Summary: The success of Keynesian activism over the past two decades was the result of a series of big negative demand shocks. COVID-19 is a negative supply shock. History says: over-easy policy + negative supply shock = stagflation . . . . . . . . .
In Moliere’s satire L'Amour Médecin (1665), a doctor arriving at the house of Sganarelle whose daughter is playing a trick on him by pretending to be sick, is quick to prescribe bloodletting, a popular treatment used against practically every disease at the time.
Keynesian economic activism has become for macroeconomists today what bloodletting was for the medical profession in 17th century France. It is a doctrinaire cure-all.
It wasn't always this way. When I was a graduate student at Columbia University in the early 1990s, the received wisdom among mainstream economists was that the twin pillars of Keynesian activism — monetary policy and fiscal policy — are at best imperfect and at worst ineffective tools.
For example, we learned that tax cuts would encourage more saving than spending as people would realize there is no free lunch, and that tax cuts will have to be paid for by tax hikes in the future. We also learned that increasing money supply would boost the economy only if it comes as a surprise, but the problem is, of course, that it is difficult to surprise people again and again.
So what happened over the past twenty years that turned gun-shy laissez-faire economists into a trigger-happy lot of Keynesian activists? I believe the answer lies in the changing nature of real world shocks.
To understand what I mean by the above, let’s quickly review the best known concept in economics: the law of supply and demand (developed by James Denham Steuart about a hundred years after Moliere). The basic idea is that the higher the price of a good, the greater will be the supply but the lower will be the demand. The market clearing price is the level at which supply and demand are in balance. In this framework, output fluctuations are driven by a shock either to the supply curve or to the demand curve.
Keynesian economics emphasize demand shocks. If a recession is brought on by a negative demand shock, Keynesian economists would argue that the government should loosen fiscal policy (e.g., spend more money and cut taxes) or/and ease monetary policy (e.g., reduce interest rates and print money) to help offset the shock in order to bring the economy back to its equilibrium.
What propelled Keynesian activism into ascendancy, and establishing it as economic orthodoxy, at least in the United States, is a series of big, unexpected, negative demand shocks over the past twenty years: 1) the bursting of the dot-com bubble in 2000, 2) the attacks on September 11, 2001, 3) the collapse of Lehman Brothers in 2008, 4) the European debt crisis in 2012.
These shocks all had the same effect of diminishing aggregate demand, whether by reducing wealth, weakening confidence, or making credit more scarce. It is impossible to deny that aggressive Keynesian policy response, championed especially by the US, succeeded in shortening the recessions following these shocks. Crucially, the aggressive policy easing did not result in a much-feared surge in inflation.
You might be wondering where I am going with this?
The world has been following the Keynesian playbook once again. Over the past eighteen months, we have seen huge fiscal stimulus and massive monetary easing (printing money) throughout the world, especially in the US. Policymakers seem to have taken as a given that COVID is a negative demand shock just like the Lehman collapse or September 11.
However, is COVID really a negative demand shock?
For a company like AMC (a US movie chain), COVID is clearly a negative demand shock. But for a company like Apple, COVID has been a positive demand shock as people bought more computers to work from home. I think it is fair to say that after the initial hit on consumer and business confidence, the main economic impact from COVID has been over the composition of aggregate demand (which favored goods over services) and not on its level.
We can debate whether COVID still represents a negative aggregate demand shock but there is little doubt that it is also a negative supply shock. The best example right now is international shipping. The Delta variant has prompted many nations to cut off land access to visiting crews. As a result, thousands of ships are stuck off congested coasts for weeks waiting to unload cargo. The World Container Index (global container freight rates), which has nearly doubled this year, is still showing no signs of deceleration.
The fact that COVID probably is as least as much of a negative supply shock as a negative demand shock is probably the reason why inflation has returned so quickly, especially in countries that have been the most aggressive in terms of policy response. US consumer inflation hit 5.4% in June, the highest in more than a decade. The fact that inflation has overshot the Fed's target of 2% should be enough proof that Keynesian activism has been excessive.
It is obvious that Biden’s $1.9 trillion stimulus passed in March was too large and even unnecessary. What is shocking is that only a handful of honest economists had the courage to speak up against it at the time. Surely the politicization of academic economists will make the dismal science even less relevant in the future.
Biden and Janet Yellen, the first US Treasury secretary with a Ph.D. in economics since Larry Summers, have been lately assuring the public and the market that the recent surge in inflation will prove to be transitory. However, other than the fact that the double digit inflation of certain goods like used cars is unsustainable, are these assurances worth anything at all?
To answer this question, we need to separate the short-term inflation outlook from the medium-term one:
1) In the short-term, inflation outlook will be largely determined by whether the Democrats manage to push through more fiscal stimulus in Congress. This is an issue that I will take up in a separate post over the next week or two, but I think we should assume that a good chunk will get through as the Democrats still have one more reconciliation bill available to them this year. This means that underlying inflation will continue to rise.
2) In the medium-term, however, inflation outlook will be influenced greatly by the impact of COVID on NAIRU (Non-Accelerating Inflation Rate of Unemployment). NAIRU is the level of the unemployment rate below which wage growth and inflation start to go up. NAIRU has been falling for the past two decades, helping to keep inflation low. However, there are good reasons to think that COVID might have raised NAIRU, especially if it turns out that COVID is here to stay. And why?
It is reasonable to assume that COVID is changing the skills that employers demand
It is reasonable to assume that female labor participation might not recover until vaccinations are developed for children
Any new push for increasing the social safety net would reduce the incentive to work
The fact that record number of businesses are reporting jobs are difficult to fill, even with the unemployment rate at 5.9% (see above chart), is consistent with my hypothesis that COVID might have pushed up NAIRU. If the hypothesis is correct, it will mean that we will see wage growth accelerating before the unemployment rate returns to its pre-COVID low. This will force the Fed to raise interest rates faster than their guidance and what the market is pricing right now (first hike in 2023). We cannot directly observe NAIRU but the possibility that it has gone up is one of the two greatest risks facing financial markets over the next twelve to twenty-four months, in my view.
Bloodletting as a common medical treatment continued into the nineteenth century, even though it likely killed more people than it cured. Among its many victims was none other than George Washington who probably died of it in 1799 when his doctors, treating what is likely to have been strep-throat, drew out about half of the blood in his body in just over a few hours. The aggressive treatment suggests that Washington's doctor was quite confident in the efficacy of his cure.
Let's hope the Keynesian economists in Biden's administration have more humility about what they don't know.