How Inflation Radically Changes Economic Ideas by John Cochrane

Inflation and the Need for a Change in Economic Policy

Introduction

Inflation teaches us that supply, not demand, constrains our economies, and government borrowing is limited.

The Impact of Inflation

The unexpected resurgence of inflation is a slap in the face, telling us that the consensus ideas of economic policy are wrong and need to change. Fortunately, the “new” ideas we need are well tested and sitting on the shelf.

Inflation comes when aggregate demand exceeds aggregate supply. The source of demand is not hard to find: in response to the pandemic’s dislocations, the US government sent about $5 trillion in checks to people and businesses, $3 trillion of it newly printed money, with no plans for repayment. Other countries enacted similar fiscal expansions and reaped inflation in proportion. Supply is more contentious. Supply did shrink during the pandemic. But inflation spiked after the pandemic was largely over, and many “supply shock” industries were producing as much as before but could not keep up with demand.

But just how much inflation came from demand, induced by looser fiscal or monetary policy, versus reduced supply matters little for the basic lesson. Inflation forces us to face the fact that “supply,” the economy’s productive capacity, is far more limited than most people previously thought. The mantras of the 2010s—”secular stagnation,” “modern monetary theory,” “stimulus”—which preached that prosperity needed only for the government to borrow or print a huge amount of money and hand it out, are in the dustbin. You asked for it. We tried it. We got inflation, not boom.

A Supply-Limited Economy Requires Supply-Oriented Policy

A supply-limited economy requires supply-oriented policy, not stimulus, to grow. “Jobs” are now a cost, not a benefit. With 3.7 percent US unemployment, every worker employed on a make-work project is one not doing something more important. Regulations make housing far too costly and time-consuming to build. A coherent immigration system brings in people who work, produce, and pay taxes. We need public infrastructure, but its obscene excess cost is a rathole we can no longer afford. Tariffs that force us to overpay for things foreigners can provide better are just a drain on the economy. Policy focused on who gets what must now focus on incentives, which are the key to growth.

The Cancer of Stagnation

Stagnation is the quietly insidious economic cancer of our era. US growth fell by half after 2000. Europe and the UK are stagnating even more. Italy has not grown in per capita terms since 2007. Reviving long-term growth drowns any other policy, and only supply, efficiency, productivity, and incentive-oriented policy can revive long-term growth.

The Limitations of Government Debt

The view that there is unlimited demand for government debt, with buzzwords like “savings glut” or “safe asset shortage,” has equally proved false. The US, UK, and Europe seem to be able to borrow about 100 percent of GDP. More debt leads to higher interest rates, trouble borrowing, and inflation as people try to spend the extra debt rather than hold on to it as a good investment.

From now on, governments must spend money as if they have to raise taxes to pay for it, now or later. They do. Projections that debt will serenely grow to 200 percent of GDP under primary deficits that are eternally 5–10 percent of GDP will simply not happen. Worse, we have lost our fiscal capacity to react to shocks. If the $5 trillion pandemic response was more debt than people will hold and caused inflation, the $10 trillion response to the next crisis will face even more trouble.

Inflation’s Lessons for Monetary and Financial Policy

This inflation has two deep lessons for monetary and financial policy. First, central banks do not entirely control inflation. Inflation control needs fiscal probity as well. Second, the fiscal blowout was in part a financial bailout, including support for Treasury, municipal, and corporate debt; money market funds; airlines; and others. The central “no more bailouts” promise of the Dodd-Frank financial reform failed. In my view, another 100,000 regulations will fail again, and the only answer is the simple classic vision of equity-financed banking.

Conclusion

These may seem like old ideas. That’s great. Progress in economics has never come from pontificators who urge someone else to throw new ingredients in the pot—say, to “care more about people,” “add psychology,” “mix politics and economics,” incorporate “real-world” complications or “heterodox” ideas—stir, and hope that a digestible soup comes out. Progress in economics has always come from answers, patiently worked out, empirically verified, simplifying reality to actionable cause and effect statements. Economic policymaking suffers from too many pundits who rush to Washington to demand trillions of spending and untold intrusions in people’s affairs, based on half-baked stewpots of novel ideas. Economic policy should rely on well-tested notions. When economists try to supply ideas in response to political demands for the appearance of novelty, they dispense bad economics and bad politics. And what seems old to us can appear novel too. Adam Smith’s 250-year-old ideas are still news to most in politics.

About the Author

JOHN H COCHRANE is the Rose-Marie and Jack Anderson Senior Fellow at the Hoover Institution, Stanford University; adjunct scholar at the Cato Institute; and author of The Fiscal Theory of the Price Level.

Footnote

Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.

SDGs, Targets, and Indicators Analysis

1. Which SDGs are addressed or connected to the issues highlighted in the article?

• SDG 8: Decent Work and Economic Growth
• SDG 9: Industry, Innovation, and Infrastructure
• SDG 10: Reduced Inequalities
• SDG 12: Responsible Consumption and Production
• SDG 13: Climate Action

The article discusses economic policy, inflation, supply and demand, government borrowing, and the need for supply-oriented policies. These issues are connected to the SDGs mentioned above, which focus on promoting economic growth, innovation, reducing inequalities, responsible consumption, and addressing climate change.

2. What specific targets under those SDGs can be identified based on the article’s content?

• Target 8.1: Sustain per capita economic growth in accordance with national circumstances and, in particular, at least 7 percent GDP growth per annum in the least developed countries.
• Target 9.2: Promote inclusive and sustainable industrialization and, by 2030, significantly raise industry’s share of employment and gross domestic product.
• Target 10.4: Adopt policies, especially fiscal, wage, and social protection policies, and progressively achieve greater equality.
• Target 12.2: By 2030, achieve the sustainable management and efficient use of natural resources.
• Target 13.2: Integrate climate change measures into national policies, strategies, and planning.

The article emphasizes the need for sustainable economic growth, inclusive industrialization, reducing inequalities, responsible fiscal policies, and addressing climate change. These align with the specific targets mentioned above.

3. Are there any indicators mentioned or implied in the article that can be used to measure progress towards the identified targets?

• Indicator 8.1.1: Annual growth rate of real GDP per capita.
• Indicator 9.2.1: Manufacturing value added as a proportion of GDP and employment.
• Indicator 10.4.1: Income growth of the bottom 40 percent of the population.
• Indicator 12.2.1: Material footprint, material footprint per capita, and material footprint per GDP.
• Indicator 13.2.1: Number of countries that have integrated climate change measures into national policies, strategies, and planning.

The article doesn’t explicitly mention these indicators, but the concepts discussed in the article can be used to measure progress towards the identified targets. These indicators can provide quantitative data to assess the achievement of the targets.

Table: SDGs, Targets, and Indicators

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Source: imf.org

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