandemic. But the more basic point is that it is a lie to claim that the neoliberal ideology described by Hartwich, Becker, and Haslam is one that holds that economies and societies should be organized along the principles of the free market. In fact, the ideology is consistent with all sorts of government interventions that have the effect of redistributing income upward.

On the whole, Edsall’s piece does a very good job laying out evidence that US trade policy has been a major factor in breeding the resentments that have led to the rise of Trump and support for racist and authoritarian policies more generally. But a key feature missing from this discussion is the fact that the worsening of the plight of non-college educated workers, to the benefit of more educated workers, was by design. There was nothing inherent to the logic of globalization or development of technology that led to this outcome.

Perhaps one factor in the resentment of white non-college educated workers is that they are repeatedly lied to about the causes of their relative decline in well-being. It might be good if it was more generally acknowledged that they are faring more poorly because we structured policy so that they would fare more poorly. In other words, it was not something that just happened, it was something the elites did to them.

[1] To preempt an obvious complaint, this need not be a brain drain story where the most educated workers leave developing countries. We can design mechanisms where rich countries share their gains by paying to educate two or three professionals for every one that arrives from a developing country. As it stands, many professionals from developing countries already move to rich countries, but there is no compensation.

It seems that businesses ordered more goods than they can sell. (Seriously, this is what the piece says.) In the old days, we might have thought that too many goods, with too few buyers, might have meant lower prices. But Marketplace tells us that businesses don’t want to take losses with big price cuts, so they will just store the stuff in warehouses.

Unfortunately, there is a shortage of warehouse space (even with the supply chain problems), so the price of storage is skyrocketing. So, the net effect is further cost pressure, along with higher labor costs.

The bad news just keeps coming.

It seems that businesses ordered more goods than they can sell. (Seriously, this is what the piece says.) In the old days, we might have thought that too many goods, with too few buyers, might have meant lower prices. But Marketplace tells us that businesses don’t want to take losses with big price cuts, so they will just store the stuff in warehouses.

Unfortunately, there is a shortage of warehouse space (even with the supply chain problems), so the price of storage is skyrocketing. So, the net effect is further cost pressure, along with higher labor costs.

The bad news just keeps coming.

With inflation remaining stubbornly high for longer than I, and many others, expected, I want to take another stab at the argument of the inflation hawks. As a jumping off point, I will use the argument put forward by Larry Summers and Jason Furman, probably the two most prominent and coherent economists arguing that we have underestimated the risks of persistently high inflation.[1]

There are three main components to the Summers-Furman (SF) argument. (Their arguments are not identical, so I’m being a bit unfair to both in trying to mash them together.)  The first is that the Biden administration provided excessive stimulus to the economy with the American Recovery Act (ARA) passed by Congress last February. They argue that demand for goods and services far exceeded the economy’s ability to supply them, leading to a sharp uptick in the rate of inflation.

Second, the SF position is that this jump in inflation has unmoored inflationary expectations. While households and businesses had long come to expect low and stable inflation, the surge in inflation we saw in the last year has changed people’s expectations. Just to be clear, this is more Summers’s concern than Furman’s. Also, he views this as a serious risk, but not a necessary outcome from the current situation.

If expectations become unmoored, inflation will be self-perpetuating. Workers will demand higher wages in the expectation that inflation will remain high. Employers who share this expectation will be prepared to pay higher wages, which they will then pass on in higher prices. This will lead to a wage-price spiral like what we saw in the 1970s.

The third key component of the SF argument is that we continue to operate the economy above its potential, adding to inflationary pressures. To prevent further acceleration of inflation we will need to reduce demand in the economy, either with aggressive interest rate hikes from the Fed or contractionary fiscal policy, or some combination.

I’ll take each of these in turn.

Did the ARA Spur Inflation?

The answer to this one is obviously yes. If we had a less ambitious stimulus package, the current inflation rate would almost certainly be lower. But we did get a lot from the ARA, along with the previous CARES Acts passed by Congress in 2020.

These pandemic packages shielded the bulk of the population from the economic effects of the pandemic and the shutdowns. In fact, large portions of the population saw their economic prospects actually improve during the pandemic. J.P. Morgan reports that most households have more money in their bank accounts now than they did before the pandemic, with the lowest income households being the biggest gainers in percentage terms.

The expansion of the child tax credit cut the child poverty rate in half and would likely lead to long-term gains for children in low- and moderate-income families, if left in place. And, the ARA provided a huge boost to the labor market. The 3.9 percent December unemployment rate is close to full employment. The biggest gainers from this tight labor market are lower paid workers who are seeing rapid wage increases. They feel the freedom to quit their jobs and seek out new ones in unprecedented numbers.

While it is undeniable that there were major benefits from the ARA, the question is what price did we pay in higher inflation. The answer is not entirely clear. Inflation has jumped pretty much everywhere in 2021 as the world economy reopened. The 7.0 percent year-over-year rate in the Consumer Price Index (CPI) is higher than for other countries, but not hugely so. The rise in Canada was 4.8 percent, in Germany 5.3 percent, and in the United Kingdom 5.4 percent.

The fact that inflation rose almost everywhere indicates that the United States would have seen a jump in its inflation rate even without the aggressive stimulus in the ARA. The rise is attributable to supply disruptions associated with the rapid reopening from pandemic shutdowns. The price of a wide range of commodities soared in 2021, although in many cases, they have recently fallen back to pre-pandemic levels.

In addition, we have seen a rise in the price of many manufactured products due to supply chain disruptions. This is also partly a result of the worldwide reopening and a massive shift in consumer demand from services to goods. People who couldn’t or wouldn’t go to restaurants or travel because of the pandemic instead bought cars, appliances, and other goods. The flood in demand was more than our supply chains could deliver. (Furman points out this shift to goods was much larger in the US than elsewhere, which he attributes to the size of the stimulus.) As a result, prices of a wide range of products soared.

While this happened everywhere, there seems to have been less of an impact in other countries. Jason Furman compared the core harmonized CPI in the eurozone with the core harmonized CPI over the last two years. He finds a jump of roughly two and a half percentage points in the average annual inflation rate over the last two years in this core index for the United States, compared to roughly half a percentage point for the eurozone. This suggests that the inflation from reopening in the US was far more than in Europe.

This view is complicated somewhat by the issue with new and used vehicles. These two components added 1.5 percentage points to the overall inflation rate in 2021 and 1.9 percentage points to the core rate. (In 2020, the vehicle contribution to inflation was 0.3 percentage points overall and 0.4 percentage points in the core.) This means that if we pulled out vehicles, most of the gap in the rise inflation rates would disappear.

The cause for the huge jump in vehicle prices is primarily a shortage of semiconductors due to a fire in a Japanese factory, not excessive demand. We would likely have seen a sharp jump in vehicle prices even without any major stimulus from the ARA.

Of course, pulling out vehicles does not make for an entirely apples-to-apples comparison. The European Union countries buy cars too, although their weight in the index is likely far lower than in the US. One important item to note is that the CPI uses a gross rather than net measure for used car sales to determine their weight in the index.[2] The difference is the money that is paid to households for selling their used cars.

As a result, the weight of used vehicles is far higher in the CPI than in the personal consumption expenditure deflator (PCE), which uses the net measure. In December of 2021, the CPI weight was 3.42 percent. By contrast, used vehicles had a weight of 1.65 percent in the PCE for November, the most recent month available.

Ordinarily, this difference would not matter much, but when used vehicles are rising at an annual rate of 37.3 percent, it matters. The use of the gross sales weighting added 0.4 percentage point to the overall CPI in 2021 and 0.5 percentage point to the core measure.

The takeaway is that taking out vehicles would pull out some of the difference in the jump in core inflation rates that Furman shows, but not all of it. The rise in vehicle prices added roughly 1.2 percentage points to the average core inflation rate over the last two years. If we say that the weight in the EU index is half as large, then this would explain 0.6 percentage points of the gap, leaving roughly 1.4 percentage points to be explained by other factors. With the core CPI accounting for just under 80 percent of the overall index, this would imply that roughly 1.1 percentage points of the higher inflation rate in the US is attributable to factors that are not common to the EU and the US.

To sum up, it’s clear that we would have seen a jump in the inflation rate in 2021 due to the economy reopening, even without the boost from the ARA. The data from the EU, where most countries did not have a comparable stimulus package, implies that the increase in the inflation rate would have been 1.0 to 2.0 percentage points less if we did not have a major stimulus/recovery package in 2021.

