Tag: Larry Summers

No end in sight for the debate over inflation

The debate over the Biden’s administrations proposed stimulus I discussed a few weeks ago is still going. If you wanted to keep up to date, here are some useful links:

The debate still hinges around three technical questions:

  • How large is the output gap? This is the gap between what an economy can theoretically produce, and what it is producing today. Think of the gap as representing idle factories or unemployed workers. The larger the gap, the more stimulus can be applied before you hit ‘supply limits,’ and cause inflation.
  • How effective will the stimulus be? Stimulus does not automatically create the demand which fills the output gap. Instead of buying a new TV, people might save the money they receive, or use it to pay down debts. Those who are concerned expect most of the stimulus to be spent, those who are more sanguine, the opposite.
  • How will inflation behave if it arrives? Both camps agree there is likely to be some inflation, but they disagree over how it will evolve. Those in favour of the stimulus as it stands expect inflation to steadily increase, perhaps even to 2% or 3%. They see this as a good thing, given inflation has been below target for almost a decade. There is little risk of it getting out of control because the Fed can always raise rates in the last instance.

    Pessimists are concerned that if inflation starts growing, it could quickly get out of control. Instead of growing to 2% or 3% and stabilising, expectations might change, causing inflation to continue higher. If the Fed has to react by rapidly raising rates, it could have negative consequences for the financial sector and the wider economy.

This says nothing about the politics around the stimulus. Biden does not want to run the risk of delivering an underpowered stimulus as Obama did after the GFC.

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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.”

Source

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.

Source

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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Fiscal policy series – debt, government spending, and the future of the state

There is a new paper on fiscal policy out by Larry Summers and Jason Furman (There is also a video presentation of their paper along with a star-studded discussion panel including Ben Bernanke, Olivier Blanchard and Ken Rogoff here. It begins at 49 minutes).

The paper argues that the drastic fall in real-interest rates over the last thirty years has made regular fiscal stimulus by government both necessary and sustainable.

The assumption that low interest rates are here to stay leads to three conclusions:

  • Fiscal policy is needed: There have been persistent shortfalls of demand since the crisis. Monetary policy is increasingly constrained in dealing with this. Interest rates have been zero (or below) zero for years. QE and perpetually loose monetary policy also comes with financial stability risks. More tools are needed.
  • Fiscal policy is affordable: With interest rates so low, debt servicing costs are low. In fact, real interest payments as a % of GDP have been falling in the US since 2000.
  • Fiscal policy is effective: There are lots of threads to this, but there are two broad points. First, it builds off research arguing that the cost of debt may not be as significant as once thought in an environment of low interest rates. Second, it builds off research that shows fiscal spending might be more effective than once thought. Governments can make productive investments which pay for themselves by increasing future output by a larger amount.

This kind of argument is increasingly the norm, and it sounds so obvious that it is worth reminding ourselves of the consensus they are critiquing. From the 1980s/90s, up until even the early/mid 2010s, it was believed that the best contribution government could make to macroeconomic growth was a balanced budget. There was a role for some moderate automatic stabilisers (e.g. unemployment benefits), but not much beyond that. If any macroeconomic stimulus was required in a crisis, it should be left to monetary policy and independent central banks.

Their contribution joins the broader reform conversation going on in macroeconomics today. Earlier this year, Anna Stansbury and Larry Summers co-authored a piece blaming the economic doldrums on declining worker power. Olivier Blanchard used his 2019 address to the AEA to discuss why public debt may not be as bad as once thought. If you would like an overview of the contemporary debates in macro, I highly recommend Blanchard and Summers’s introduction to the edited book: “Evolution or Revolution? Rethinking Macroeconomic Policy after the Great Recession.”

I’m going to be following up on this paper and fiscal policy more broadly over the next week. Stay tuned!