Both Republicans and Democrats talk about inflation. Neither has anything useful to say.
A number of political analysts have observed that inflation has displaced other issues as the dominant issue in this election cycle. That may well be true, but should it be?
The left at first tried to dismiss inflation as transitory. When that was clearly false, some said inflation is not that harmful. When voters clearly appeared to believe that inflation matters, the left switched to “it’s not our fault,” citing high levels of inflation in many other countries and blaming supply chain disruptions and Russia’s war against Ukraine.
The last of these has at least a little bit of merit, but there are many low inflation countries that suffered from these same problems. The unifying feature of economies with high inflation is loose monetary and aggressive fiscal policies to combat the Covid induced recession.
Republicans certainly share the blame for loose monetary policy. Political pressure from both parties has encouraged the Fed to keep interest rates far too low for far too long. Other countries have experienced a similar dynamic to varying degrees. Democrats bear most of the blame for just how aggressive fiscal policy has become, but Republicans share some of the blame for actions taken during the Trump administration.
Democrats say that Republicans complain about inflation but offer no solutions. On that the Democrats have a point. The Democrats offer solutions, that aren’t solutions. The “Inflation Reduction Act” was about climate change subsidies. Most economists agree its role in terms of inflation will be minimal. Student loan forgiveness is a wealth transfer. If unfunded through tax increases on someone, student loan forgiveness will just make inflation worse in the long term. Price controls on drug prices, like all price controls, just make markets less efficient. Real reform here would require U.S. drug companies that receive U.S. patent protection grant “most favored nation” status to U.S. consumers. Under this rule drug companies would be free to set prices, but they could not charge any U.S. consumer, including Medicare, any more than the least expensive price they charge outside the U.S. This would be good public policy, but it has nothing to do with inflation.
What is inflation?
Remember, inflation is a rise in the general price level. Higher or lower prices for individual commodities are not inflationary or deflationary. For example, in the absence of accommodating monetary policy, higher energy prices just mean lower prices for other goods (or recession, but that requires a much longer discussion).
What would help?
So what should both parties be saying on inflation. First, it is a serious problem. Second, the Fed is doing the right thing by raising interest rates, and we (the politicians) will avoid pressing the Fed to back off before the job is complete. Third, if elected we (the politicians) will not make the Feds job harder by cutting taxes or increasing spending.
What role should inflation play in the mid-term elections?
Neither party is saying anything like that. So from my perspective, inflation is not an issue for the mid-terms. Maybe it should be, but it certainly does not help me decide on who to vote for. In any case, we will have divided government for the next two years, even if the Republicans gain both the House and the Senate, since Biden is President. Divided government means that we are unlikely to see either tax cuts or major spending legislation. That may be the best we can hope for since it will make the Feds job easier.
If not inflation, what issues should drive the election?
Vote on abortion rights, there are clear choices to choose from, no matter where you stand. Vote on preserving democracy and election integrity, there are clear choices. Vote on America’s commitment to NATO and the defense of Ukraine against Russia, there are clear choices. Vote on climate change or energy security, there are clear choices.
But please don’t vote on inflation. There is no party that offers a good answer here.
I have been asked why we have so few endorsements in U. S. House races for the mid-term elections. The answer is partly that we don’t have the resources to cover these races. It is also partly because most U.S. House races are foregone conclusions after the primaries.
We do have some general guidelines about how to think about these races. In order of priority they are: we oppose any candidate who supports Donald Trump and his 2020 election behavior; we oppose any candidate who is against U.S. efforts to aid Ukraine’s defense from the Russian invasion; we oppose candidates who support extreme positions on the abortion issue; we oppose any candidate who believes we should address inflation with price controls or windfall profits taxes; and we oppose candidates who deny that climate change is a serious issue.
Our feeling is that the first two of these issues are the priority for the 2022 U.S. Congressional elections.
Donald Trump, never a good person or candidate, has become increasingly destructive to the nation and even his own party. Candidates who would not be on the ballot but for Donald Trump’s endorsement and who support his wild claims about the 2020 election should not be voted for under any circumstances. For a complete list of Trump endorsements, go here. Obviously Trump endorses a lot of candidates just because he likes backing winners. As a general rule, I would recommend against voting for most of these candidates. (I might make exceptions for incumbent candidates who did not ask for and did not need Trump’s endorsement and who deny Trump’s claims about the 2020 election.) If you can’t abide the Democrat, vote for a third party candidate or write in someone’s name.
The fate of Western democracy, the preservation of a rules-based international order, and the prevention of a physical and cultural genocide in Ukraine depends upon the U.S. and our allies supporting Ukraine and expelling Russia from Ukraine. Conveniently, all 57 of the U.S. House members who voted against aid for Ukraine are Trump supporters. For their names, visit our Rogues Gallery of Candidates.
