Macro economists argue over higher inflation (again)

Prominent macro economists are divided over whether the Biden administration’s proposed $1.9 trillion stimulus bill is likely to stoke inflation and curb future investment.

In a Washington Post op-ed on Friday, former United States Secretary of the Treasury, Larry Summers, argued that the $1.9 trillion stimulus bill risked overstimulating the economy and stoking inflation. Summers argued the program, mostly short-term spending to counter the effects of the COVID-19, could also consume political and economic space required for the long-term investments.

“The Biden plan is a vital step forward, but we must make sure that it is enacted in a way that neither threatens future inflation and financial stability nor our ability to build back better through public investment,”said Summers.

On Saturday, former IMF Chief Economist, Olivier Blanchard, backed Summers in several tweets.

Critics argue their fears are overblown. Counter-arguments fall broadly into three categories: firstly, inflation is less responsive to employment than it once was, secondly, it is difficult to estimate what constitutes excess stimulus, and, thirdly, that long-term investments could pay for themselves.

Inflation is less responsive to employment than it once was

Summers op-ed comes at a time when a vocal minority of economists are warning of higher inflation due to the combination of loose monetary policy, fiscal stimulus, and household’s pent-up savings.

In contrast, Nobel Prize winner Paul Krugman argues that stimulus is unlikely to cause unsustainable inflation. His argument hinges on the Phillips curve, the supposed inverse relationship between inflation and unemployment which has guided macroeconomic policy making since the 1960s. For decades, economists thought targeting low unemployment with stimulus would only accelerate inflation, as in-demand workers bargained for higher wages, and raised prices.

Krugman points to new research which suggests that the Philips curve is actually “flat,” and low unemployment is unlikely to significantly increase inflation. As long as the Federal Reserve keeps inflation expectations stable, there is little risk a “hot” economy will generate inflation by itself.

Markets show no sign of expecting higher inflation. According to David Beckworth, Senior Research Fellow at Mercatus, “Markets have skin in the game and have already priced in a large Biden relief package. And yet, no evidence of overheating as far as the eye can see.”

Others, like Slate’s Jordan Weissmann, argue that the structural conditions for inflation are weaker now than in the past. Global supply chains, alternatives to oil, weak unions, and independent central banks mean low unemployment is unlikely to translate into higher wages and prices quickly.

The difficulty in estimating the output gap

In a recession, government stimulus hopes to close the “output gap” between what economies can hypothetically produce – “potential output” – and reality. Theoretically, too much stimulus could exceed potential output and lead to inflation as companies scramble to meet outsized demand.

But for sceptics, measures of potential output are notoriously unreliable; it cannot be observed directly, only retrospectively. The Congressional Budget Office, which produces these estimates, has been wrong before. As a result, Summers’ critics treat his claim that the proposed stimulus will be excessive with caution. “Nobody actually knows what our potential output really is,” said Weissman.

Self-financing long-term investments

During Biden’s Presidential campaign, a $2 trillion dollar plan was announced to accelerate the transition to clean energy. For summers and others, the size of the COVID-19 package will exhaust the economic capital needed for those long-term investments.

Others have responded by arguing investments into climate, transport, and infrastructure pay for themselves. “Compared with other major infrastructure projects in U.S. history, and these projects will give back more than they cost,” said economist Noah Smith in a recent Bloomberg column

These debates take place in the shadow of the Obama administration. In 2009, concerns about debt led the administration to downsize its post-financial-crisis stimulus. For some, the slow recovery cost Obama control of the House in 2010.

The Biden administration wants to avoid a similar situation by going big straight out the gate. Summers’ role in rejecting proposals for a larger stimulus package in 2009 have made him a target for a new generation of progressive economists. Expect these debates to continue.


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