Expectations

Far more important than the causes of the inflation in 2021 is the question of its impact on expectations of future inflation. If the economy is to see a 1970s wage-price spiral, it would mean that people had come to expect that high inflation will persist, rather than being just a one-time jump. This does not seem to be the case.

The breakeven inflation rates for inflation-indexed bonds and standard Treasury bonds have risen only modestly. As of January 26, the breakeven inflation rate for the 10-year Treasury bonds was 2.4 percent. This is roughly 0.2 percentage points higher than the peaks in 2018, a period when few people were worried about runaway inflation. Given the differences between the CPI and core PCE that the Federal Reserve Board targets, it is also roughly consistent with the Fed’s long-run 2.0 percent average inflation target.

The breakeven rate for 5-year Treasury bonds was 2.78 percent, this compares to 2018 peaks of 2.15 percent. The higher breakeven rate for the 5-year Treasury bonds is primarily due to the high current inflation rate. However, it is very much consistent with the expectation that inflation will quickly be falling back to the rates we had been seeing prior to the pandemic.

These breakeven rates are very important for the argument that expectations of inflation have become unmoored since the financial markets are daily giving us a measure of what investors expect. Financial markets can, of course, be wrong, as was the case with the stock bubble in the 1990s and the housing bubbles in the 2000s, but the question here is what is expected, not what the future will actually hold.

It is hard to believe that the people investing in financial markets hold qualitatively different views about inflation than the people running businesses, who are making decisions on wage increases and prices. There is a huge amount of overlap in these groups, and they are in constant contact. If expectations of inflation had become unmoored, we should be seeing more evidence of this fact in the bond market.

In this respect, it’s worth noting that the breakeven rates are not even moving in the right direction for this view. The 5-year breakeven rate peaked at almost 3.2 percent in mid-November and has since then trended downward. The breakeven rate on the 10-year Treasury peaked at over 2.7 percent at roughly the same time. This means that the additional data on inflation over the last two months has not contributed to rising expectations of inflation.

There is an important qualification to this trend in inflation expectations. The Fed has begun to take a notably more aggressive stance towards inflation over this period, with a high probability of multiple interest rates hikes in 2022. This change in stance likely helped to reduce inflationary expectations, but it still implies that financial markets are confident that, with the expected course of Fed actions, inflation will remain contained.  

There is one other point worth noting on the expectations issue. In the 1970s, the dollar fell in value against the currencies of our trading partners. In a simple story, where everything else is held equal, we would expect the value of the dollar to fall if our inflation rate exceeds the inflation rate of our trading partners.

The idea is that if inflation is 10 percentage points higher in the US over the next five years than in the eurozone, then we would expect the dollar to fall by roughly 10 percent against the euro to maintain the relative price differentials between goods produced in the US and Europe. The real world is, of course, much more complicated, and there are large divergences in currency values from what would be needed to maintain this sort of purchasing power parity.

However, it is worth noting that the value of the dollar has risen sharply over the last year, rising more than 6.0 percent against the euro. This rise is hardly conclusive, but it does not indicate investors expect inflation in the US to far exceed inflation in the eurozone over the near-term future.

Are We Above Potential GDP?

The final key issue is whether the economy is currently operating above its potential and therefore, likely to be subject to additional inflationary pressures going forward, rather than just facing the risk that the inflation from 2021 is being locked in due to expectations. The basic argument for being above potential is that GDP in the fourth quarter was 3.1 percent above the level in the fourth quarter of 2019, even though we have 2.9 million fewer people working. If we were producing near the economy’s potential in 2019, then we must be above it now.

A closer look shows a more ambiguous picture. While employment is down by 1.8 percent from the fourth quarter of 2019, hours worked have fallen much less. The index of aggregate hours from the establishment survey was down just 0.7 percent from its level in the fourth quarter of 2019. The reason for the difference is an increase in the length of the average workweek from 34.3 hours in the fourth quarter of 2019 to 34.7 hours in the fourth quarter of last year.

It could be argued that this increase in average hours is not sustainable, that people will come to resent working extra hours and stop doing it. However, there is a big factor arguing in the opposite direction. Spencer Hill, in an analysis for Goldman Sachs, calculates that the increase in people working from home is saving 600 million hours a month in commuting time.[3] This translates into an average per worker savings in commuting time of 3.8 hours a month, or 0.9 hours per week. The rise of 0.4 hours in the length of the average workweek comes to less than half of this savings.

There are huge differences in hours and work experiences across the workforce, but it hardly seems implausible that a worker who formerly spent 8 to 10 hours a week commuting would be entirely comfortable putting in 4 to 5 more hours each week working at home than they did previously at the office. The extent to which time saved commuting translates into increased hours of work remains to be seen (as opposed to more leisure), but presumably it is not zero.

We also need to make an adjustment to the hours index for the increase in the number of people who report being self-employed and therefore are not counted in the establishment data. This figure was almost 400,000 higher (combining incorporated and non-incorporated self-employed) in the fourth quarter of 2021 than the fourth quarter of 2019. If we assume the self-employed put in the same number of hours on average as payroll employees, this reduces the drop in total hours over these two years to just 0.4 percent.

With GDP 3.1 percent higher than in the fourth quarter of 2019 and hours worked 0.4 percent lower, the implied increase in productivity is 3.5 percent. That implies annual productivity growth of a bit less than 1.8 percent. This is higher than the 1.5 percent annual rate in the three years prior to the pandemic, but not hugely so.

It is also possible to identify efficiency gains associated with the pandemic that could account for more rapid productivity growth in the last two years. At the top of this list is business travel. The money spent on business travel in the United States fell from $291 billion in 2019 to $131 billion in 2020, and then rebounded slightly to $157 billion in 2021.   

Business travel is, in effect, an expense of doing business, like the steel used to construct an office building or the energy used to power a factory. If companies can produce the same output with less business travel, it is effectively an increase in productivity, just as if they needed less steel to put up a building or less energy to operate their factories.

While it may be the case that businesses are actually less productive as a result of the decline in business travel, it is reasonable to believe that this is not the case. As it stands, we are producing a slightly higher level of GDP with much less business travel. (It’s possible there will be some long-term effect where we see smaller productivity gains in future years because of less person-to-person contact, but we’ll have to hold off in assessing that one.)

Anyhow, it might go against our economist instincts to think that companies would needlessly waste money sending their employees flying around the country and the world, but it is at least possible that this is the case. If we treat the reduction in travel as eliminating waste, then we went from spending 1.5 percent of GDP on business travel to 0.8 percent of GDP in 2021, implying a gain in productivity from this pandemic induced innovation of 0.7 percentage points, equivalent to 0.4 percentage points of annual growth over the last two years. This change alone could fill the gap between the implied productivity growth of the last two years and the average rate for the three years prior to the pandemic.[4]

While there are big question marks here on the extent to which longer hours can be maintained and the impact of reduced business travel on longer term productivity, it is at least plausible that these factors can allow for the increase in output we have seen over the last two years without overburdening the economy.

It is also worth mentioning that we will likely see further gains in labor supply if we can bring the pandemic under control. In December, 1.1 million people reported that they were not working or looking for work because of the pandemic. They were either sick with COVID-19, caring for a family member who was sick, or worried about catching the disease. If the pandemic is brought under control, most of these people will presumably come back into the labor market. We also see many people unable to work for part of the month, because they had COVID-19 or had to care for family members who were sick.

If we can bring the pandemic under control in the months ahead, it should lead to a substantial expansion in the labor supply. It will also be good for people’s health and lives.

The Path Forward: Back to Normal

While it is difficult to know when the supply chain problems will ease, it is not hard to identify their impact. The Bureau of Labor Statistics reports that the price index for final demand for transportation and warehousing services rose 16.6 percent last year. This is a cost that gets factored into the price of just about everything.

One example that shows the impact clearly is apparel. The index for apparel prices in the CPI rose 5.8 percent last year. The overwhelming majority of our apparel is imported, most of it from developing countries like China and Bangladesh. The index for the price of imports of apparel rose by 1.5 percent over the last year.

Presumably, most of the 4.3 percentage gap between the CPI index and the import price index is explained by higher transportation costs. If we can expect that at some point in 2022 that these supply chain problems will be overcome, then not only will apparel prices stop rising, but much of their increase in the last year will be reversed.

