The ghost of Christmas inflation haunts US

Inflation continues to surge. From its inflection point in February 2021 to last month, the US consumer price index has grown 6 per cent – an 8 per cent annualised rate.

The underlying cause is no mystery. Starting in March 2020, the US government created about $3 trillion of new bank reserves (an equivalent to cash) and sent cheques to people and businesses. The Treasury then borrowed another $2 trillion or so and sent even more cheques. The total stimulus comes to about 25 per cent of GDP, and to around 30 per cent of the original federal debt. While much of the money went to help people and businesses severely hurt by the pandemic, much of it was also sent regardless of need, intended as stimulus (or “accommodation”) to stoke demand. The goal was to induce people to spend, and that is what they are now doing.

Milton Friedman once said that if you want inflation, you can just drop money from helicopters. That is basically what the US government has done. But this US inflation is ultimately fiscal, not monetary. People do not have an excess of money relative to bonds; rather, people have extra savings and extra apparent wealth to spend. Had the government borrowed the entire $5 trillion to write the same cheques, we likely would have the same inflation.

Other purported factors – including “supply shocks”, “bottlenecks”, “demand shifts” and corporate “greed” – are not relevant to the overall price level. The ports would not be clogged if people were not trying to buy lots of goods. If people wanted more TVs and fewer restaurant meals, the price of TVs would go up and the price of restaurant meals would go down. Greed did not suddenly break out last year.

By contrast, inflation, when all prices and wages rise together, comes from the balance of overall supply and demand. The economy’s capacity to produce goods and services turns out to be lower than expected. Here, the labour shortage – the “Great Resignation” – is a key underlying fact. Employers can’t find people to work because many people remain on the sidelines, not even looking for jobs.

The US Federal Reserve was completely surprised by the surge of inflation, and through most of the year insisted it would be “transitory”, and go away on its own. That turned out to be a major institutional failure. Is it not the Fed’s main job to understand the economy’s supply capacity and fill – but not overfill – the cup of demand?

One might expect that among the thousands of economists the Fed employs, there is a group working on figuring out ports’ capacity, the effects of microchip shortages, how many people have retired or are not returning to work, and so forth. One would be disappointed. Central banks have sketchy ideas of supply, mostly centred on statistical trends in labour markets.

Why did this fiscal stimulus produce inflation when previous stimulus efforts from 2008 to 2020 fizzled? There are several obvious possibilities. First, this stimulus was much bigger. Former US Secretary of the Treasury Lawrence H. Summers correctly prophesied inflation in May 2021 by simply looking at the immense size of the spending packages, relative to any reasonable estimate of the GDP shortfall.

Second, officials misunderstood the Covid recession. GDP and employment did not fall because there was a lack of “demand”. In a pandemic, you can send people all the money in the world and they still won’t go out to dinner or book a flight, especially if those services are suspended by government fiat. To the economy, a pandemic is like a blizzard. If you send people a lot of money when the snow is falling, you do not get activity in the snowdrifts, but you will get inflation once the snow has cleared.

Third, unlike in previous crises, the government created money and sent cheques directly to businesses and households, rather than borrowing, spending, and waiting for the effect to spread to incomes.