Abortion, no matter how important the issue is to you, or which side you are on, is almost certainly going to be decided at the state level. If that is your priority issue, focus your attention on the gubernatorial and state legislature elections.
Inflation is primarily an issue for the Federal Reserve Board. We would recommend voting against candidates who want to undermine the Feds efforts. We also oppose candidates who think the right way to deal with inflation is price controls or windfall profits taxes. There aren’t very many candidates who support either of these policies and they are recognizable by their association with the “Working Families Party,” so they are easy to identify.
On climate change, the “Inflation Reduction Act” went about as far as either party is willing to go. Republicans are unlikely to get enough votes to repeal it. Many Democrats seem reluctant to take the one step that would make a difference: a carbon tax with a comparable tariff. There are reasonable differences of opinion on the issue of what, if anything, should be done about climate change. However, candidates who view concerns about climate change as a hoax do not seem worthy of consideration. Again, these candidates are fairly easy to identify because they tend to be hard-core Trump supporters.
In my opinion, there was a fair amount of truth in President Biden’s speech to the nation last night. I agree that the single greatest threat to American democracy, at the moment, comes from Donald Trump and his loyalists, what Biden calls the MAGA Republicans.
For that reason, the Centrist Independent Voter will be endorsing a number of Democrats who would be far too left or populist for our taste, in normal times. But as Biden says, “these are not normal times.” Generally speaking, we will be endorsing the opponent of any candidate who owes his place on the ballot to a Trump endorsement.
Where Biden Missed Opportunities
It takes no courage to call out extremism in your opponent’s political party. It takes courage to call out extremism in your own political party. Liz Cheney (R) and Adam Kinzinger (R) deserve praise for having done so in the Republican Party.
If Biden had called out the extremists within his own party, he would have earned our praise. There were many opportunities to do this.
Political Violence
Biden mentions that political violence is never justified. I could not agree more. But the only example he points to is January 6th. He could have mentioned the riots that accompanied many of the Black Lives Matter protests. He could have condemned the violence and vandalism that accompanied protests against the World Trade Organization, the International Monetary Fund, and the World Bank a few years earlier. But these were examples of the use of political violence by the left. I am glad that Biden condemned all political violence. However, to gain credibility with independents and mainstream Republicans, he should have admitted that we face the threat of political violence across the political spectrum.
Am I Expecting Too Much?
You might say that if Biden were to admit to faults on the left he would have hurt his party in the upcoming mid-term elections. Fair enough. But let’s not get sanctimonious and demand that mainstream Republicans openly condemn Donald Trump, in the middle of election season. I expect politicians to be self-serving. I am delighted when they are not. Biden’s speech, while correct on many counts, was self-serving.
Inflation
Another missed opportunity for Biden to call out extremism in his own party was his silence on inflation. We mention elsewhere that, in the end, inflation is a monetary phenomenon. However, in the face of accommodating monetary policy, aggressive government spending (fiscal policy) will increase inflation. Biden claims the employment benefits of the Covid relief spending without admitting its role in sparking inflation.
This would have been an excellent opportunity to reject the Modern Monetary Theorists in the Democratic Party. This crowd, which includes many in the Progressive Caucus, believe in a cornucopia theory of economics in which there is no price to be paid for ever expanding government spending.
Biden’s silence on the issue was to be expected from a self-serving politician. A simple admission that there should be limits on government spending would have given him real credibility among independents.
Democratic Party Support for MAGA Republicans
Perhaps the biggest missed opportunity in Biden’s speech was his failure to condemn cynical attempts by his own party to promote the candidacy of MAGA Republicans in the primaries. The Democratic Party, and associated PACs, did so because they believe that MAGA candidates will be easier to defeat in the general election. How can Democrats think that independents will take the threat from the far right seriously when the Democratic Party works to support these far right candidates in the primaries? How can Biden give this speech, arguing that MAGA Republicans are a grave threat to the nation, while his own party funds efforts to get them elected? The only conclusion I can draw is that he and his party are just self-serving politicians.
Even a veiled condemnation of these efforts would have given him a real boost among independents.
Bottom Line
Yes, extremist Trump supporters, like those who participated in the January 6 attack on the Capitol, are a grave threat to the nation. We should all do what we can to make sure that they do not acquire political power. However, extremism has many faces. The President, and Democrats in general, would be more credible in calling out extremism if they were willing to admit it exists within their own ranks.
Is the Cancellation of Student Debt Good Public Policy?
I have not actually heard a reasonable attempt to rationalize student debt cancellation as good public policy. If you know of one, please post it in the comment section.
The pause in student debt payments during the early stages of the pandemic could be justified as fiscal stimulus (needed at the time) or as part of a broad array of policies to cushion the individual financial impacts of the pandemic. What the White House announced yesterday is different.
