The Great Inflation Debate: Supply Shocks and Wealth Effects in a Multipolar World Economy

Yves here. The article by Tom Ferguson and Servaas Storm summarizes a new, data-driven analysis of the causes of the current inflation in the US and Europe. Confirming an earlier study, they find the primary cause was supply restrictions, as in Covid and now also Russian-sanctions created shortages and supply chain interruptions.

However, this updated and extended work does find that too much demand also played a role. But contrary to widespread ideology, it was not the result of government spending. The timing and magnitude of price increases contradict that theory. Instead, it was spending by the top 10% after lockdowns and travel restrictions ended.

By Thomas Ferguson, Research Director and Professor Emeritus, University of Massachusetts, Boston; and Servaas Storm, Senior Lecturer of Economics, Delft University of Technology. Originally published at the Institute of New Economic Thinking website

Setting the record straight and identifying less destructive pathways forward than round after round of interest rate increases.

Economic history is full of episodes in which inflation triggered both intense social conflicts and heated debates among economists and policymakers over its causes. The present worldwide upsurge in prices is no exception: from the moment governments and central banks first contemplated how to protect their citizens from COVID, inflation hawks and doves divided over whether the measures would touch off an inflationary price spiral.

The arguments intensified as government relief packages swelled and central banks not only supported those but embarked on gigantic programs of quantitative easing to buttress swooning financial markets. In the U.S., discord reached a fever pitch as the incoming Biden administration brought in what became its $1.9 trillion relief package in early 2021. Not only analysts allied with Republican administrations, but prominent Democratic economists predicted disaster, arguing that the Biden relief package, taken together with an earlier December 2020 relief package, was far too large for the likely demand shortfall that the administration intended to offset – and therefore would very likely generate a surge in U.S. inflation.

We underestimated the extent to which inflation would become a problem. So, we undertook a review to figure out why we missed the turn and get a sense of what policy should have been. As we scrutinized the data it quickly became plain that the conventional wisdom that roots the inflationary upsurge in the Biden stimulus is seriously deficient. What is now trumpeted as a triumph of insightful economic analysis is really something else. It looks more like the fabled case of the broken clock that eventually tells the correct time: That, in other words, after being so wrong in the financial crisis of 2008 and the ensuing Euro crisis, inflation hawks finally got lucky for reasons they have not correctly identified to this day.

Our new INET working paper thus undertakes a fresh analysis of the U.S. inflation experience since COVID in hopes of setting the record straight and identifying less destructive pathways forward than round after round of interest rate increases.

The discussion is organized as follows. The first section begins by retracing inflation’s time path in the United States. This lays out benchmarks and GDP data that sets the stage for our analysis in section 2 of whether the observed pattern of price rises is consistent with claims about the role of the Biden stimulus in generating excess demand. Scrutiny of inflation’s course also prepares the way for the discussion in later parts of our paper of how the twin crises of 2022 – the outbreak of war in Ukraine and the off-the-charts weather extremes that so much of the world experienced – have dramatically recast the problem of inflation going forward.

Section 2 presents our critical analysis of the claims about the Biden stimulus. Our demonstration of their spuriousness proceeds in three steps. First, we build on section 1’s discussion of inflation’s course to show how outlandish are notions that rounds of federal (and state-level) pandemic relief spending somehow fueled mighty bursts of consumer demand. The two key data series – stimulus spending and inflation – move dramatically out of phase. While the first ebbs quickly, the second only surges.

Other studies underscore our conclusion. For instance, according to the Brookings Institute Hutchins Center Fiscal Impact Measure, fiscal policy has been a drag on U.S. economic growth from the second quarter of 2021 onwards, driven by the waning effects of the pandemic relief spending, a rise in federal and state tax collections and declines in real federal, state and local purchases. It is obvious that the fiscal drag on U.S. economic growth coincides in time with rising PCE inflation, directly contradicting claims that the Biden stimulus was a major driver of accelerating inflation. Other sources show that American households spent only a small fraction of their 2020 and January 2021 Economic Impact Payments (EIPs) within a couple of months of arrival and did not raise spending at all following the third round of EIPs in March 2021. Taken together, these findings should put to bed claims that the surge in inflation has been caused by Biden’s pandemic relief spending.