That should not sound far-fetched. We already have a great example where we saw exactly this sort of story. Television prices fell 6.5 percent from August to December after rising 10.2 percent from March to August. Prior to their run-up in the spring and summer, the index for television prices had been consistently falling for decades.

It seems plausible that there will be many other items, most notably new and used vehicles, where we will see a similar price trajectory to what we saw with televisions. The price increases of the last year may not be fully reversed, but it is more likely that the price of many of these items will be going down in 2022 rather than rising further.

Clearly, much hinges on getting this story right. No one would want to see the sort of wage-price spiral that we saw in the 1970s. But, we also don’t want to see anything like the surge in unemployment from the 1981–82 recession, especially if it’s intended to combat an inflation problem that does not exist.

[1] Jason Furman and Larry Summers gave me very useful comments on an earlier draft of this post.

[2] The Bureau of Labor Statistics article on the harmonized index just gives an aggregate weight for transportation. It appears that the harmonized index applies the gross measure for the United States, although it is not clear from the article which weight is used since the transportation index doesn’t match up with the category in the CPI news release.

[3] Goldman Sachs, 2022. “U.S. Economics Analyst: Productivity Gains Will Outlast the Pandemic,” January 16,2022.

[4] To make this entirely comparable, we would need to also take account of increased spending on Zoom and other services that were needed as a result of the increase in people working from home.

With inflation remaining stubbornly high for longer than I, and many others, expected, I want to take another stab at the argument of the inflation hawks. As a jumping off point, I will use the argument put forward by Larry Summers and Jason Furman, probably the two most prominent and coherent economists arguing that we have underestimated the risks of persistently high inflation.[1]

There are three main components to the Summers-Furman (SF) argument. (Their arguments are not identical, so I’m being a bit unfair to both in trying to mash them together.)  The first is that the Biden administration provided excessive stimulus to the economy with the American Recovery Act (ARA) passed by Congress last February. They argue that demand for goods and services far exceeded the economy’s ability to supply them, leading to a sharp uptick in the rate of inflation.

Second, the SF position is that this jump in inflation has unmoored inflationary expectations. While households and businesses had long come to expect low and stable inflation, the surge in inflation we saw in the last year has changed people’s expectations. Just to be clear, this is more Summers’s concern than Furman’s. Also, he views this as a serious risk, but not a necessary outcome from the current situation.

If expectations become unmoored, inflation will be self-perpetuating. Workers will demand higher wages in the expectation that inflation will remain high. Employers who share this expectation will be prepared to pay higher wages, which they will then pass on in higher prices. This will lead to a wage-price spiral like what we saw in the 1970s.

The third key component of the SF argument is that we continue to operate the economy above its potential, adding to inflationary pressures. To prevent further acceleration of inflation we will need to reduce demand in the economy, either with aggressive interest rate hikes from the Fed or contractionary fiscal policy, or some combination.

I’ll take each of these in turn.

Did the ARA Spur Inflation?

The answer to this one is obviously yes. If we had a less ambitious stimulus package, the current inflation rate would almost certainly be lower. But we did get a lot from the ARA, along with the previous CARES Acts passed by Congress in 2020.

These pandemic packages shielded the bulk of the population from the economic effects of the pandemic and the shutdowns. In fact, large portions of the population saw their economic prospects actually improve during the pandemic. J.P. Morgan reports that most households have more money in their bank accounts now than they did before the pandemic, with the lowest income households being the biggest gainers in percentage terms.

The expansion of the child tax credit cut the child poverty rate in half and would likely lead to long-term gains for children in low- and moderate-income families, if left in place. And, the ARA provided a huge boost to the labor market. The 3.9 percent December unemployment rate is close to full employment. The biggest gainers from this tight labor market are lower paid workers who are seeing rapid wage increases. They feel the freedom to quit their jobs and seek out new ones in unprecedented numbers.

While it is undeniable that there were major benefits from the ARA, the question is what price did we pay in higher inflation. The answer is not entirely clear. Inflation has jumped pretty much everywhere in 2021 as the world economy reopened. The 7.0 percent year-over-year rate in the Consumer Price Index (CPI) is higher than for other countries, but not hugely so. The rise in Canada was 4.8 percent, in Germany 5.3 percent, and in the United Kingdom 5.4 percent.

The fact that inflation rose almost everywhere indicates that the United States would have seen a jump in its inflation rate even without the aggressive stimulus in the ARA. The rise is attributable to supply disruptions associated with the rapid reopening from pandemic shutdowns. The price of a wide range of commodities soared in 2021, although in many cases, they have recently fallen back to pre-pandemic levels.

In addition, we have seen a rise in the price of many manufactured products due to supply chain disruptions. This is also partly a result of the worldwide reopening and a massive shift in consumer demand from services to goods. People who couldn’t or wouldn’t go to restaurants or travel because of the pandemic instead bought cars, appliances, and other goods. The flood in demand was more than our supply chains could deliver. (Furman points out this shift to goods was much larger in the US than elsewhere, which he attributes to the size of the stimulus.) As a result, prices of a wide range of products soared.

While this happened everywhere, there seems to have been less of an impact in other countries. Jason Furman compared the core harmonized CPI in the eurozone with the core harmonized CPI over the last two years. He finds a jump of roughly two and a half percentage points in the average annual inflation rate over the last two years in this core index for the United States, compared to roughly half a percentage point for the eurozone. This suggests that the inflation from reopening in the US was far more than in Europe.

This view is complicated somewhat by the issue with new and used vehicles. These two components added 1.5 percentage points to the overall inflation rate in 2021 and 1.9 percentage points to the core rate. (In 2020, the vehicle contribution to inflation was 0.3 percentage points overall and 0.4 percentage points in the core.) This means that if we pulled out vehicles, most of the gap in the rise inflation rates would disappear.

The cause for the huge jump in vehicle prices is primarily a shortage of semiconductors due to a fire in a Japanese factory, not excessive demand. We would likely have seen a sharp jump in vehicle prices even without any major stimulus from the ARA.

Of course, pulling out vehicles does not make for an entirely apples-to-apples comparison. The European Union countries buy cars too, although their weight in the index is likely far lower than in the US. One important item to note is that the CPI uses a gross rather than net measure for used car sales to determine their weight in the index.[2] The difference is the money that is paid to households for selling their used cars.

As a result, the weight of used vehicles is far higher in the CPI than in the personal consumption expenditure deflator (PCE), which uses the net measure. In December of 2021, the CPI weight was 3.42 percent. By contrast, used vehicles had a weight of 1.65 percent in the PCE for November, the most recent month available.

Ordinarily, this difference would not matter much, but when used vehicles are rising at an annual rate of 37.3 percent, it matters. The use of the gross sales weighting added 0.4 percentage point to the overall CPI in 2021 and 0.5 percentage point to the core measure.

The takeaway is that taking out vehicles would pull out some of the difference in the jump in core inflation rates that Furman shows, but not all of it. The rise in vehicle prices added roughly 1.2 percentage points to the average core inflation rate over the last two years. If we say that the weight in the EU index is half as large, then this would explain 0.6 percentage points of the gap, leaving roughly 1.4 percentage points to be explained by other factors. With the core CPI accounting for just under 80 percent of the overall index, this would imply that roughly 1.1 percentage points of the higher inflation rate in the US is attributable to factors that are not common to the EU and the US.

To sum up, it’s clear that we would have seen a jump in the inflation rate in 2021 due to the economy reopening, even without the boost from the ARA. The data from the EU, where most countries did not have a comparable stimulus package, implies that the increase in the inflation rate would have been 1.0 to 2.0 percentage points less if we did not have a major stimulus/recovery package in 2021.

Expectations

Far more important than the causes of the inflation in 2021 is the question of its impact on expectations of future inflation. If the economy is to see a 1970s wage-price spiral, it would mean that people had come to expect that high inflation will persist, rather than being just a one-time jump. This does not seem to be the case.

The breakeven inflation rates for inflation-indexed bonds and standard Treasury bonds have risen only modestly. As of January 26, the breakeven inflation rate for the 10-year Treasury bonds was 2.4 percent. This is roughly 0.2 percentage points higher than the peaks in 2018, a period when few people were worried about runaway inflation. Given the differences between the CPI and core PCE that the Federal Reserve Board targets, it is also roughly consistent with the Fed’s long-run 2.0 percent average inflation target.

