Bad government policy is responsible for inflation
The U.S. is now in a period of the highest inflation rates in 40 years. The government isn’t responsible for all of the surge in inflation, but it’s responsible for most of it.
I’ll explain how misguided government policies led to high inflation, but first let’s consider the alternative explanation President Joe Biden and some other Democratic politicians have offered.
According to Sen. Elizabeth Warren: “One clear explanation for higher inflation? Giant corporations are exploiting their market power to further raise prices.” Or Sen. Bernie Sanders: “The problem is corporate greed, collusion & profiteering.”
In a recent speech, Biden pledged to reduce inflation by “asking large corporations and the wealthiest Americans to not engage in price gouging and to pay their fair share in taxes.”
Inflation began to increase sharply last spring. Did a sudden epidemic of corporate greed break out at that point? Were the previous years of low inflation the result of corporations being generous? Was the high inflation of the 1970s attributable to an earlier epidemic of corporate greed?
The truth is that corporations and other businesses usually charge the price they believe maximizes their profits. Business owners are no more greedy today than they were two years ago.
Biden, Sanders, and Warren know that. The corporate greed stuff is just so much political misdirection.
The real reason businesses — large and small — raised prices during the past year is that they’ve faced a surge in demand for their products at the same time as their costs have soared.
The surge in demand that set off the inflation has two causes: 1) The Niagara of federal government spending, particularly the $2 trillion American Rescue Plan that Biden and Congress enacted in March 2021, and 2) a change in the Federal Reserve’s procedures that caused them to keep their foot on the monetary accelerator for too long.
Enacting the American Rescue Plan had predictable consequences for inflation. The U.S. economy was well into recovery from the 2020 pandemic recession, unemployment was rapidly falling, and output was increasing.
Lawrence Summers, former Treasury secretary under President Clinton, Jason Furman, former chair of the Council of Economic Advisers under President Obama, and some other prominent liberal economists argued that injecting an additional $2 trillion into the economy in those circumstances would significantly worsen inflation.
Disregarding this analysis, the Biden Administration not only pushed the American Rescue Plan through Congress on a party-line vote. Also, Congress enacted an additional $1.2 trillion in spending on infrastructure.
And, but for the objections of Sen. Joe Manchin, last fall Biden and the Democratic majority in Congress would have passed another $2 trillion in spending with the Build Back Better Act.
The effect of this surge in government spending was made worse by the supply chain problems arising from the pandemic. But while problems with supply can lead to increases in the prices of some products — as notably happened with new cars — they don’t lead to inflation, which is a sustained increase in the general price level.
That brings us to the second explanation for the surge in inflation: policy errors by the Federal Reserve. Even in the face of a gusher of government spending and problems with supply chains, the Fed has the tools to rein in demand, thereby avoiding a prolonged surge in inflation.
Those tools — primarily raising interest rates and reducing the Fed’s holdings of Treasury bonds and mortgage-backed securities — work best if used before a wage-price spiral begins.
A wage-price spiral, such as we’re now experiencing, can become self-reinforcing, as workers push for higher wages to offset higher prices, causing firms to raise prices even higher to offset increased wage costs, leading workers to push for even higher wages, and so on.
The last time we experienced a wage-price spiral was the 1970s, when inflation rose above 10%. The Fed learned from that experience that it needed to preempt inflation before it got entrenched in the economy.
By and large the Fed was successful in doing so, giving us 40 years of relatively stable prices. But then in August 2020, the Fed announced that it would follow a new policy of allowing inflation to rise, at least for a time, in order to push down the unemployment rate.
Fed Chair Jerome Powell and his colleagues convinced themselves that inflation had been low for so long that it was very unlikely it would ever again rise much above 2%. Obviously, they were wrong.
The Fed has finally reacted to rising inflation, but a year late. As a consequence, they will have to raise interest rates to levels likely to cause a recession later this year or early next year.
The resulting higher unemployment will be a direct consequence of bad government policies.