More than anything, debt cancellation is now a political payoff to a special interest group that supported Biden, and the Democratic Party generally, in 2020. As a political payoff, it is no worse and no better than any other political payoff to a special interest group. It is no worse than Sen. Kyrsten Sinema getting rid of the carried interest provisions in the “Inflation Reduction Act,” in return for financial support from the private equity industry. It is no worse than Sen. Joe Manchin defending the coal industry. It is no worse than many of the special tax breaks added by Republicans to the 2017 tax act.
I am not saying that all of the things mentioned above are necessarily bad public policy. Some are, some are not. What I am saying is that they are not why these things happened. They happened as a quid-pro-quo for political support.
When viewed that way, the cancellation of student debt is just the payment of a political debt. It’s not good or bad, it’s just part of the grease that makes the political system work. It is hard to get angry about it when viewed this way, unless you believe the political system can be entirely altruistic.
Does it Lower the Cost of Higher Education?
Some might counter that the cost of higher education is too high and this lowers the cost of higher education. Student debt cancellation lowers the cost of higher education in the same way that cancelling auto loan debt for cars purchased in the last 2 years lowers the cost of cars. A lucky few have more cash, but the cars still cost the same. Cancellation does nothing to make higher education less expensive going forward. By the same token, the claim that it will cause colleges to charge more is weak, since there is little reason to expect the debt cancellation to be repeated.
The debt cancellation is a form of fiscal stimulus. Unfortunately, stimulus expenditures are the last thing we need at this time. In defense of the cancellation, it is only mildly stimulative and therefore only mildly inflationary. To understand why, one needs to reflect on the income effects of the debt cancellation. Cancelling $10,000 of debt to be paid over 10 years only increases disposable income by about $1,000 each year. Theoretically, the impact might be slightly higher since the cancellation affects future income/wealth and therefore has a small additional impact on current consumption. More importantly, if the student owes a really large amount of debt, their annual payments may not be affected at all under the income-driven repayment plans. In those cases, the cancellation of debt just reduces the size of the debt to be forgiven in 10 to 25 years, from the date they borrowed the funds, depending on which plan they are participating in. Even that effect is potentially smaller if the debt forgiveness is a taxable event. All of that being said, student debt cancellation should have a negligible impact on inflation.
Of course, in the long run, debt cancellation will increase the size of the deficit. This could be offset by higher taxes. It is unlikely that the Biden administration will propose specific tax increases to accomplish this. To do so would make it obvious that this is simply a wealth transfer from one group of people to another.
The Bottom Line
Student debt cancellation is a payoff. If it is effective at keeping the target group aligned with the Democratic Party, and if it does not alienate others in the coalition, then it is good politics for Democrats. That is a big if.
First, let’s all admit the “Inflation Reduction Act” of 2022 (IRA) has virtually nothing to do with controlling inflation. Whatever its merits or failures are, they are not about controlling inflation. The name of the act is shameless marketing. The non-partisan Congressional Budget Office estimated the Act’s effect on future prices to be between +0.1% and -0.1%. Some news sources have been referring to the IRA, more accurately, as the climate, health care, and tax act or something similar. Although a number of economists support this legislation, I am unaware of any serious economist who believes that the IRA will have a meaningful impact on inflation. However, for simplicity I will refer to it as the “IRA,” but don’t be fooled.
Climate Legislation
The IRA has a number of subsidies, tax credits, and regulatory incentives to encourage faster adoption of electric and hydrogen cars. It has incentives for rapid development of solar, wind, and nuclear power. It also provides for subsidized loans to encourage consumers to buy various kinds of equipment to reduce their use of energy and/or carbon emissions. Finally, it includes subsidies to make existing energy production, including fossil energy, cleaner.
The Bargain with Manchin
In order to get this package of incentives past Sen. Joe Manchin (D) of West Virginia, Sen. Chuck Schumer (D-NY), the Democratic Majority Leader in the Senate, had to facilitate additional fossil fuel production through promises about federal lease sales and facilitating future build out of energy infrastructure. The fulfillment of these promises is dependent upon separate legislation that could not be passed as part of the reconciliation process. This energy infrastructure legislation faces threats from both the right and the left.
If Sen. Manchin’s quid-pro-quo for supporting the IRA, a separate bill facilitating faster build out of energy infrastructure is passed, that would be a good thing. If it fails because of resistance from progressive environmentalists, we should expect to see a new Republican senator from West Virginia in a few years. If it fails because of mean-spirited resistance from Republican senators, maybe we will end up with two Democratic senators from West Virginia.
Are the Climate Provisions Good Public Policy?
None of the climate change legislation in the IRA is especially bad and some of it may be good, but all of it is suboptimal when compared to a carbon tax and tariff system. Such a system would not only be more efficient in reducing green house gas emissions, it would also have provided a new source of government revenue. If the government did not turn around and spend those additional funds on new programs but simply used them to reduce the deficit, this approach might actually reduce inflation. (But that is a more complicated issue best addressed elsewhere.)
