July 22, 2021
Larry Summers says he’s worried about the US economy, even more than he was worried when he started to sound the alarm in February. The well-known economist and former US treasury secretary said last week, “the focus of concern right now should be on overheating.”
He’s not talking about climate, but about the economy growing too fast and running into persistent high inflation like we had in the 1970s, along with other possible crises. On the same day that he issued the above warning, the Consumer Price Index (CPI) for June was 5.4 percent above its level one year earlier. Press reports noted that this was the biggest one-year jump since 2008.
There are many reasons to question whether his fears are well-grounded; more on that below. But first, some background on why this debate is so important at this particular moment in US history.
Most of the time in the United States, the two most important policies that determine people’s living standards over time — including the rate of employment and unemployment — are monetary and fiscal policy.
Monetary policy is decided by the Federal Reserve, which sets short-term interest rates, and currently also directly influences long-term rates (including those paid on home mortgages). Over time, the Fed’s interest rate policy is the most important policy determining how much employment and unemployment we have. This is because of the effect of interest rates on economic activity — e.g., note the recent boost that the housing market has gotten from low mortgage rates. But most importantly, the Fed has typically raised interest rates when it has decided that unemployment has gotten “too low,” thereby setting a limit on how close we can get to full employment.
Fiscal policy is the government’s use of taxing and spending, including some of the federal spending since the pandemic/recession began that has served as both relief and stimulus. It can also boost employment substantially, especially during a recession or when the economy is recovering.
As my colleague Dean Baker, and Jared Bernstein (currently on Joe Biden’s Council of Economic Advisers) explained in their book, “Getting Back to Full Employment”: as the economy approaches full employment there are not only millions more jobs, but substantial reductions in income inequality. Lower-wage workers see bigger increases in wages and employment than those higher up the income ladder; the same is true for Black workers as compared with white workers.
Historically, our government institutions, including the Fed, have been much too conservative about allowing the economy to reach full employment. The Fed actually caused most of the recessions that the US experienced since World War II, by raising interest rates.
Regarding fiscal policy, the federal stimulus during the Great Recession, for example, was far too small to compensate for the shortfall in spending from the collapse of the real estate bubble. It was just 2 percent of GDP, less than a quarter of what was needed. And about half of that was canceled by state and local government budget cuts.
So, it has been a historic achievement that, as Summers complains, the US government is running a projected deficit of 13.4 percent of GDP this year (after 14.9 percent last year). And the current chair of the Federal Reserve, Jerome Powell, has shown a greater commitment to full employment than perhaps any previous Fed chair. Unemployment is currently at 5.9 percent — with millions more unemployed than at the 3.5 percent rate that was achieved before the pandemic.
As we have seen since the 1990s, the limits on fiscal and monetary policy have turned out to be considerably less constraining than both economists and policymakers had — for decades — maintained. Even in the recent past, the Fed did not have its current commitment to full employment; and the Congress and president would never have approved the kind of spending that it has recently implemented, in order to ease suffering and hasten economic recovery.
There is another urgent part of this story: the next two elections could very well determine the next few decades of American politics and life, including whether the current system of minority rule can persist. Readers here will know what I am talking about: voter suppression, gerrymandering, the electoral college, the Senate (with filibuster), and the Supreme Court. And other institutions and laws that allow Republicans to hold national power without winning a majority of voters.
The implementation of these two most important — and often misunderstood — economic policies could very well decide which party wins the next two elections.
Which brings us back to Larry Summers, who met with two of Biden’s top economic advisers at the White House on that same day last week. His argument is directed at the size of both the expansionary fiscal and monetary policy — i.e., the Fed’s zero short-term interest rates plus money creation (“quantitative easing”), and the very large federal budget deficit. Together, he says, these will push the economy beyond its potential GDP and bring us out-of-control inflation.
Of course, economists recognize that there are limits to what can be done with fiscal and monetary policy, but most do not see the current burst of inflation as evidence of an imminent threat. As Dean Baker pointed out, more than half of the 0.9 percent increase in the CPI for June was due to cars. There is no reason to think that this will continue, since it is a result of post-pandemic shortages (e.g., of semiconductors) and pent-up demand. Some of the increase in annual inflation, including in recent months, is an artifact because current prices are being compared with prices that were depressed by the pandemic a year earlier.
Summers’s comparison to the 1970s is also unconvincing. It took many years in the 1960s and 1970s to change people’s expectations of inflation. And there were major oil shocks, as well as stronger organized labor, often with cost-of-living allowances that kept their wages rising with inflation.
The Wall Street Journal’s latest survey of economists, reported this week, sees US GDP growth as having peaked at a 9.1 percent annual rate for the second quarter, and declining to 3.3 percent for the second quarter next year.
And for now, as Fed Chair Powell noted this week, “Measures of longer-term inflation expectations have moved up from their pandemic lows and are in a range that is broadly consistent with the FOMC’s longer-run inflation goal.” The bond markets concur: the interest rate on 10-year bonds fell to 1.2 percent this week. They don’t seem to be shaken by the latest CPI report. Or by Larry Summers’ arguments.
We can already catch a glimpse of what this society could look like if these changes in the boundaries of economic policy are not reversed, e.g., with the expanded Child Tax Credit, which if made permanent is projected to reduce child poverty by about 45 percent. The future of the country is at stake; not only our economic and social progress, but — because the economic results of the next few years may well be politically determinative — the fate of our democracy.