The breakeven rate for 5-year Treasury bonds was 2.78 percent, this compares to 2018 peaks of 2.15 percent. The higher breakeven rate for the 5-year Treasury bonds is primarily due to the high current inflation rate. However, it is very much consistent with the expectation that inflation will quickly be falling back to the rates we had been seeing prior to the pandemic.

These breakeven rates are very important for the argument that expectations of inflation have become unmoored since the financial markets are daily giving us a measure of what investors expect. Financial markets can, of course, be wrong, as was the case with the stock bubble in the 1990s and the housing bubbles in the 2000s, but the question here is what is expected, not what the future will actually hold.

It is hard to believe that the people investing in financial markets hold qualitatively different views about inflation than the people running businesses, who are making decisions on wage increases and prices. There is a huge amount of overlap in these groups, and they are in constant contact. If expectations of inflation had become unmoored, we should be seeing more evidence of this fact in the bond market.

In this respect, it’s worth noting that the breakeven rates are not even moving in the right direction for this view. The 5-year breakeven rate peaked at almost 3.2 percent in mid-November and has since then trended downward. The breakeven rate on the 10-year Treasury peaked at over 2.7 percent at roughly the same time. This means that the additional data on inflation over the last two months has not contributed to rising expectations of inflation.

There is an important qualification to this trend in inflation expectations. The Fed has begun to take a notably more aggressive stance towards inflation over this period, with a high probability of multiple interest rates hikes in 2022. This change in stance likely helped to reduce inflationary expectations, but it still implies that financial markets are confident that, with the expected course of Fed actions, inflation will remain contained.  

There is one other point worth noting on the expectations issue. In the 1970s, the dollar fell in value against the currencies of our trading partners. In a simple story, where everything else is held equal, we would expect the value of the dollar to fall if our inflation rate exceeds the inflation rate of our trading partners.

The idea is that if inflation is 10 percentage points higher in the US over the next five years than in the eurozone, then we would expect the dollar to fall by roughly 10 percent against the euro to maintain the relative price differentials between goods produced in the US and Europe. The real world is, of course, much more complicated, and there are large divergences in currency values from what would be needed to maintain this sort of purchasing power parity.

However, it is worth noting that the value of the dollar has risen sharply over the last year, rising more than 6.0 percent against the euro. This rise is hardly conclusive, but it does not indicate investors expect inflation in the US to far exceed inflation in the eurozone over the near-term future.

Are We Above Potential GDP?

The final key issue is whether the economy is currently operating above its potential and therefore, likely to be subject to additional inflationary pressures going forward, rather than just facing the risk that the inflation from 2021 is being locked in due to expectations. The basic argument for being above potential is that GDP in the fourth quarter was 3.1 percent above the level in the fourth quarter of 2019, even though we have 2.9 million fewer people working. If we were producing near the economy’s potential in 2019, then we must be above it now.

A closer look shows a more ambiguous picture. While employment is down by 1.8 percent from the fourth quarter of 2019, hours worked have fallen much less. The index of aggregate hours from the establishment survey was down just 0.7 percent from its level in the fourth quarter of 2019. The reason for the difference is an increase in the length of the average workweek from 34.3 hours in the fourth quarter of 2019 to 34.7 hours in the fourth quarter of last year.

It could be argued that this increase in average hours is not sustainable, that people will come to resent working extra hours and stop doing it. However, there is a big factor arguing in the opposite direction. Spencer Hill, in an analysis for Goldman Sachs, calculates that the increase in people working from home is saving 600 million hours a month in commuting time.[3] This translates into an average per worker savings in commuting time of 3.8 hours a month, or 0.9 hours per week. The rise of 0.4 hours in the length of the average workweek comes to less than half of this savings.

There are huge differences in hours and work experiences across the workforce, but it hardly seems implausible that a worker who formerly spent 8 to 10 hours a week commuting would be entirely comfortable putting in 4 to 5 more hours each week working at home than they did previously at the office. The extent to which time saved commuting translates into increased hours of work remains to be seen (as opposed to more leisure), but presumably it is not zero.

We also need to make an adjustment to the hours index for the increase in the number of people who report being self-employed and therefore are not counted in the establishment data. This figure was almost 400,000 higher (combining incorporated and non-incorporated self-employed) in the fourth quarter of 2021 than the fourth quarter of 2019. If we assume the self-employed put in the same number of hours on average as payroll employees, this reduces the drop in total hours over these two years to just 0.4 percent.

With GDP 3.1 percent higher than in the fourth quarter of 2019 and hours worked 0.4 percent lower, the implied increase in productivity is 3.5 percent. That implies annual productivity growth of a bit less than 1.8 percent. This is higher than the 1.5 percent annual rate in the three years prior to the pandemic, but not hugely so.

It is also possible to identify efficiency gains associated with the pandemic that could account for more rapid productivity growth in the last two years. At the top of this list is business travel. The money spent on business travel in the United States fell from $291 billion in 2019 to $131 billion in 2020, and then rebounded slightly to $157 billion in 2021.   

Business travel is, in effect, an expense of doing business, like the steel used to construct an office building or the energy used to power a factory. If companies can produce the same output with less business travel, it is effectively an increase in productivity, just as if they needed less steel to put up a building or less energy to operate their factories.

While it may be the case that businesses are actually less productive as a result of the decline in business travel, it is reasonable to believe that this is not the case. As it stands, we are producing a slightly higher level of GDP with much less business travel. (It’s possible there will be some long-term effect where we see smaller productivity gains in future years because of less person-to-person contact, but we’ll have to hold off in assessing that one.)

Anyhow, it might go against our economist instincts to think that companies would needlessly waste money sending their employees flying around the country and the world, but it is at least possible that this is the case. If we treat the reduction in travel as eliminating waste, then we went from spending 1.5 percent of GDP on business travel to 0.8 percent of GDP in 2021, implying a gain in productivity from this pandemic induced innovation of 0.7 percentage points, equivalent to 0.4 percentage points of annual growth over the last two years. This change alone could fill the gap between the implied productivity growth of the last two years and the average rate for the three years prior to the pandemic.[4]

While there are big question marks here on the extent to which longer hours can be maintained and the impact of reduced business travel on longer term productivity, it is at least plausible that these factors can allow for the increase in output we have seen over the last two years without overburdening the economy.

It is also worth mentioning that we will likely see further gains in labor supply if we can bring the pandemic under control. In December, 1.1 million people reported that they were not working or looking for work because of the pandemic. They were either sick with COVID-19, caring for a family member who was sick, or worried about catching the disease. If the pandemic is brought under control, most of these people will presumably come back into the labor market. We also see many people unable to work for part of the month, because they had COVID-19 or had to care for family members who were sick.

If we can bring the pandemic under control in the months ahead, it should lead to a substantial expansion in the labor supply. It will also be good for people’s health and lives.

The Path Forward: Back to Normal

While it is difficult to know when the supply chain problems will ease, it is not hard to identify their impact. The Bureau of Labor Statistics reports that the price index for final demand for transportation and warehousing services rose 16.6 percent last year. This is a cost that gets factored into the price of just about everything.

One example that shows the impact clearly is apparel. The index for apparel prices in the CPI rose 5.8 percent last year. The overwhelming majority of our apparel is imported, most of it from developing countries like China and Bangladesh. The index for the price of imports of apparel rose by 1.5 percent over the last year.

Presumably, most of the 4.3 percentage gap between the CPI index and the import price index is explained by higher transportation costs. If we can expect that at some point in 2022 that these supply chain problems will be overcome, then not only will apparel prices stop rising, but much of their increase in the last year will be reversed.

That should not sound far-fetched. We already have a great example where we saw exactly this sort of story. Television prices fell 6.5 percent from August to December after rising 10.2 percent from March to August. Prior to their run-up in the spring and summer, the index for television prices had been consistently falling for decades.

It seems plausible that there will be many other items, most notably new and used vehicles, where we will see a similar price trajectory to what we saw with televisions. The price increases of the last year may not be fully reversed, but it is more likely that the price of many of these items will be going down in 2022 rather than rising further.

Clearly, much hinges on getting this story right. No one would want to see the sort of wage-price spiral that we saw in the 1970s. But, we also don’t want to see anything like the surge in unemployment from the 1981–82 recession, especially if it’s intended to combat an inflation problem that does not exist.

[1] Jason Furman and Larry Summers gave me very useful comments on an earlier draft of this post.

