The threat of stagflation

Turn on the TV, radio, social media, news sites, and podcasts and the COVID-19 virus story is topic number 1 through 100 with only the weather report offering relief. The pandemic has both disrupted and ended people’s lives.

The federal government is facing the momentous task of reversing the effects of the resulting recession with a combination of expansionary fiscal and monetary policy. On the fiscal side, rescue spending, financed with gobs of new debt, prevented further deterioration of the economy. On the monetary side, the Federal Reserve has pursued both traditional and unconventional policies.

The public debt of the United States has risen quickly over the last several months. From Feb. 20, 2020 through June 20, 2020, the government’s total public debt has increased by about $3.068 trillion from $23,409 trillion to $26,477 trillion. While the federal government has gone on a borrowing binge and approved huge relief spending, the Federal Reserve is creating huge amounts of dollars that end up paying for the debt.

Lurking behind the easing of monetary policy is the fear that too much money chasing too few goods will lead to inflation, thereby decreasing the purchasing power of the dollar. Once the crisis is over, there is the prospect of prices and inflation accelerating simultaneously, or what people of a certain age will remember as stagflation.

In other words, one potential economic consequence of deficit-financed public spending and the Federal Reserve’s emergency lending programs and interest rate cuts is the threat of inflation in a post Covid-19 economy. Among other things, inflation eats away at the purchasing power of people’s paychecks.

It also disrupts people’s behavior, causing demand-pull inflation. Suppose a rise in prices sets off rumors that prices will increase still more. This is common during inflationary times, when the increasing prices of goods lead people to expect that prices will be even higher tomorrow. People rush in, causing prices to go higher still. People buy more of a product when inflation is rampant, anticipating that the price will only rise more.

Meanwhile, firms selling the products see prices go up and decide not to take advantage of good times by increasing their offerings, but instead hold back, waiting for tomorrow. Thus demand goes up and supply goes down.

At its worst, the entire economy goes out of control, as happened in the 1970s. After several decades of unprecedented growth, signs of a slowdown emerged amid events such as sudden oil price spikes in 1973 and 1979, and increased global competition precipitated important economic changes. In the hope of inflating the economy out of unemployment, the government printed tons of money.

The economy was stuck between a rock and a hard place. Economists called the twin phenomenon of stagnating growth and double- digit inflation: “stagflation.” In 1979, President Jimmy Carter appointed Paul Volcker to chair the Federal Reserve Board. He pursued tight monetary policies, pushing interest rates over 20 percent, with the desired consequence of a steep and prolonged business recession breaking the back of runaway inflation. By 1986, inflation almost disappeared entirely.

The legendary philosopher king of baseball, Yogi Berra, allegedly once said: “It’s tough to make predictions, especially about the future.” Still, many financial mavens are fretting and speculating about the danger of price inflation resulting from money being printed at a frenetic pace in the United States. They fear the country may be entering an era of double-digit inflation similar to the 1970s and that stagflation may return to the daily lexicon.

As John Maynard Keynes wrote, “Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

Americans can only hope that Lenin was wrong or misquoted, and they will not experience the return of stagflation. Time will tell if the inflation mongers are right.

The economy and COVID-19, Part 2

Americans are struggling to adjust to a pandemic whose future progression is uncertain. They have not seen an economic downturn of quite such scale or scope, and people are unsure about how the United States can pull out of the crisis.

Righting the economic ship will require a delicate balance of managing debt and encouraging growth. A large infrastructure investment program that includes private contributions is a feasible way to achieve that goal.

Governments are struggling to prop up economies while confronting the serious and immediate public health challenges of COVID-19, resulting in unprecedented emergency spending and huge budget deficits throughout the world. In the United States, Congress has passed huge spending bills to help businesses and households that have swollen the national debt by about $2.4 trillion. The Congressional Budget Office numbers for its Doctor Doom scenario recently projected a budget deficit of more than $3.7 trillion for the current fiscal year.

Outstanding national debt now exceeds $25 trillion. Additional outlays in response to a second wave of COVID-19 outbreaks could further increase the debt and add to sovereign risk. Even in a low interest rate environment, higher debt service costs will crowd out other government spending. Trying to explain to the average politician that debt is a drag on future growth is a waste of time. Spending today and making a suitcase of promises is what helps them get reelected tomorrow. The future is someone else’s concern.

The Federal Reserve Bank has taken emergency measures to make credit easier to obtain with a bigger money supply and lower interest rates. Additionally, the Fed is lending more than $2 trillion to businesses and state and local governments. There is concern that the Fed’s actions risk future price inflation which would decrease the purchasing power of the dollar. The era of the dollar as the world’s primary reserve currency may also come to an end. In that case the U.S. would no longer benefit from the typical safe-haven demand from foreign investors as the value of the dollar collapses.

Policymakers note that these concerns must take a backseat to addressing the immediate crisis. The present commands their attention, but they may insufficiently appreciate that the future may be more of the present.

Going forward, the U.S. will have to manage the debt, deficits, and debt service payments, and at the same time find ways to support economic recovery to grow its way out of all this debt. While fiscal consolidation—raising taxes, cutting spending, or both—is the tried and true method for tackling debt challenges, it is likely to encounter some major tactical problems.

Raising taxes is politically difficult given the perception among many in Congress that voting for tax increases is tantamount to announcing your retirement from elective politics. Similarly, cutting high-dollar payment programs like Social Security, and Medicare is bound to be strongly opposed by legions of elderly voters.

Another approach is to focus and allocate resources to areas that create the most jobs. The time is long overdue for a bipartisan infrastructure investment package that rebuilds America’s crumbling roads and bridges, invests in future industries, and promotes increased productivity while immediately employing people whose income would give the American economy a shot in the arm. There is a broad consensus among mainstream economists that infrastructure investment has a large multiplier effect through the economy.

The problem is where the actual dollars can come from to fund such an ambitious program. One solution is to recruit private firms to help start, fund, and run as many of these infrastructure projects as possible. If properly structured, such public-private partnerships could tap into the billions of dollars in private capital hungering for low-risk investment opportunities able to offer decent rates of return.

COVID-19 has introduced a host of new economic challenges. A robust infrastructure program that includes private participation would be an effective way to begin to address them.