Steven Pearlstein is a former business and economics columnist for The Washington Post and the Robinson professor of public affairs at George Mason University. He is the author of “Moral Capitalism: Why Fairness Won’t Make Us Poor.”
One of the more enduring fallacies informing discussions of the economy is that there are a couple of dials located in a vault somewhere in Washington that officials can turn this way or that to control employment, output, inflation - even the price of gasoline.
Anytime something good happens, some politician inevitably steps forward to claim credit for having got the dials just right. And anytime something bad happens, you can be sure the media and political opponents will blame officials for tuning the dials to the wrong settings.
That’s what happened earlier this year when inflation began to take off and the president, Congress and Federal Reserve were criticized for overstimulating the economy in response to the pandemic. We heard it again late last month when the government reported a second quarterly decline in gross domestic product, triggering dire and exaggerated predictions of recession from Republicans. And now Democrats in Congress are embracing the same fallacy as they ram through a package of climate, tax and health-care initiatives fancifully marketed as the “Inflation Reduction Act of 2022.”
Though kernels of truth stud all of these critiques, they derive from a faulty mental model of the economy and how it works. So let’s step back and see what is really going on.
In the spring of 2020, as a global pandemic was about to plunge the global economy into what would have been a nasty depression, central banks and governments around the world effectively printed trillions of dollars out of thin air to keep businesses from closing and laying off workers while providing households with income to live on. It worked: After a scary few months of plunging stock prices and rising unemployment, financial markets recovered, most businesses continued to operate and most people who wanted jobs could find them.
Unfortunately, as a few of us warned, the governments would go on to provide too much of this fiscal and monetary stimulus for too long.
The charitable explanation, at least in the United States, was that officials were determined not to repeat what they believed - wrongly - was the mistake of excess timidity during the financial crisis and recession of 2008, and that any big jump in the inflation rate would be short-lived. An equally plausible explanation is that President Joe Biden and a Democratic Congress were eager “not to let a good crisis go to waste,” and so used it to justify big increases in public spending and investment to achieve economic, social and environmental justice.
At the same time, the Federal Reserve (whose chair, not coincidentally, just happened to be up for reappointment) was unwilling to begin winding down its extraordinary money-printing out of fear that it would burst the bubble it had created in stock and real estate markets or weaken a labor market that was tight enough finally to deliver wage increases to low-skilled workers.
What is often forgotten is that even before the pandemic and before all this economic stimulus, the U.S. economy was already significantly out of balance. For decades, the country had been living well beyond its means, running large and persistent trade and budget deficits made possible by an overvalued dollar, artificially low interest rates and the willingness of trading partners to recycle their surpluses back into the American economy. Indeed, those imbalances had persisted for so long that just about everyone had come to think they were the new normal and that they could continue in perpetuity.
Given that pre-pandemic prosperity was already dependent on large doses of fiscal and monetary stimulus, it should have come as no surprise that pumping in trillions of dollars in additional stimulus over the next two years would lead to rising prices and wages. Indeed, that was the point of these rescue efforts - to prevent a deflationary spiral, set a floor under household income, stimulate investment and prop up prices of stocks, bank loans and real estate.
In hindsight, it is clear that policymakers ignored warnings and overdid it. But it is equally true that economic policy is not a science, and that the global economy is not a system that can be controlled by a couple of dials in Washington.
No less specious, of course, is the Democrats’ claim that inflation will be significantly reined in by a slimmed-down tax and spending bill that closes corporate tax loopholes, extends and expands clean energy tax credits, extends health insurance subsidies to the working class and gives Medicare the power to negotiate prices on a dozen overpriced drugs.
The Congressional Budget Office estimates that, over the next two years, the Inflation Reduction Act is likely to change the inflation rate by less than one tenth of 1% - but it isn’t sure whether the change would be up or down.
Even over the next five years, according to the Committee for a Responsible Federal Budget, the package moving through Congress would reduce the federal budget deficit by a piddling $25 billion - a rounding error in a $23 trillion economy. Regardless of the final number, the measure will hardly dent an annual federal budget deficit projected to run at the unsustainable rate of 5% of GDP over the next 10 years.
Equally silly is the Republican critique that the same officials who mistakenly triggered inflation with too much stimulus have now lit the fuse on a long and deep recession by withdrawing it.
First off, most of us do not have sensitive enough economic antenna that we can tell the difference between a national economy that is producing 1% more goods and services than the previous year and an economy that is producing 1% less. The measurement of GDP, the gross domestic product, is too imprecise, the difference too small. The partisan hyperventilating about whether we are or aren’t in a recession is more about politics than economics.
More significantly, given that the economy and the financial markets are coming off an intentionally induced sugar high, the fact that output, employment, home sales and stock prices might be coming down a bit is both healthy and necessary. Over the last year, the economy “created” more than 6 million jobs, an increase of 4%. At a time of restrained immigration and lots of baby boomer retirements, there just aren’t enough workers to keep up that pace or even fill the open jobs already out there. And with government and household spending and borrowing coming off record levels created by all that stimulus, we should hardly be surprised if unemployment ticks up from its current historic - and unsustainable - low of 3.5%.
Yes, some workers may lose a job as the economy adjusts to a more sustainable level of spending and output, but the evidence from employers is that in most places most should be able to find another. And to the degree people are unable to find jobs, it is not because some officials set the macroeconomic dials wrong in Washington - it is because workers are unwilling or unable to move to where the jobs are. Or because educational and labor market institutions are not producing the trained workers that businesses need.
The adjustment to a more stable and sustainable economic balance cannot be and will not be painless.
Relative to other things, the value of stocks and real estate will have to fall and some of the loans used to buy them written down.
Some workers will have to acquire new skills and move to find jobs, while employers may have to move to find workers and spend more to train them.
The wages paid for lower-skilled jobs will have to rise to attract and retain workers, while the inflated incomes of those at the top will have to fall.
Government spending will have to be brought more in line with government revenue. Households will have to borrow less and save more. Interest rates will have to rise closer to historic levels while the value of the dollar will have to fall, raising the relative price of what we import while reducing the apparent price of what we produce for the rest of the world.
The alternative to bringing things back into balance is to continue living with the boom-and-bust cycle of the past 30 years. Such an economy will require ever larger doses of fiscal and monetary stimulus to prevent falling into recession. It will also remain an economy in which the rich get richer and the poor get poorer. It will remain an economy that becomes increasingly and dangerously indebted to the rest of the world.
In short, a healthy, sustainable economy is not one that requires government officials to be constantly and dramatically adjusting macroeconomic dials in Washington to keep things in balance. Rather, it is one that relies more on the natural self-correcting mechanisms of open, competitive and well-regulated markets.
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