[2] The Bureau of Labor Statistics article on the harmonized index just gives an aggregate weight for transportation. It appears that the harmonized index applies the gross measure for the United States, although it is not clear from the article which weight is used since the transportation index doesn’t match up with the category in the CPI news release.

[3] Goldman Sachs, 2022. “U.S. Economics Analyst: Productivity Gains Will Outlast the Pandemic,” January 16,2022.

[4] To make this entirely comparable, we would need to also take account of increased spending on Zoom and other services that were needed as a result of the increase in people working from home.

Pretty much everyone looking at the 4th quarter GDP report (including me) noted that a surge in inventories was responsible for 4.9 percentage points of the 6.9 percent growth in the quarter. But, the Washington Post had a unique take, it told readers that inventories didn’t actually rise, it was simply that prices were higher:

“Thursday’s GDP report noted that private inventory investment from motor vehicle dealers was a leading contributor to growth in the final three months of 2021. But that doesn’t mean that dealerships have been able to fill up their lots and catch up with consumer demand. Rather, Jonathan Smoke, chief economist at Cox Automotive, noted that the models themselves have gone up in value as car prices surge higher and higher.

“‘The real driver of the retail inventory measurement was the dollar value, driven by new vehicle price inflation,’ Smoke said. ‘This does not mean that real unit inventories are up substantially — they are not.'”

It’s not clear what the Washington Post is referring to. The 6.9 percent growth in GDP report, and the 4.9 percentage contribution of inventories is also in real terms. This means that its measure of inventories for cars is adjusted for inflation. Price adjustments are never perfect, but the Commerce Department realizes that car prices have risen.

Pretty much everyone looking at the 4th quarter GDP report (including me) noted that a surge in inventories was responsible for 4.9 percentage points of the 6.9 percent growth in the quarter. But, the Washington Post had a unique take, it told readers that inventories didn’t actually rise, it was simply that prices were higher:

“Thursday’s GDP report noted that private inventory investment from motor vehicle dealers was a leading contributor to growth in the final three months of 2021. But that doesn’t mean that dealerships have been able to fill up their lots and catch up with consumer demand. Rather, Jonathan Smoke, chief economist at Cox Automotive, noted that the models themselves have gone up in value as car prices surge higher and higher.

“‘The real driver of the retail inventory measurement was the dollar value, driven by new vehicle price inflation,’ Smoke said. ‘This does not mean that real unit inventories are up substantially — they are not.'”

It’s not clear what the Washington Post is referring to. The 6.9 percent growth in GDP report, and the 4.9 percentage contribution of inventories is also in real terms. This means that its measure of inventories for cars is adjusted for inflation. Price adjustments are never perfect, but the Commerce Department realizes that car prices have risen.

Yes, that was the clear meaning of a front page article telling readers how bad things are for workers today. The piece told us:

“In interviews with more than a dozen workers, many said that despite considerable pay raises — as much as 33 percent, in some cases — they were still struggling to cover basic expenses. Several workers said they had taken second jobs to keep up with rising costs for groceries, gas and rent. And many said their budgets will be even more strained once student loan payments resume in May.”

Of course, the Washington Post was trying to tell us how bad things are now, under President Biden, not how bad they were two years ago when Donald Trump was still in the White House. But fans of arithmetic can easily determine that however horrible things might be now for workers, they were worse two years ago when real wages were lower for the vast majority of workers.

The chart below shows the change in real wages over the last two years for the same industry categories featured in the Washington Post article.

 

Source: Bureau of Labor Statistics.

 

As can be seen, real wages rose over these two years in all but three industries, manufacturing, construction, and mining and logging. Together, these three industries account for just over 14 percent of total employment.

While workers in these sectors saw declines in real wages over the last two years, workers in all other sectors on average have higher real wages today than they did two years ago. In many cases, the real wage is substantially higher. For example, in retail trade, the real average hourly wage is 3.4 percent higher. In the financial activities sector, it is 3.6 percent higher, and in the huge leisure and hospitality sector, which employs more than 15.7 million workers, wages are up by 7.3 percent.

This means that if workers are experiencing serious hardship today, things must have been really awful for them in December of 2019 when most workers had lower real wages. I don’t believe the Washington Post had front page pieces making this point at the time.

It is worth commenting on the use of two-year wage growth rather than the last year. There was a large composition effect that raised wages in 2020 when many low-paid workers were laid off. The composition effect went in the opposite direction, lowering average wages in 2021 when these low-paid workers were rehired.

This is the reason why honest analysts look at the two years together, not just 2021 in isolation.        

Yes, that was the clear meaning of a front page article telling readers how bad things are for workers today. The piece told us:

“In interviews with more than a dozen workers, many said that despite considerable pay raises — as much as 33 percent, in some cases — they were still struggling to cover basic expenses. Several workers said they had taken second jobs to keep up with rising costs for groceries, gas and rent. And many said their budgets will be even more strained once student loan payments resume in May.”

Of course, the Washington Post was trying to tell us how bad things are now, under President Biden, not how bad they were two years ago when Donald Trump was still in the White House. But fans of arithmetic can easily determine that however horrible things might be now for workers, they were worse two years ago when real wages were lower for the vast majority of workers.

The chart below shows the change in real wages over the last two years for the same industry categories featured in the Washington Post article.

 

Source: Bureau of Labor Statistics.

 

As can be seen, real wages rose over these two years in all but three industries, manufacturing, construction, and mining and logging. Together, these three industries account for just over 14 percent of total employment.

While workers in these sectors saw declines in real wages over the last two years, workers in all other sectors on average have higher real wages today than they did two years ago. In many cases, the real wage is substantially higher. For example, in retail trade, the real average hourly wage is 3.4 percent higher. In the financial activities sector, it is 3.6 percent higher, and in the huge leisure and hospitality sector, which employs more than 15.7 million workers, wages are up by 7.3 percent.

This means that if workers are experiencing serious hardship today, things must have been really awful for them in December of 2019 when most workers had lower real wages. I don’t believe the Washington Post had front page pieces making this point at the time.

It is worth commenting on the use of two-year wage growth rather than the last year. There was a large composition effect that raised wages in 2020 when many low-paid workers were laid off. The composition effect went in the opposite direction, lowering average wages in 2021 when these low-paid workers were rehired.

This is the reason why honest analysts look at the two years together, not just 2021 in isolation.        

The news media have been constantly hyping inflation in recent months. While everyone has been seeing the huge rise in gas prices over the last year (that’s what happens when the world reopens after a pandemic), used car prices have risen almost as rapidly. From December 2020 to December 2021 they rose 37.3 percent. This accounted for 1.03 percentage points of the 7.0 percent overall inflation in the last year.

We know the story of these price increases. A fire in a semiconductor plant in Japan has created a worldwide shortage of semiconductors, which has slowed car production. With people unable to get new cars, they are bidding up the price of used cars.

But beyond the specifics, there is an interesting accounting issue (oxymoron?) here. The Consumer Price Index (CPI), which is our most used measure of inflation, uses a different methodology for used cars than the Personal Consumption Expenditure (PCE) deflator calculated by the Commerce Department.

The CPI counts the full value that consumers pay for a car in determining its weight in the index. In December, this weight was 3.42 percent. By contrast, the PCE uses a net measure that subtracts out what consumers are paid for the used cars they sell. In the PCE, used cars had a weight of 1.65 percent for November, the most recent month available. This means that the weight of used cars is approximately 1.8 percentage points higher in the CPI than in the PCE.

Typically, this 1.8 percentage point difference would not matter much, but when the price of used cars and trucks is going up 37.3 percent in a year, it matters. In contrast to the 1.03 percentage points that used vehicles contributed to the CPI over the last year, they contributed just 0.62 percentage points to the inflation rate in the PCE.[1] This means that if we were measuring inflation in the CPI using the net methodology of the PCE, it would be roughly 0.4 percentage points lower over the last year. (There are other differences in methodology that make this calculation a bit more complicated.)

Of course, even subtracting 0.4 percentage points still leaves us with a 6.6 percent year-over-year inflation rate, which is high by anyone’s standard, but this gap does make a difference in how we see the world. For example, the average hourly wage for production and nonsupervisory workers rose 5.8 percent over the last year. Measured against the 7.0 percent inflation rate, this implies a 1.2 percentage point decline in real wages. (They rose 4.0 percent in the prior year, this is a pandemic-composition story.) However, measured against a CPI that uses the PCE deflator net measure, the decline was just 0.8 percentage points.

