On Inflation

So many people have asked about my views on inflation that I’m pausing my antitrust series to address the topic. Back to antitrust next week.

“If [Biden] succeeds, the President will cast 40 years of economic doctrine on history’s ash heap. But that’s a big if.” — Michael Hirsh, in Foreign Policy

In my day job, I work with many families who own large operating businesses. To a family, without a single exception, these businesses are experiencing labor and supplier inflation unlike anything anyone has seen since the 1970s.

The question is not whether this inflation in operating costs is real — it certainly is. The question is whether the current inflationary boomlet will persist and insinuate itself into the broader economy. If not, investment portfolios probably needn’t be adjusted for inflation worries. If so, most investor portfolios will need to be revised.

Operating businesses are faced with rapidly rising costs on two fronts. The first is for labor, mostly unskilled or semi-skilled. Although the nation’s unemployment rate remains high, it’s very hard to attract workers. Why is this?

The short answer is that no one knows for sure. In all likelihood it arises from a combination of factors, all relating to the pandemic:

• Fear of COVID, of having to interact with customers or fellow employees.
• Problems with school-age children who are still taking classes online.
• Problems with child care.
• The fact that many workers actually enjoyed being at home and are reluctant to return to the grind. Low-skilled workers often have a tenuous connection to the world of work in the first place.
• Historically generous government benefits that allow many lower-wage workers to maintain their lifestyles without working.

But all these factors will be coming to an end soon: fear of COVID is ebbing rapidly; most kids will be going back to school in-person in the fall; whatever childcare arrangements families used before COVID will soon be available again; many workers will be enjoying a hybrid work schedule that allows them to work from home several days a week; government benefits will eventually run out.

In other words, while it’s hard to believe now, labor problems may well work themselves out in a relatively short period of time, possibly before year end.

Supplier problems seem to be partly the result of the labor issues, which affect suppliers as well as the operating companies themselves, and partly the result of supply-chain disruptions. Both are annoying but almost certainly temporary — the rewards for solving the supply-chain issues are quite large, and as a result many people will be working hard on them.

But that’s the positive side of the story. Let’s look at the other side.

Until the very high inflation years of the 1970s, Keynesian economists believed that permanently low unemployment could be achieved by accepting higher inflation, and also that the higher inflation could be kept under control. The 1970s proved them to be disastrously wrong.

That experience led to the rise of monetarism, the view that money supply drives inflation in the long run. But monetarism, too, ran into trouble, as the relationship between money growth and inflation proved to be highly unstable.

Today, the so-called “New Keynesians” rule the roost. These economists, who dominate the world’s central banks, believe that inflation is driven by three factors: supply-side shocks, whether or not the economy is operating at full capacity, and what sort of inflation expectations consumers have.

The New Keynesians could be as wrong as the old Keynesians, of course, but even if they’re right, notice that two of the three conditions for inflation already exist: supply-side problems and consumer inflation expectations (which are around 5 percent).

But what about the third condition? Is the U.S. economy operating above its efficient capacity? The answer, for now, is no. The country still has nearly eight million fewer workers than it had before COVID, and many businesses are still recovering from the pandemic.

But consider this: wholly aside from monetary and fiscal stimulus, the recovery from the pandemic was already far stronger than almost anyone, including the Fed and the incoming Biden Administration, were predicting. On top of that we have the added octane of historically high monetary stimulus and fiscal stimulus that is greater than at any peacetime era in American history. And in the past, high spending was countercyclical, designed to boost a poor economy — the Biden spending is pro-cyclical.

Is it inconceivable that a powerful organic economic recovery supercharged with massive monetary and fiscal stimulus could put the economy into overdrive — that is, operating well above its natural capacity?

It’s true that if this happens, the Fed could simply raise rates, perhaps substantially, but that would kill off not just inflation but also the economy itself. Does anyone believe the Fed would have the moxie to plunge the country into a recession just before the midterm elections, thus putting the Republicans in charge of both houses of Congress?

But there may be more to worry about than an inflationary breakout. Between the Fed and the Biden Administration, U.S. government debt has reached staggering and never-before-seen levels. It’s true that at current interest rate levels the debt is sustainable, but what if rates rise significantly?

Far worse, what happens if all this spending accomplishes nothing more than a brief spurt of high growth and the economy then settles down to the dreadful 1 percent to 2 percent growth rate we’ve experienced since the Financial Crisis (until recently)? Alarmingly, even the Biden Administration itself predicts that longer-term growth will settle back to 1.9 percent.

The combination of slow growth and high inflation is called stagflation, the disease that afflicted the U.S. economy in the 1970s and that nearly destroyed the country. Even if inflation remains low, the triple-whammy of heavy indebtedness, very low inflation, and slow growth represent secular stagnation, the disease Japan has suffered from for three decades and that is very difficult to emerge from.

There is certainly a happy way out of all this: the spending spree could lead to permanently higher growth and we could grow our way out of our debt. But if any of the other three paths happen — high inflation, stagflation or secular stagnation — Joe Biden might be the last Democratic president in our lifetimes. It’s a risky game we’re playing.