I’ll start by noting that over the past couple of decades, it has proved far less necessary to worry about inflation than most economists have long thought. Economists used to believe in something called the Phillips curve, for example, which asserted that the odds of inflation rise as the rate of unemployment descends. They even used to believe that they could use the Phillips curve to make predictions. The last half decade of low, low unemployment and low, low inflation has trashed that faith. Median wages have only begun to inch up in real terms very recently, and these days many economists believe that the US economy could make profitable and noninflationary use of even more fiscal stimulus than it has received. There’s been a fair amount of fiscal stimulus under Trump; deficit spending has soared in a way that Republicans would never have permitted under a Democratic President, and yet all the indicators have toddled happily along nonetheless. The Fed is so far from worrying about inflation these days that its great fear of late seems to be that it has kept interest rates so low for so long that if it needs to add fiscal stimulus by monetary means, there’s not much lower it can go.
All of this is by way of saying, it’s a little perverse at the moment for me to even raise the specter of inflation, and I know it. Let me explain what made me think to ask the question.
In the 1970s, Keynesian economics failed to explain the combination of high unemployment and high inflation that became known as “stagflation.” This intellectual failure gave a policy opening to Friedman’s monetarism and, a decade later, to Thatcher and Reagan’s neoliberalism. Did Keynesianism fail because its premises were wrong, as Friedman and other advocates of shrinking the government asserted, or because the Keynesians were misreading the economic signals at the time? This is a big debate among economists. Among the most striking economic signal in the 1970s were the spikes in the real price of oil. Looking through the decade’s numbers, I’ve been impressed by the fact that real food prices seemed to spike in tandem with real oil prices, which makes sense, given that modern agriculture is driven by fossil fuel, via fertilizer and farm machinery. In other words, during the 1970s, two costs that an average working person could not forgo, food and fuel, both rose relative to the prices of other goods, leaving workers with less to spend on any other category, and as Keynes showed, the spending of people with less income is far more crucial to the strength of the economy than the spending of those at the top. This leads me to wonder, in my amateur, I’m-only-a-novelist-playing-at-economics way, if an economic crisis caused by a sudden rise in the cost of core goods might be different in kind from an economic crisis caused by a collapse in demand. Maybe the right remedy for one might not be beneficial for the other?
There’s a suggestion of this in an endnote to Binyamin Appelbaum’s new book, The Economists’ Hour. Appelbaum believes that Keynesianism can be reconciled with the conditions of the 1970s:
Stagflation can be explained in a Keynesian framework, but the explanation was not well understood at the time. The gist is that higher oil prices forced people to reduce consumption of oil, or of other goods, which increased unemployment. The United States responded with an economic stimulus, driving up inflation. Why was the stimulus ineffective? The original problem was a decline in the supply of oil, so pumping money into the system drove up prices. It was a demand-side response to a supply-side problem. Nations that refrained from stimulating their economies, including Germany and Switzerland, experienced an economic downturn but did not experience higher inflation.
My question is whether a COVID-19 pandemic, if it does break out in America (this coming fall if not this spring or summer), might be more like the 1970s oil crisis than like the 2009 financial crisis. In America, as in all industrialized economies, the bulk of the economy long ago shifted away from manufacturing to service. But during a pandemic, the supply of services is bound to contract, as people stay home from work because of either illness or fear of illness. And if services end up suffering a supply-side shock—if there are suddenly far fewer people offering services—will pouring money into the economy help? (Pouring in money is what a number of policy makers are now contemplating.) If far fewer people are healthy or brave enough to cut your hair, babysit your children, or deliver your groceries, because they’re all sheltering in place in their homes, won’t juicing the economy merely drive up the price of these services, without doing much to increase the number of people available to perform them?
I’m offering this only as speculation. I may have misunderstood some of the economic fundamentals here; for example, in the gig economy we have now, all those haircutters, babysitters, and grocery deliverers will probably be abruptly without income during a pandemic, and maybe the demand-side shock caused by their loss of income will cancel out any supply-side shock caused by their sudden withdrawal of services, and so they’ll need to get some new money in their wallets after all. Or it may be the case that the underlying capacity of the economy to absorb more stimulus is still simply greater than any compromise of that capacity that might be inflicted by the pandemic’s shock to the supply of services.
UPDATE, 6:20pm: I just discovered that Appelbaum himself raised more or less exactly this issue, more cogently, in an online op-ed at the New York Times a few days ago:
Cutting rates is not an effective antidote for the coronavirus. Lower interest rates increase economic growth by driving up demand, while the disruptions caused by the spread of the virus are reducing the supply of goods. Cutting rates won’t address that “supply shock.” It won’t hasten the return of Chinese workers to factories, or speed ships across the Pacific.