Government is driving inflation
Inflation is proving to be more than transitory, reaching an 18-year high of 4.7 per cent last month. Government-created distortions of personal incomes, savings and labour market choices are helping fuel it. These distortions also make inflation harder to forecast, although economists have long struggled to develop a viable theory that forecasts inflation. As a result, many central banks have been slow to react to the price rises. At a fundamental level, inflation reflects our collective inability to agree on how to pay for the massive debts incurred during the pandemic.
Policy-makers assumed the pandemic’s major effect was greater for demand than supply. The disruption to supply surprised the Bank of Canada, which in summer 2020 predicted “much of the initial decline in supply is likely to be relatively shortlived.” Central bankers are now hedging their forecasts, however. Bank of Canada Governor Tiff Macklem recently acknowledged price increases were more than temporary, partly because the Bank has downgraded its estimate of potential economic growth nearly a full point to 1.6 per cent. For his part, Fed Chair Jerome Powell has admitted that “Supply-side constraints have gotten worse. The risks are clearly now to longer and more persistent bottlenecks, and thus to higher inflation.”
The government’s most striking distortion was to provide so much emergency income support that personal disposable incomes actually rose in a recession. Earned income fell sharply but massive government support more than made up the difference. The increases in incomes and savings show that much government aid was not needed, especially during the slow shift from economy-wide stimulus to targeting specific sectors. The government response also distorted the labour market, resulting in the unusual pattern of high unemployment combined with high job vacancies.
Accelerating inflation underscores how economists have long struggled to understand price dynamics. Higher inflation was unforeseen because, as former Fed Governor Daniel Tarullo observed, economists have no reliable theory of inflation. Although “the money supply” must be broadly linked to prices, it has proved hard to define exactly what constitutes the money supply — though maybe right now it doesn’t matter that much: all standard measures have swelled since 2020.
Most models of inflation use the Phillips Curve assumption of a stable tradeoff between inflation and unemployment: the lower is unemployment, the higher is inflation. But recently the curve has flattened. Very high unemployment in 2009 and 2020 should have resulted in persistent price deflation but did not: inflation only moderated briefly. The blurred relationship between unemployment and inflation has led some economists to relabel it the “Phillips Cloud.”
Nor do price expectations reliably anticipate inflation. Firms set their prices based on actual cost and demand conditions, usually at the local level, rather than on economy-wide expectations. Tarullo advises central banks to watch wages and prices and to start hiking interest rates once actual inflation rises. So far, central banks have not followed this advice.
Harvard’s Kenneth Rogoff argues that economists struggle to understand inflation dynamics because “controlling long-run inflation is fundamentally a political-economy challenge, not a technocratic one.” In the 1960s and 1970s inflation originated in the soaring costs of the Vietnam War and Great Society social programs, which in the absence of tax hikes raised government deficits and put pressure on the Fed to keep monetary policy.
More broadly, inflation is symptomatic of an inability to agree on who will pay for high government debts. Friedman elaborated that “The Federal government is the engine of inflation — the only one there is. But is has been the engine of inflation at the behest of the American public, which wants the government to spend more but not raise taxes — so encouraging resort to the hidden tax of inflation … Inflation is taxation without legislation.”
That perfectly captures the public’s current mindset. We are acting as if the pandemic’s enormous cost can be off-loaded to a few wealthy individuals and large firms. History suggests corporate income or wealth taxes never generate sizeable revenues and only delay hikes in the broadbased taxes, like the income tax, that are the sole reliable sources of significant revenues.
In 2003, Nobel laureate Robert Lucas claimed macroeconomics had succeeded because “its central problem of depression prevention has been solved.” The world did dodge depression in both 2008 and 2020. But the victory is hollow. The short-term stimulus required to contain the downturn lowers long-term growth, leaving GDP no higher. That’s a failure because, as former U.S. Treasury Secretary Larry Summers has observed, “The Keynesian aspiration was not to merely reduce the amplitude of cyclical fluctuations, but also to increase overall growth.” Summers concludes the failure of extraordinary stimulus to produce a better outcome “should be a (if not the) principal preoccupation of contemporary macroeconomics.”
The Bank of Canada eventually will curb inflation. But the longer it delays, the higher rates will have to rise, aggravating the pain of soaring debts during the pandemic. Delaying also threatens the Bank’s most important asset: its independence. If inflation continues for any length of time, critics who warned about the dangers of excessive stimulus will insist on greater oversight. Governments must work to eliminate their deficits, now that central banks are ending purchases of government debt, or the upward pressure on interest rates will intensify.