The path to a recovery for all

The risk of an uneven recovery far exceeds the risk of uncontrollable inflation. Data and research show that the inflation hawks are wrong again. Congress must do more.

In today’s post I evaluate arguments made by inflation hawks like Larry Summers and Olivier Blanchard against the $1.9 trillion relief package. With better data and cutting-edge research, I debunk the flimsy arguments. Below is an excerpt of my piece for the Institute for New Economic Thinking.

A Big Fiscal Push is Urgent, The Risk of Overheating Is Small

The $1.9 trillion stimulus should be large because the need is large

With the stakes so high, disagreement among economists, even those who normally agree with each other, is heated. The question is whether spending at this level is necessary for full recovery or will instead overheat the economy. It appears that the inflation hawks have lost this skirmish, but the war is only getting started.

Most vocal inflation hawks are Larry Summers, a former Secretary of the Treasury, and Olivier Blanchard, a former Chief Economist at the International Monetary Fund. John TaylorGreg Mankiw, and Bill Dudley have raised similar concerns. On the other side are Janet Yellen, current Secretary of the Treasury, Jay Powell, current Chair of the Federal Reserve, Paul Krugman, a past Nobel Prize winner, and Gita Gopinath, the current Chief Economist at the International Monetary Fund, among others.

A critical review of the claims in this debate is plainly necessary. This essay focuses on four main areas of debate: potential output, inflation expectations, targeting on need, and pent-up demand. In each case, the data, research, and prior experience strongly suggest that the risks of doing too little far outweigh the risks of doing too much.

The $1.9 trillion package is not too big, it’s our estimates of capacity that are too low.

The risk of overheating rests on the dubious assumption that the relief package will create more demand than can be met easily and will thus lead to uncontrollable inflation. Making the same mistake that so many did in the policy debates of the Great Recession and its painfully slow recovery, the hawks are underestimating the economy’s capacity. They base their argument on elementary comparisons of potential output from the Congressional Budget Office and GDP from the Bureau of Economic Analysis. That approach is outdated and flawed.

Conceptually, the hawks’ focus on the difference between GDP and potential output—the so-called output gap—is sensible. But they breeze past the commanding fact that similar calculations during the Great Recession understated the shortfall in demand and led to policy responses that were far too small.

Let’s look at Blanchard’s arithmetic on potential output:

“In January 2020, the unemployment rate was 3.5 percent, the lowest since 1953; it can reasonably be taken as being close to the natural rate. Put another way, output was probably very close to potential. The Congressional Budget Office (CBO) has estimated the potential real growth for the past few years at around 1.7 percent. Given that actual real GDP in 2020 Q4 was 2.5 percent below its level a year earlier, this CBO estimate implies an output gap in 2020 Q4 of 1.7% + 2.5% = 4.2%, or, in nominal terms, about $900 billion.”

His math checks out, but his assurance does not. For years after the Great Recession, estimates of potential output have been revised downward again and again. See Figure 1. For example, in its forecast published in 2010, CBO expected potential output in 2020 to be $4 trillion (in nominal dollars) higher than its estimate it published in 2020. Using CBO’s earlier forecast and the BEA’s current estimate of GDP, the output gap would be $2½ trillion. That’s more than the relief package and nearly three times Blanchard’s estimate.

The radically different views about the shortfall in output is no simple coding error or a big rethink of methods. The dramatic revision is the result of years of distress after the Great Recession and a policy response that was profoundly lacking.

It is unlikely that the U.S. economy could quickly reach the levels expected in 2010. But this exercise illustrates how a timid policy response in the face of the Great Recession led to immense damage in our productive capacity. We now have ten million jobs fewer than before the crisis—a larger shortfall than any time in the Great Recession—substantial unused capacity remains. Doing too little would be disastrous.

Other problems exist with using current estimates of GDP. First, the headline number masks a dramatic shift in the components during the Covid crisis. Most importantly, GDP is subject to revisions, which can be substantial. The BEA release even states, “The GDP estimate released today is based on source data that are incomplete or subject to further revision by the source agency.” During the last recession, the downward revisions in GDP growth for 2008 were over 2 percentage points. Using preliminary estimates of GDP to judge the output gap could lead us to do too little, as we did in the Great Recession (Sahm, 2015).

Fontanari, Palumbo, and Salvatori (2019) are also critical of CBO-style estimates of potential output. They propose an alternate approach that does not depend on unobservables like the natural rate of unemployment and show that it produces better, more stable estimates of economic capacity. Coibion, Gorodnichenko, and Ulate (2018) provide three other estimates of potential output in 2016—when the Fed justified the rate increases by risks of overheating. That action proved premature. Other methods like Blanchard and Quah (1989), Galí (1999), and Cochrane (1994), also find markedly larger gaps and less cyclicality than the CBO’s approach.

Recent experiences do not prove that CBO’s current output gaps are too small now. But they do underscores the uncertainty around such estimates. It is irresponsible for inflation hawks to rely so heavily on CBO’s estimates.

Inflation expectations among families are unlikely to move up and push on inflation higher.

During the past few decades, actual inflation and expected inflation among families have been low and stable. Many economists credit monetary policy for stable, low inflation and creating the expectations of a similar path going forward. See Figure 2. The prized stability is referred to as “anchored expectations.”

Inflation hawks worry that the trade-off between unemployment and inflation, which weakened substantially over the years, as noted in Blanchard, Cerutti, and Summers (2015), could return with trillions of dollars in fiscal spending. Now they warn of “regime change” in which uncontrollable inflation comes roaring back. They fear that expectations will become unmoored, leading incontrollable inflation. If the Fed waits, as Chair Powell (2020), has promised, to raise interest rates only after higher inflation occurs then inflation would spiral.