Declining real wages are still bad news, and would be especially bad if we expected these declines to persist for any period of time, but using an alternative and reasonable measure for used vehicle prices eliminates one-third of the drop over the last year. That seems worth noting.

[1] Prices for used vehicles in the PCE deflator actually rose slightly faster over the last year, going up 42.5 percent.

The news media have been constantly hyping inflation in recent months. While everyone has been seeing the huge rise in gas prices over the last year (that’s what happens when the world reopens after a pandemic), used car prices have risen almost as rapidly. From December 2020 to December 2021 they rose 37.3 percent. This accounted for 1.03 percentage points of the 7.0 percent overall inflation in the last year.

We know the story of these price increases. A fire in a semiconductor plant in Japan has created a worldwide shortage of semiconductors, which has slowed car production. With people unable to get new cars, they are bidding up the price of used cars.

But beyond the specifics, there is an interesting accounting issue (oxymoron?) here. The Consumer Price Index (CPI), which is our most used measure of inflation, uses a different methodology for used cars than the Personal Consumption Expenditure (PCE) deflator calculated by the Commerce Department.

The CPI counts the full value that consumers pay for a car in determining its weight in the index. In December, this weight was 3.42 percent. By contrast, the PCE uses a net measure that subtracts out what consumers are paid for the used cars they sell. In the PCE, used cars had a weight of 1.65 percent for November, the most recent month available. This means that the weight of used cars is approximately 1.8 percentage points higher in the CPI than in the PCE.

Typically, this 1.8 percentage point difference would not matter much, but when the price of used cars and trucks is going up 37.3 percent in a year, it matters. In contrast to the 1.03 percentage points that used vehicles contributed to the CPI over the last year, they contributed just 0.62 percentage points to the inflation rate in the PCE.[1] This means that if we were measuring inflation in the CPI using the net methodology of the PCE, it would be roughly 0.4 percentage points lower over the last year. (There are other differences in methodology that make this calculation a bit more complicated.)

Of course, even subtracting 0.4 percentage points still leaves us with a 6.6 percent year-over-year inflation rate, which is high by anyone’s standard, but this gap does make a difference in how we see the world. For example, the average hourly wage for production and nonsupervisory workers rose 5.8 percent over the last year. Measured against the 7.0 percent inflation rate, this implies a 1.2 percentage point decline in real wages. (They rose 4.0 percent in the prior year, this is a pandemic-composition story.) However, measured against a CPI that uses the PCE deflator net measure, the decline was just 0.8 percentage points.

Declining real wages are still bad news, and would be especially bad if we expected these declines to persist for any period of time, but using an alternative and reasonable measure for used vehicle prices eliminates one-third of the drop over the last year. That seems worth noting.

[1] Prices for used vehicles in the PCE deflator actually rose slightly faster over the last year, going up 42.5 percent.

Don’t worry, Thomas Edsall is not endorsing Donald Trump’s big lie that he really won the election, but he is pushing a line that is almost as pernicious. In a piece discussing whether Republicans and their elected officials really believe that Trump won the election, Edsall comments:

“Musa al-Gharbi, a sociologist at Columbia, pointed out in an email that acceptance of Trump’s false claims gives Republican politicians a way of bridging the gap between a powerful network of donors and elites who back free trade capitalism and the crucial bloc of white working-class voters seeking trade protectionism and continued government funding of Social Security and Medicare:”

The problem here is that the “powerful network of donors and elites” does not at all back free-trade capitalism, which should be more apparent than ever in the middle of this two-year-long worldwide pandemic.  The pandemic has persisted in large part because this “powerful network” has insisted on protecting government-granted patent monopolies on vaccines, tests, and treatments.

These monopolies have hugely slowed the pace of vaccination, allowing new strains like delta and omicron to develop and infect the world. If we instead let vaccines be produced and the technology be freely transferred (no enforcement on non-disclosure agreements), the whole world could have been vaccinated long ago.

This system of protectionism does have the benefit of transferring hundreds of billions of dollars every year from the rest of us to the wealthy. For political purposes, it is very much to the advantage of these powerful elites to pretend that their wealth is just the result of the free market, but it is not true, and it is gaslighting to pretend it is.

Don’t worry, Thomas Edsall is not endorsing Donald Trump’s big lie that he really won the election, but he is pushing a line that is almost as pernicious. In a piece discussing whether Republicans and their elected officials really believe that Trump won the election, Edsall comments:

“Musa al-Gharbi, a sociologist at Columbia, pointed out in an email that acceptance of Trump’s false claims gives Republican politicians a way of bridging the gap between a powerful network of donors and elites who back free trade capitalism and the crucial bloc of white working-class voters seeking trade protectionism and continued government funding of Social Security and Medicare:”

The problem here is that the “powerful network of donors and elites” does not at all back free-trade capitalism, which should be more apparent than ever in the middle of this two-year-long worldwide pandemic.  The pandemic has persisted in large part because this “powerful network” has insisted on protecting government-granted patent monopolies on vaccines, tests, and treatments.

These monopolies have hugely slowed the pace of vaccination, allowing new strains like delta and omicron to develop and infect the world. If we instead let vaccines be produced and the technology be freely transferred (no enforcement on non-disclosure agreements), the whole world could have been vaccinated long ago.

This system of protectionism does have the benefit of transferring hundreds of billions of dollars every year from the rest of us to the wealthy. For political purposes, it is very much to the advantage of these powerful elites to pretend that their wealth is just the result of the free market, but it is not true, and it is gaslighting to pretend it is.

In his column on health care this morning (much of which I agree with, since my wife had similar experiences), Ross Douthat argues that we should be willing to pay very high prices for prescription drugs and other medical innovations. The basic argument is that if a drug or new technology can save your life or the life of a loved one, wouldn’t it be worth paying hundreds of thousands of dollars, or even millions, if you had the money or could get an insurer or the government to pay it?

The answer is of course, “yes,” but it’s the wrong question. To see the point, firefighters often save lives at great risk to themselves. If we pose Douthat’s question, since they often save lives, wouldn’t it be worth paying hundreds of thousands of dollars, or even millions, to firefighters?

Perhaps we should pay firefighters an order of magnitude more money, but we don’t. The reason is simple. We don’t have to. We can find people who are willing to do the work and take the risk for much lower pay.

We should raise the same question about prescription drugs. Sure, the COVID-19 vaccines are fantastic and have saved millions or even tens of millions of lives, and prevented an enormous amount of suffering. In that sense, they are worth hundreds of billions or even trillions of dollars. But do we have to pay this sort of money to get vaccines?

There is plenty of evidence that we don’t. Peter Hotez and a team of researchers at Texas Children’s Hospital and Baylor University developed an effective vaccine on a shoestring. To be clear, this vaccine has not undergone extensive clinical trials, so it may yet prove less effective than preliminary results indicate, but the point is that we can get innovation without paying people billions of dollars.

In the case of the highly effective mRNA vaccines, these were done on the public dime. The researchers were of course paid for their work, but none of them got rich working on NIH grants. In fact, according to the New York Times, Dr. Katalin Kariko, one of the leading mRNA pioneers, never earned more than $60,000 a year in decades of doing pathbreaking work on government grants. The idea that we need to pay scientists outlandish salaries to get innovation is absurd on its face.

In fact, the quest for money can actually impede innovation. In a piece last week, the NYT described how progress in developing mRNA vaccines was slowed because Kariko was unable to arrange a collaboration with another top scientist because of a dispute over patent ownership. Patent battles can often block productive research.

Douthat’s experience with seeking care for his Lyme disease also should have acquainted him with another problem with our patent monopoly system of financing innovation: people have the incentive to lie. There are many products where patent monopolies allow companies to charge exorbitant prices precisely because they claim they will hugely improve a person’s health.

Often this is not true, but the prospect of big payoffs encourages drug manufacturers and device makers to make exorbitant claims for their products. We see this sort of marketing all the time, most dramatically with the opioid crisis, where manufacturers paid billions of dollars in settlements based on the allegation that they misled doctors on the addictiveness of the new generation of opioid drugs. If these drugs were selling as cheap generics, they would not have anywhere near as much incentive to lie about the safety of their products.

In short, there is no reason to believe that we have to create billionaires to get important innovations in health care. In fact, there are good reasons for believing that our system of patent monopoly financing (as opposed to open-source public financing) stifles innovation and leads to worse health care outcomes. The choice is not whether we are willing to pay lots of money to get better health care; the choice is whether we want good health care, or are we more interested in making a small number of people very rich.