We then look at alternative explanations for the price rises. We consider in turn four supply-side sources of inflation: imports, energy prices, rise in corporate profit margins, and COVID. We believe discussions of COVID’s impact have thus far only tangentially acknowledged its importance. In particular, the analysis of its impact on low-wage labor markets in the U.S. has missed important implications of COVID’s continuing importance for wage patterns. The pandemic continues to wreak havoc in labor markets in complex ways that analysts and governments have yet to grapple with, not just directly but now also in the form of long COVID and COVID-induced complications to other illnesses.

Our conclusion is that these commonly cited factors played critical roles in bringing on and sustaining inflation, but they cannot explain all of it. There really is an aggregate demand problem when supply is constrained. This is a point we acknowledge we missed earlier. But the source of this surprise surge in demand was not federal government spending. It came from a feature of this inflation that no one has thus far spotlighted: the unprecedented gains in household wealth, particularly for the richest 10% of households, which we show powered the recovery of aggregate US consumption expenditure, especially from July 2021.

Our estimates indicate an aggregate wealth impact on consumption of $1 trillion during 2020Q1-2022Q1. This implies that the wealth effect amounted to about half of the size of the $2.1 trillion Biden corona support measures. The wealth effect on consumption demand is not based on a broad-based stimulus, however, but rather on the skewed, highly concentrated, pandemic gains in personal wealth arising mostly from the Federal Reserve’s quantitative easing program. Almost three-quarters of the wealth effect on consumption is due to higher wealth for just the richest 10%—and the richest 1% alone account for more than 40% of the increase in consumption demand.

Analysts who have fastened on excess bank reserves generated by quantitative easing as the cause of this spending miss the key point: Reserves (and for that matter the money supply figured any number of ways) have long towered far over legal requirements. But with the waning of the vast Omicron wave of COVID, affluent Americans came out in force and started spending. They had not done this earlier, at virtually the same level of bank reserves.

Section 3 considers how the war in Ukraine and the climate shocks of the summer of 2022 have now added entirely new dimensions to the problem of inflation going forward. The outbreak of war in February had dramatic effects on prices for food, energy, and other important commodities, including fertilizers. More fundamentally, the western democratic countries’ sanctions on Russia, especially the restrictions on the use of the U.S. dollar, dramatically reshuffled existing military alliances and defense arrangements, not simply in NATO, but also in the Pacific. With friction increasing between the U.S. and China, the shifts in the military balance and alliances vastly accelerated evolving patterns in the global economy and the international relations system that until then were maturing at a glacial pace. This newly minted “New World Order” has profound implications for the reliability of global supply chains and patterns of demand, not least in energy. In our view, it implies a long period of intensified and irregularly variable pressures on supply chains that will keep interacting with COVID and climate extremes. Depending on how peripheral wars flare up and down, further changes in alliances and safe areas for commerce will disrupt trading patterns as parts of the world economy partially decouple from each other.

Our conclusion outlines how we believe policies for dealing with inflation have to change if the majority of the world’s population is not to be stressed to an inhuman degree. Our argument is basically that current inflation combines the worst of wartime price rises and the price cycles that wracked earlier agricultural societies. It responds only at an enormous cost to monetary policies because it arises mostly from supply-side difficulties.

Many of these pressures, unfortunately, will vary directly with the extent to which cooperation, rather than destructive competition prevails in the new, rapidly evolving system of international relations. Without serious efforts to restrain super-power interventions, arms spending, and resort to war, no inflation containment strategy is likely to work very well. If, somehow, the current drift toward a multipolar system with a bias toward intensifying conflict can be arrested, then inflation control will be much easier. But supply-side inflation can only be dealt with efficiently through initiatives that work on the supply issues, such as vigorous antitrust, tight limits on commodities markets, and other targeted (microeconomic) regulatory measures, together with major investments in public health and renewable energy.