The research does not support the hawks. As Jason Sockin and I show, consumers for decades have paid little attention to news about inflation (2015). Likewise, Detmeister, Jorento, Massaro, and Peneva (2015) demonstrated that consumers’ expectations do not respond to Fed announcements. The risk of “unanchored” inflation, after years of stable expectations, is low. Market-based measures of expected inflation have been volatile lately, which is likely due to massive uncertainty, including a new monetary policy framework, a shift in fiscal policy, and the pandemic, not inflation fears.

Inflation experts at the Federal Reserve Board, such as Rudd (2020), show convincingly that underlying inflation remains low and persistent. Nor is it likely to step up quickly. In fact after a decade of low inflation, Powell sees some inflation as welcome. The Federal Reserve—an institution with a long history of inflation fears—is not worried about overheating. The inflation hawks are out of touch with reality, again.

Inflation phobias are hard to quell, especially among economists who lived through the era of high inflation and high unemployment—referred to as “stagflation.” Malmendier, Nagel and Yan (2021) show that personal experience with high inflation helps explain the behavior of inflation hawks on the Federal Open Market Committee since the 1950s. Many inflation hawks outside the Fed share that same background.

Ironically, recent research suggests that we may have taken the wrong lessons from stagflation. Using geographically detailed data, Hazell, Herreño, Nakamura, and Steinsson (2020) find that changes in unemployment since the early 1980s have had essentially no effect on inflation. Moreover, disinflationary pressures have increased. Stock and Watson (2020) find that globalization is one factor holding down inflation.

The selective memory of the inflation hawks is frustrating. They remember stagflation clearly like it was yesterday, but they forget the Fed’s decades of experience since then at keeping inflation under control. The inflation hawks need a whole series of bad events for their doomsday scenario to come true. Each of these events is less likely than the next. In contrast, it is easy to see the scarring scenario come to pass.

$1.9 trillion should be large because the need is large.

A weak, if now very common, critique of the relief package is that it is “beyond the imperative of relief,” in Summers’ words. One shred of evidence that inflationist hawks point is aggregate employee compensation is being back on track.

A narrow focus on aggregates is the wrong way to judge the circumstances of most families. Half of U.S. families lost employment income last year and less than one fifth received jobless benefits. Yellen rightly argues, “I want to make sure that Americans don’t suffer needlessly.” Over half of the money would go directly to families, including stimulus checks, unemployment benefits, education, housing assistance, and child benefits. See Figure 3.

The current stage of the economic crisis differs from the situation last spring when the CARES Act passed. Our economy was in free fall then. Congress, the President, and the Federal Reserve moved quickly to pump trillions of dollars into the economy. It worked. Over the summer we clawed back half of the 20 million jobs lost in the spring. Yet, 10 million jobs are still missing–a loss larger than that in the depths of the Great Recession.

Aggregate employee compensation has recovered. How can that be? The answer has to do with the massive income inequality in the United States. Aggregate personal income—the largest component of which is employee compensation—is dizzyingly skewed toward the highest income families. In 2018, the most recent available data, the bottom 60% of households by income have less aggregate income than the top 10%. And the top 10% has markedly more income than the next 10%. Keep in mind that the $1,400 checks go the bottom 80% of households and the extra unemployment benefits are even more skewed to lower income families See Figure 4. And more than those with low incomes—live paycheck to paycheck with little if any savings (Weidner, Kaplan, Violante, 2014). The need is always there, especially now.

Doing too little risks locking in even more inequality. Inequality worsened during the Great Recession and its slow recovery. In 2018 the top 10% by personal income had $2.5 trillion more in personal income than in 2007. That is two and half times more than the aid to families in the new relief package. The $1.9 trillion package fights today’s crisis and the threat of even more damage.

A big relief package is necessary for a rapid recovery for all.

Without a big new relief package the labor market recovery could take until early 2023, a full three years after the Covid crisis began. With the relief package the recovery should come much sooner. The surge in consumer spending in January suggested that the $600 checks enacted in the December package once again spurred demand. Families are not so flush with cash, as the hawks claim, that more money will do nothing to stimulate spending. Experience in the Covid crisis and prior recessions shows undeniably that relief works.

Yes, Americans entered the Covid crisis in a better place financially than the Great Recession.. The shock that pushed us into this recession is different: a global deadly pandemic, not a bursting housing price bubble. However, a year into the current crisis the job losses remain massive. Moreover, we know from the 2001 recession that even a mild recession can hold back the labor market for years.

Since 2001, jobless recoveries where the labor market lags GDP have been the norm. Another would be devastating. The real unemployment rate—adjusted to include the millions who have dropped out of the labor force in the pandemic—is close to 10 percent, which is 6 percentage points above its pre-recession level. See Figure 5. To close the current shortfall in payrolls, we would need to add one million jobs, on average, every month for the rest of the year. More relief could help us achieve that ambitious goal. Wringing our hands over the low inflation risk will not.

We do not already have “all the ingredients for a booming economy,” and more relief will not “light a fire” leading to uncontrollable inflation. Let’s face facts: millions of Americans are suffering, the cleavage between the haves and the have nots is widening, and relief works.

Conclusion: Complacency, not inflation, is enemy number one. Congress must do more.

Now is the time for action. Now is not the time for inflation fears. The need is to do more is immense, and policymakers must deploy every tool they have. It is appropriate to consider the risks of overheating and the risks of suffering. It is not appropriate to downplay the suffering. The evidence and the research clearly show that the risks of doing too little are ones on which we should base policy. The hawks are peddling outdated thinking. When the world changes, we must change, especially when our decisions affect millions of people. It’s time to listen to Americans and help them back on their feet quickly. It’s time to build an economy that works for everyone.

The inflation hawks are wrong. Congress must go big.