What Should We Do About Inflation? (Part 2)
More stuff where it's possible, less demand where it's not.
If you haven’t already read Part 1, I recommend you do so before going further. I’m also experimenting with a new approach where I put all of the charts into a downloadable PDF (below the paywall) to save space in your inbox.
Inflation is what happens in a market economy when the amount of money and credit used to buy goods and services grows faster than the volume of goods and services available.1 There are only two ways to stop this process: constrain spending, or increase supply. The best strategy strikes a balance between the two approaches by raising production as much as possible, while rationing consumption when necessary to manage unresolvable shortages.
Many of the current imbalances between production and consumption are attributable to the pandemic and to the Russian invasion of Ukraine. Those are massive ongoing disruptions with enormous costs. Most of the inflation we have experienced should therefore be understood as a (clunky) way to distribute those costs—one that is far better than most of the alternatives. The sooner the public health situation is normalized and the sooner peace is restored in Europe, the sooner we should expect the pace of price increases to ebb.
Falling prices of everything from graphics cards to stainless-steel skillets to ocean freight rates suggests this process is already well underway. Since last summer, the growth rate of the money supply has normalized and the federal budget deficit has collapsed. High and rising levels of inventories (outside of motor vehicles) should help sustain the downward pressure on consumer goods prices, while the backlog of 1.7 million uncompleted housing units coming through the construction pipeline will be a helpful antidote to the upward pressure on rents attributable to strong (but slowing) wage growth.
Unfortunately, policymakers across the world are losing patience.2 The danger is that they will resort to the destructive approach of pushing total spending down to meet the impaired level of supply. Instead of waiting for temporary shortages to (mostly) go away on their own, policymakers would force us to endure sustained losses in real output and living standards. Inflation would be tamed at the cost of tanking the economy. Perversely, businesses would likely respond by cutting investment in physical and intangible capital, reducing their productive potential and making it that much harder to raise living standards without bumping into supply constraints in the future.
Is there an alternative?
As the old joke goes, “I wouldn’t start from here”.
Many of our current challenges are due to failures to preserve supply during the first weeks and months of the pandemic. A recent estimate from the Federal Reserve Bank of San Francisco attributed just 3.6 percentage points of the total 9.1% increase in the level of the PCE price index since January 2020 to demand-related factors. Had demand been the only thing affecting inflation over the past 12 months, prices would have grown just 2.5%.3
Unfortunately, oil and gas extraction and refining capacity were vaporized by bankruptcies in early 2020, automakers shut down production and canceled their orders for parts, cattle herders and hog farmers culled their inventories, and airlines failed to retain or replace retiring pilots. Had none of that happened, the world economy would be in a far healthier position today.4
Beyond that, temporary shifts in what consumers wanted (or were able) to buy during the pandemic collided with the virus-induced disruptions to global manufacturing and shipping. Those pressures have been easing recently, but according to the Federal Reserve Bank of New York, the situation is still about three standard deviations worse than normal. Supply shortfalls don’t explain all of the extra inflation over the past two-and-a-half years, but they account for the preponderance of it.5
Russia’s most recent invasion of Ukraine has compounded these preexisting issues by squeezing the availability of commodities ranging from potash to wheat to neon. The shock has been magnified by past policy failures, most obviously the Europeans’ unwillingness to diversify their energy supplies after Russia’s 2014 invasion of Ukraine. And while the democracies’ military planners and sanctions administrators were prepared for the possibility of a Russian invasion, the officials in charge of maintaining strategic stockpiles of food, energy, and industrial inputs seem to have been caught by surprise.
More generally, the Russian invasion is yet another reminder of the dangers of relying on globally-traded oil and gas for transportation fuel, heating, and electric power generation, rather than more dependable non-traded sources such as nuclear, solar, wind, and hydro.6 Energy-saving investments such as insulation, heat pumps, and fuel-efficient cars that may have once appeared expensive now look far more affordable in retrospect. Similarly, the war is also revealing the strategic vulnerabilities posed by an industrialized agricultural system that depends on so much artificial fertilizer (made from natural gas, among other things) to grow crops that often aren’t even meant for human consumption.
“Such good advice, and so timely”, you might say. Choices have consequences, and it’s tempting for a fatalist to conclude that we can’t escape the pain associated with the mistakes of the past. “Trying to postpone the inevitable will only make things worse in the long run, etc etc.”
It would certainly be a mistake to ignore the limitations we now face. But it would also be a mistake to conclude that nothing constructive can be done today to hasten and amplify the forces that should lead inflation to moderate on its own. The following is by no means comprehensive, but it should at least provide a sense of what could be possible if policymakers were interested in responding to the challenge of inflation without crushing consumer spending.