Fiscal policy also has to adapt: to control supply shock inflation of the type the world is now fated to experience, existing explorations of ways to steady demand over the business cycle have to embrace much bolder macroeconomic measures to control over-spending when supply plummets or becomes more volatile. Some of these include measures in the spirit of (Keynes, 1940); another could be progressive consumption taxes.

What has to be avoided is precisely what is happening now, as central banks respond to the demands for protection from inflation by kicking interest rates up and up. That is a program that is guaranteed to undermine economic progress and, potentially, democracy itself. It makes about as much sense as raising rates in response to harvest failures in old-time agricultural economies.

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  1. PlutoniumKun

    I can’t find the link to it at the moment, but a couple of weeks ago I read an interesting discussion on the point of why Central Banks are so determined to raise interest rates when the data points to supply chain problems as being the source of inflation. The hypothesis is that Central Banks are perfectly aware that current inflation has nothing to do with monetary supply and that raising interest rates will hit working people hard, but that they are choosing this option because they see this as their only possible exit ramp from the post crash world of excessively loose monetary policy. Most central bankers are well aware that the past decades policies have done nothing but pump up asset (rentier) values at the expense of the real economy. In other words, they are ignoring short to medium term considerations and focusing instead on trying to ‘normalise’ policy, with current inflation being simply the excuse. So, just maybe, they are trying to do the right thing for once, but unfortunately political considerations means it can only be done at the expense of a lot of short to medium term pain for anyone who isn’t a banker.

    Anyway, I’ve no particular opinion on this hypothesis, but I’m throwing it out there as a possible reason why Central Banks are doing what they appear to be hell set on doing right now.

    1. Bob

      Excellent point. The Fed sees the bigger problem is artificially low interest rates and is taking the opportunity inflation offers as an excuse to address the out of control growth of debt world wide. Makes sense to me.

    2. Mikel

      Here in the USA, the Fed, would never say out loud that the ridiculous stock bubble needs to be burst and housing (homes and apartments) prices need to come down before they suck the blood out of every other aspect of the economy.
      The Fed has to show deference to the “confidence fairy.”

      I think there should be balance.
      Saving money should be a viable option and not only looking for cheap credit/loans.

      1. lyman alpha blob

        I agree, but the problem with the Fed is they have just the one tool, and Congress refuses to open up their own toolshed.

        Raising interest rates will make the assessed value of homes go down, although not the overall cost of purchasing one since interest rates are higher. All this means is that houses are still out of reach of most people, but now any property sellers get less money for themselves while the banks get even more (of course they do!).

        My house is not really worth a half million dollars, more like a third of that, but that is what comparable homes in my neighborhood have been selling for until recently. Rising interest rates and falling home prices won’t hurt my family too badly since we purchased when prices hadn’t skyrocketed yet, but they will cause a lot of people who recently purchased with small or no down payments to be underwater on their mortgages again. But unless I missed something, there has been nothing from Congress about helping people whose mortgages are underwater to keep them in their homes.

        If we didn’t have a bunch of buffoons running things, government entities might coordinate their efforts to produce the best outcome for the most people, but there seems to be no interest in that. So instead we get continued beatings in the hopes of improved morale.

        1. Eric

          I would question the statement “my house is not really WORTH X”. What makes you say that? Is it where you live? Is it prior demand/price?

          The long run appreciation rate for housing has historically been around 3% per annum (a rate which makes housing a historically bad investment compared others and which lags real inflation by probably 100 bps). Using my house as an example, I purchased 18 years ago at 250 – it’s now Zillow “valued” at around $425 – and that’s what comps have supported. Most of that ZillowAppreciation was in the last three years, for sure – but I would say that’s an upward reversion to mean.

          Anyway, whenever I hear someone say “my house is WORTH X” I always wonder where that numbers comes from – and I definitely see a lot of people swinging way high and low for various reasons – I tend to look at mean reversion over a long period and see if the value makes sense based on that.