In his column on health care this morning (much of which I agree with, since my wife had similar experiences), Ross Douthat argues that we should be willing to pay very high prices for prescription drugs and other medical innovations. The basic argument is that if a drug or new technology can save your life or the life of a loved one, wouldn’t it be worth paying hundreds of thousands of dollars, or even millions, if you had the money or could get an insurer or the government to pay it?

The answer is of course, “yes,” but it’s the wrong question. To see the point, firefighters often save lives at great risk to themselves. If we pose Douthat’s question, since they often save lives, wouldn’t it be worth paying hundreds of thousands of dollars, or even millions, to firefighters?

Perhaps we should pay firefighters an order of magnitude more money, but we don’t. The reason is simple. We don’t have to. We can find people who are willing to do the work and take the risk for much lower pay.

We should raise the same question about prescription drugs. Sure, the COVID-19 vaccines are fantastic and have saved millions or even tens of millions of lives, and prevented an enormous amount of suffering. In that sense, they are worth hundreds of billions or even trillions of dollars. But do we have to pay this sort of money to get vaccines?

There is plenty of evidence that we don’t. Peter Hotez and a team of researchers at Texas Children’s Hospital and Baylor University developed an effective vaccine on a shoestring. To be clear, this vaccine has not undergone extensive clinical trials, so it may yet prove less effective than preliminary results indicate, but the point is that we can get innovation without paying people billions of dollars.

In the case of the highly effective mRNA vaccines, these were done on the public dime. The researchers were of course paid for their work, but none of them got rich working on NIH grants. In fact, according to the New York Times, Dr. Katalin Kariko, one of the leading mRNA pioneers, never earned more than $60,000 a year in decades of doing pathbreaking work on government grants. The idea that we need to pay scientists outlandish salaries to get innovation is absurd on its face.

In fact, the quest for money can actually impede innovation. In a piece last week, the NYT described how progress in developing mRNA vaccines was slowed because Kariko was unable to arrange a collaboration with another top scientist because of a dispute over patent ownership. Patent battles can often block productive research.

Douthat’s experience with seeking care for his Lyme disease also should have acquainted him with another problem with our patent monopoly system of financing innovation: people have the incentive to lie. There are many products where patent monopolies allow companies to charge exorbitant prices precisely because they claim they will hugely improve a person’s health.

Often this is not true, but the prospect of big payoffs encourages drug manufacturers and device makers to make exorbitant claims for their products. We see this sort of marketing all the time, most dramatically with the opioid crisis, where manufacturers paid billions of dollars in settlements based on the allegation that they misled doctors on the addictiveness of the new generation of opioid drugs. If these drugs were selling as cheap generics, they would not have anywhere near as much incentive to lie about the safety of their products.

In short, there is no reason to believe that we have to create billionaires to get important innovations in health care. In fact, there are good reasons for believing that our system of patent monopoly financing (as opposed to open-source public financing) stifles innovation and leads to worse health care outcomes. The choice is not whether we are willing to pay lots of money to get better health care; the choice is whether we want good health care, or are we more interested in making a small number of people very rich.

Many economists, including me, have been attributing the high inflation of the last year to problems associated with reopening from the pandemic. According to this view, price increases in many areas will slow soon, and in some cases, like new and used cars, be largely reversed. In this view, the problem with inflation is temporary and will be resolved without major policy changes in the not distant future.

However, there is an alternative view, pushed by economists like Larry Summers and Jason Furman, that the stimulus provided by the American Recovery Act, and the prior CARES Acts passed in 2020, provided too large a boost to the economy. They pushed the economy beyond its ability to produce goods and services. In this view, the inflation problem is not temporary; we are likely to see continuing problems with inflation unless the Fed takes steps to clamp down on demand and slow the economy.

The basic logic of this argument is that GDP in the last quarter of 2021 will be well above the level of output in the fourth quarter in 2019 (the last pre-pandemic quarter), even though employment is still well below the 2019 level. Since we also saw a drop in investment, the capital stock will be below its trend growth path. This should mean that productivity should be lower than its pre-pandemic trend path. And, the pandemic has raised costs in many areas, putting further pressure on prices.

I will make three points as to why I don’t view these arguments as compelling:

  • The drop in hours worked is less than the drop in employment, due to the lengthening of average workweeks. This means that total hours are not far below the level in the fourth quarter of 2019.
  • The drop in investment was actually small compared to prior recessions, with structure investment seeing the largest falloff. Furthermore, the relationship between investment and near-term productivity growth is very weak in any case.
  • There is an easily identifiable source of substantial productivity gains – less business travel – which could have increased productivity over this period by more than 0.5 percentage points.

The Drop in Hours and the Drop in Employment

Taking these in turn, it is important to recognize that there has been a substantial increase in the length of the average workweek from before the pandemic. This presumably reflects the decision by employers who can’t hire more workers to have their existing workforce put in more hours. The length of the average workweek was 34.3 hours in the fourth quarter of 2019. It was 34.7 hours in the fourth quarter of last year.

While the drop in employment between the fourth quarter of 2019 and the fourth quarter of 2021 was almost 2.0 percent, the drop in hours using the Bureau of Labor Statistics index of aggregate hours was less than 0.7 percent.

Furthermore, the payroll data misses a substantial increase in the number of people reporting that they are self-employed. This figure was almost 400,000 higher (combining incorporated and non-incorporated self-employed) in the fourth quarter of 2021 than the fourth quarter of 2019. If we assume the self-employed put in the same number of hours on average as payroll employees, this reduces the drop in total hours over these two years to just 0.4 percent.

If we assume that fourth-quarter GDP growth will be 5.0 percent (the latest projection from the Atlanta Fed’s GDPNOW model), then GDP will be 2.7 percent higher in the fourth quarter of 2021 than in 2019. If we add in the 0.4 percent decline in hours over these two periods, that implies productivity growth of 3.1 percent over the last two years, 1.6 percent annually. That is somewhat higher than the 1.0 percent average since the end of the Great Recession, but almost exactly in line with the 1.5 percent average productivity growth in the three years before the pandemic hit.

This means that we don’t need to postulate any extraordinary uptick in productivity growth to say that the economy is still operating within its potential, if it was at its potential in the fourth quarter of 2019. Of course, it is possible that even in the fourth quarter of 2019 the economy was still somewhat below its potential. While the unemployment rate was very low, the prime-age employment to population ratio was still below prior peaks. And, there was no evidence of accelerating inflation at the time. If there was still some slack in the economy at the end of 2019, there is less reason to believe that we are operating above the economy’s potential level of output now.

Investment and Productivity

Clearly, there is some link between investment and productivity growth, but it is not a strong one and certainly not an immediate one. In the 2001 recession, non-residential investment fell by 2.2 percent from its 2000 level. It fell further in 2002 so that it was 8.9 percent below its 2000 level. Even in 2003, it was still 6.6 below its 2000 level.

Nonetheless, productivity growth soared in these years. It averaged 3.8 percent between 2000 and 2003. It is almost certainly true that productivity growth would have been even quicker without the falloff in investment, but even this large drop did not prevent rapid increases in productivity.

By comparison, investment was 5.3 percent below its 2019 level in 2020. It’s on a path to be more than 2.0 percent above its 2019 level in 2021. It seems unlikely that the relatively modest drop in investment in 2020 coupled with the still below trend path level in 2021 would have a major impact on productivity this year.

The Wonders of the Internet and Productivity Growth

The pandemic has forced companies to change the way they do business. One change has been that there is far less business travel. The money spent on business travel in the United States fell from $291 billion in 2019 to $131 billion in 2020, and then rebounded slightly to $157 billion in 2021.   

Business travel is in effect an expense of doing business, like the steel used to construct an office building or the energy used to power a factory. If companies can produce the same output, with less business travel, it is effectively an increase in productivity, just as if they needed less steel to put up a building or less energy to operate their factories.

While it may be the case that businesses are actually less productive as a result of the decline in business travel, it is reasonable to believe that this is not the case. As it stands, we are producing a slightly higher level of GDP with much less business travel. (It’s possible there will be some long-term effect, where we see smaller productivity gains in future years because of less person-to-person contact, but we’ll have to hold off in assessing that one.)