    3. cnchal

      > Anyway, I’ve no particular opinion on this hypothesis,

      I have an opinion. It’s total horseshit.

      Central banksters, like the Bernanke, were explicit. Pump stawk and bond prices so that the richest dinner tables were overflowing and the few crumbs that fell off would nourish the peasants.

      Now that peasant can demand a buck an hour moar, all the central bankster’s hair is on fire. Never forget who these venal clowns work for, the filthy rich and that’s it.

      Really want to kill inflation? Tax the shit out of the rich.

      1. Paris

        “Tax the shit out of the rich”.
        Except this never works as intended, does it. It always impoverishes the middle class, who has no escape route from higher taxes, while the rich grow richer.
        Niall Ferguson if I’m not mistaken said once that wealth changes hands only under the most extreme circumstances, i.e., wars, pandemics, revolutions. I can’t wait to see that happening- maybe it’s already happening, pandemics? Check. War? Check. Btw, same Ferguson wrote yesterday that he agrees with Kissinger and that the probability of a world war now is very high…

        1. lyman alpha blob

          If it doesn’t work as intended, then politicians need to get better intentions. There is no reason taxing the super rich ought to hit the middle class, unless that’s where the taxes are aimed to begin with. You can’t just target income, you need to target wealth.

          The megarich can borrow off their massive assets, use the loans for spending money, and then never pay a dime in income taxes. That needs to stop.

      2. Anon

        I’ll take it one step further: knocking labor down a peg can only help enlistment, and otherwise softens the market for the pending (re)armament.

    4. LY

      Central banks see that better fiscal and tax policy is not on offer, so raising interest rates is the main lever they have. If they really are trying to get away from the ZIRP tendencies of the past, we’ll see the interest rates reverse once there’s a whiff of recession.

      Personally, I think the policies are driven by high energy prices. High oil prices are politically unacceptable, and driving them down, regardless of other consequences, is what’s on offer. The obvious move of stopping sanctions is not on offer because that would threaten US hegemony. That’s less palatable to the elites than squeezing the bottom 90% or recession.

  2. Robert Hahl

    Isn’t it true that interest rates must rise during an inflation to protect the currencies, otherwise people will tend to buy (now) anything that they might need in the future, or that should hold some value? (Think of all those Germans in 1923 who saw someone dump a wheelbarrow full of cash on to the street, in order to steal the wheelbarrow. My grandfather told me that story and handed me 17 million Deutschmarks to prove it.) Raising interest rates seems like the only thing that really works. I think this is also what Russia did when, as uncle Joe Biden said, the ruble was rubble.

    1. icepick

      No, Russia’s interest rate went up to 20% only for a brief period and it has been stabilized at 7.5% for a long time.

      Russia’s economy is saved by government spending (M2 supply emission went up 20% compared to 12% annualized inflation). Inflation means nothing when wages grow faster than that.

  3. Fred

    It remains to be seen if spiking interest rates is a feasible approach in the long haul with regard to the predatory finance system. Do not underestimate their lobbying with the government. Asset managers definitely would prefer inflation over high raises of interest rates quite contrary to long term lenders like banks. First and foremost asset managers are interested in aggregate asset prices across a certain portfolio. BlackRock and other hedge fonds keep heavily lobbying for easy monetary policies to inflate asset dealings and prices. The only thing they worry about is inlation to run away which probably might happen only if a wage price spiral kicked in. Cedric Durand made that kind of argument in great detail in the latest issue of New Left Review. So maybe it is not QE vs QT but some sort of mixed monetary policies to keep inflation on relatively moderate levels while allowing finance to to keep running a predominantely rentier economy. The recent intervention how the Bank Of England pivoted with the Gilt crisis would be an example.

  4. Wukchumni

    I’m only used to that old time 70’s inflation in the BC era (Before Computers) when merely changing the font on something was a herculean task and changing packaging size a real burden.

    Sometimes you’d see 2 or 3 price stickers on something, and all of it had to be manually done, there was no mouse clique.

    I keep seeing ‘Biflation’ where you get the worst of all worlds, take a $18 25 pound bag of Thai Jasmine rice and 2 years later it’s a 20 pound bag that costs $24.

    And news traveled a little quicker than molasses, with about half of the world not playing along in the Communist bloc in terms of inflation-effectively neutered-they didn’t matter.

    The whole world is going through hefty inflation, I don’t think that’s ever happened in modern times.

    I see the result of inflation’s cat of nine tales lashing against everything.

    A haircut and a shave was $20 BC (Before Covid) and they all lost out on income during Covid, so that was when prices got raised to $30, and last time it was $42.

    Has the price of razors or brooms to sweep up my dearly departed split ends gone up?

    There being no effective mechanism this time around to quell inflation, as interest rates are 10% lower than they should be to stimulate saving, or just keeping pace with current inflation.

    This will only exacerbate inflation, and in the end your money will be worth nothing.

  5. spud

    bad bad article, they touch on it, then completely ignore it, “IMPORTS” as Michael Hudson has said, we have to pay other peoples prices.

    how you gonna tax the rich, and institute regulation under free trade. they keep ignoring the 900 pound pink gorilla standing in the room right next to them that has a gigantic smirk on its face. its embarrassing for sure.

    the authors might have recognized how expensive it is to ship 1000’s of miles, how much precious fossil fuels are burned up in shipping what used to be made here. how long it takes, that is the lag time from ordering in countries 1000’s of miles away, till the actual order is ready to be shipped, then the shipping, unloading, and distribution time.

    it would simply be a fraction of the time if it was made here, only a fraction of the fossil fuels would be burned if it was made here, and the distribution time would be a fraction if it was made here.

    free trade is terribly inefficient and expensive, and is a direct attack on a civil society, the environment, and only benefits the few.

    terrible article.

  6. Cristobal

    There is just too much money out there. Years ago I tried to puzzle out what might wrong with our economic situation. Not being a real economist I thought about debt, looked up as near as I could the total amount of world debt. It was a humongous number even then, and is now surely much bigger. So, every dollar of this debt is paying interest of, maybe 3 percent(?). Do the arithmatic. A trillion here and a trillion there and pretty soon we are talking real money. Michael Hudson has done a more sophisticated analysis, but the result is about the same. The amount of money up there in the giant pool of money sloshing around looking for a profibable return is about to – or already has – swallowed the world. Thanks to free trade, it is free to move around the world at will, change its color, disrupt the real economies of the world where people live, hide from taxing authorities, destroy the natural world, cause wars (the most profitable business ever), jack up the price of everything, corrupt political systems the world over, and grow ever bigger. It puts the COVID virus to shame.

      1. Cristobal

        To pile on, and try to answer the question posed by this link, the interest rate does not matter. Low rates lead to more money circulating amongst ¨us¨, those who spend it on things like food, housing and shelter and also for production of actual goods. Higher rates on the other hand lead to more money being sucked up into the so-called ¨giant pool of money¨ via higher interest payments to the lenders. There is just too much money out there. How to tame it is the question: debt jubilee, end free trade, re-define usury to mean any interest on debts as the church once did (supposedly), a sharia banking system? None of these are practical. We may be left to muddle along, waiting for the eventual economic collapse that is always just around the corner but never quite arrives in full. The very original thinker, Gertrude Stein, once wrote a book called ¨Money¨ in which she tried to nail down what it really is. It is out of print and hard to find, but has many pithy observations and is worth a read if anyone ever runs across it.

        1. spud

          it won’t end till it can’t go on. what can’t go on, won’t go on. what can’t be paid back, won’t get paid back.

          don’t expect the free traders in power to understand anything. they are simply 100% driven by greed, selfishness, a feverish idiotology, and hatred for anyone who does not exhibit merit, like those dirty blue collar workers.

          the crypto scammers, or the hedge fund rape and pillage plunderers. those are their hero’s.

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