Anyhow, it might go against our economist instincts to think that companies would needlessly waste money sending their employees flying around the country and the world, but it is at least possible that this is the case. If we treat the reduction in travel as eliminating waste, then we went from spending 1.5 percent of GDP on business travel to 0.8 percent of GDP in 2021, implying a gain in productivity from this pandemic induced innovation of 0.7 percentage points, equivalent to 0.4 percentage points of annual growth over the last two years. This strengthens the case that the economy is operating well within its capacity.[1]     

Are We Demanding Too Much from the Economy in 2022?

There is no doubt that we are still seeing considerable supply disruptions from both the rapid reopening and the ongoing pandemic. But these are not easily or well-addressed by cutting back demand. We will still see lots of people getting sick and missing work even if the Fed raised rates by two or three percentage points.

It will take some time to work through these issues. Also, there is clearly a large-scale reshuffling of the workforce, as many workers are taking the opportunity to leave jobs they don’t like for better ones. This is disruptive to the economy, but a big positive for workers who have this freedom. We will likely see job churn settle down to more normal levels, as the same workers are not likely to continue to quit jobs every few weeks, and employers become more effective in providing incentives to retain workers. Also, some bad employers will simply go out of business.

Anyhow, there is little reason to believe that, if we can get the pandemic under control, the supply problems we are now seeing (along with pretty much every other wealthy country) will not dissipate over the course of the year. And, with prices stabilizing or reversing in many areas, workers will have seen substantial wage gains since the start of the pandemic.  

[1] To make this an apples-to-apples comparison, we would need to factor in the increased expenses companies incurred from using Zoom and similar services. I’m too lazy to try to do that, but I’m pretty confident that the additional spending would not come close to the savings from reduced business travel. 

Many economists, including me, have been attributing the high inflation of the last year to problems associated with reopening from the pandemic. According to this view, price increases in many areas will slow soon, and in some cases, like new and used cars, be largely reversed. In this view, the problem with inflation is temporary and will be resolved without major policy changes in the not distant future.

However, there is an alternative view, pushed by economists like Larry Summers and Jason Furman, that the stimulus provided by the American Recovery Act, and the prior CARES Acts passed in 2020, provided too large a boost to the economy. They pushed the economy beyond its ability to produce goods and services. In this view, the inflation problem is not temporary; we are likely to see continuing problems with inflation unless the Fed takes steps to clamp down on demand and slow the economy.

The basic logic of this argument is that GDP in the last quarter of 2021 will be well above the level of output in the fourth quarter in 2019 (the last pre-pandemic quarter), even though employment is still well below the 2019 level. Since we also saw a drop in investment, the capital stock will be below its trend growth path. This should mean that productivity should be lower than its pre-pandemic trend path. And, the pandemic has raised costs in many areas, putting further pressure on prices.

I will make three points as to why I don’t view these arguments as compelling:

  • The drop in hours worked is less than the drop in employment, due to the lengthening of average workweeks. This means that total hours are not far below the level in the fourth quarter of 2019.
  • The drop in investment was actually small compared to prior recessions, with structure investment seeing the largest falloff. Furthermore, the relationship between investment and near-term productivity growth is very weak in any case.
  • There is an easily identifiable source of substantial productivity gains – less business travel – which could have increased productivity over this period by more than 0.5 percentage points.

The Drop in Hours and the Drop in Employment

Taking these in turn, it is important to recognize that there has been a substantial increase in the length of the average workweek from before the pandemic. This presumably reflects the decision by employers who can’t hire more workers to have their existing workforce put in more hours. The length of the average workweek was 34.3 hours in the fourth quarter of 2019. It was 34.7 hours in the fourth quarter of last year.

While the drop in employment between the fourth quarter of 2019 and the fourth quarter of 2021 was almost 2.0 percent, the drop in hours using the Bureau of Labor Statistics index of aggregate hours was less than 0.7 percent.

Furthermore, the payroll data misses a substantial increase in the number of people reporting that they are self-employed. This figure was almost 400,000 higher (combining incorporated and non-incorporated self-employed) in the fourth quarter of 2021 than the fourth quarter of 2019. If we assume the self-employed put in the same number of hours on average as payroll employees, this reduces the drop in total hours over these two years to just 0.4 percent.

If we assume that fourth-quarter GDP growth will be 5.0 percent (the latest projection from the Atlanta Fed’s GDPNOW model), then GDP will be 2.7 percent higher in the fourth quarter of 2021 than in 2019. If we add in the 0.4 percent decline in hours over these two periods, that implies productivity growth of 3.1 percent over the last two years, 1.6 percent annually. That is somewhat higher than the 1.0 percent average since the end of the Great Recession, but almost exactly in line with the 1.5 percent average productivity growth in the three years before the pandemic hit.

This means that we don’t need to postulate any extraordinary uptick in productivity growth to say that the economy is still operating within its potential, if it was at its potential in the fourth quarter of 2019. Of course, it is possible that even in the fourth quarter of 2019 the economy was still somewhat below its potential. While the unemployment rate was very low, the prime-age employment to population ratio was still below prior peaks. And, there was no evidence of accelerating inflation at the time. If there was still some slack in the economy at the end of 2019, there is less reason to believe that we are operating above the economy’s potential level of output now.

Investment and Productivity

Clearly, there is some link between investment and productivity growth, but it is not a strong one and certainly not an immediate one. In the 2001 recession, non-residential investment fell by 2.2 percent from its 2000 level. It fell further in 2002 so that it was 8.9 percent below its 2000 level. Even in 2003, it was still 6.6 below its 2000 level.

Nonetheless, productivity growth soared in these years. It averaged 3.8 percent between 2000 and 2003. It is almost certainly true that productivity growth would have been even quicker without the falloff in investment, but even this large drop did not prevent rapid increases in productivity.

By comparison, investment was 5.3 percent below its 2019 level in 2020. It’s on a path to be more than 2.0 percent above its 2019 level in 2021. It seems unlikely that the relatively modest drop in investment in 2020 coupled with the still below trend path level in 2021 would have a major impact on productivity this year.

The Wonders of the Internet and Productivity Growth

The pandemic has forced companies to change the way they do business. One change has been that there is far less business travel. The money spent on business travel in the United States fell from $291 billion in 2019 to $131 billion in 2020, and then rebounded slightly to $157 billion in 2021.   

Business travel is in effect an expense of doing business, like the steel used to construct an office building or the energy used to power a factory. If companies can produce the same output, with less business travel, it is effectively an increase in productivity, just as if they needed less steel to put up a building or less energy to operate their factories.

While it may be the case that businesses are actually less productive as a result of the decline in business travel, it is reasonable to believe that this is not the case. As it stands, we are producing a slightly higher level of GDP with much less business travel. (It’s possible there will be some long-term effect, where we see smaller productivity gains in future years because of less person-to-person contact, but we’ll have to hold off in assessing that one.)

Anyhow, it might go against our economist instincts to think that companies would needlessly waste money sending their employees flying around the country and the world, but it is at least possible that this is the case. If we treat the reduction in travel as eliminating waste, then we went from spending 1.5 percent of GDP on business travel to 0.8 percent of GDP in 2021, implying a gain in productivity from this pandemic induced innovation of 0.7 percentage points, equivalent to 0.4 percentage points of annual growth over the last two years. This strengthens the case that the economy is operating well within its capacity.[1]     

Are We Demanding Too Much from the Economy in 2022?

There is no doubt that we are still seeing considerable supply disruptions from both the rapid reopening and the ongoing pandemic. But these are not easily or well-addressed by cutting back demand. We will still see lots of people getting sick and missing work even if the Fed raised rates by two or three percentage points.

It will take some time to work through these issues. Also, there is clearly a large-scale reshuffling of the workforce, as many workers are taking the opportunity to leave jobs they don’t like for better ones. This is disruptive to the economy, but a big positive for workers who have this freedom. We will likely see job churn settle down to more normal levels, as the same workers are not likely to continue to quit jobs every few weeks, and employers become more effective in providing incentives to retain workers. Also, some bad employers will simply go out of business.

Anyhow, there is little reason to believe that, if we can get the pandemic under control, the supply problems we are now seeing (along with pretty much every other wealthy country) will not dissipate over the course of the year. And, with prices stabilizing or reversing in many areas, workers will have seen substantial wage gains since the start of the pandemic.  

[1] To make this an apples-to-apples comparison, we would need to factor in the increased expenses companies incurred from using Zoom and similar services. I’m too lazy to try to do that, but I’m pretty confident that the additional spending would not come close to the savings from reduced business travel. 

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