Are the IRA’s climate provisions better than nothing? The climate change provisions, while suboptimal, will encourage the deployment of electric vehicles and electric vehicle infrastructure. These climate change provisions will also encourage the development of solar, wind, and nuclear energy production which will all certainly play a part in addressing climate change in the long run.
We can only hope that, in the not too far distant future, these kinds of credit and subsidy approaches will be replaced by a broad based carbon tax and tariff approach. If this happens, the capital investments encouraged by the IRA will not have been wasted. Unfortunately, the costs of these investments will be born disproportionately by the general taxpayer rather than carbon consumers. In addition, uncountable other activities that would have contributed to reducing carbon emissions under a broad based tax and tariff plan will have been passed over by focusing on a few governmentally favored solutions.
Health Care Legislation
Extending Subsidies Under the Affordable Care Act
The IRA would extend, for three years, the Affordable Care Act subsidies that were included in the 2021 American Rescue Plan. Subsidies are wealth transfers. They are not anti-inflationary. The right level of subsidy for health care insurance is a legitimate area for debate. I would be more inclined to support larger subsidies for ACA premiums, if they were matched with higher deductibles and co-pays. For more on this question visit the Centrist Independent Voter’s policy position on Health Care.
Allowing Medicare to “Negotiate” Drug Prices
For those of you who think that the IRA fights inflation by controlling health care costs, please remember subsidies and price controls do not lower prices. Subsidies and price controls simply hide costs or shift them to other consumers or to the taxpayer.
Giving the government the ability to “negotiate” prices with drug companies is really just a kind of price control. In this case, the government’s ability to “negotiate” arises because it can forbid drug companies from charging more than the government’s offered price for the drugs. Without that, the government’s offer to pay, say $100/dose, might be met with “fine pay what you want, but we (the drug companies) are going to charge the patient $500.” The government “negotiation” only works because it can prevent the drug company from charging the patient any more than the government offer.
This is not to say that giving Medicare the ability to negotiate prices with pharmaceutical companies is a bad thing. Within limits, it might be a good thing. But follow the process through. (I am ignoring co-pays here for simplicity.) Let’s assume that Medicare says that it will only pay $100 for a given drug and the drug company is forbidden from selling the drug to Medicare patients for any more than $100. The drug company has a number of choices, it can: 1) accept that price and produce as much as is demanded at that price; or 2) it can accept that price, but limit the amount of the drug that it produces, creating shortages and possibly black markets; or 3) it can simply refuse to sell the drug to Medicare patients at all.
The challenge for the government is to figure out the price that will induce the drug company to provide the amount demanded at that price. This is not always an easy thing to do, but it can be done. The challenge for the drug company in these negotiations will be to persuade the government that, absent a higher price, the company will choose option 2 or 3 above.
The drug company also has a choice to make about investments in research on future drugs. Drugs that are likely to face enormous demand, if successful, may well be developed normally even in the face of possible limits on prices imposed by Medicare. But research on drugs with more limited potential demand may simply not receive funding. This has been the case pushed by the pharmaceutical industry, and it has at least a little bit of merit. If the government uses its power under the IRA aggressively, it may lower the price on drugs in the short run, but choke off the supply of many new drugs in the future.
International Equity in Funding Drug Research
For a long time, U.S. consumers have been providing benefits to drug consumers in other countries. The highly profitable market in the U.S. encouraged the development of new drugs and Canadian, European and other consumers benefited by being able to buy those drugs at substantially lower prices. The best policy for Medicare, in the long run, might be to demand “most favored nation status.” That would mean that drug companies could not charge Medicare patients any more than the lowest price that they charge in any other developed country. This will discourage U.S. drug companies from offering drugs at heavily discounted prices outside of the U.S. Most favored nation treatments will, therefore, not result in U.S. consumers paying the current heavily discounted prices that many non-U.S. customers now get. It will result in higher prices outside of the U.S. and lower, but equivalent, prices in the U.S. In this way, the burden of supporting the development of future drugs will be more equitably shared across the developed world.
Capping Out-of-Pocket Drug Costs for Medicare Recipients
Similarly, capping out-of-pocket costs for those on Part D of Medicare does not curb inflation. It simply shifts the costs of these drugs to others. How does that happen? Drug companies confronted with the out-of-pocket cap will simply raise the premium for all those insured under their plans. This is not collusion. It will be driven by the underlying economics in the presence of the cap. The losers will be those people who opted for low cost “catastrophic coverage” plans and were never confronted with the need for expensive drugs. In the face of higher premiums, some people may forego Part D drug plans altogether. Is this good public policy? I don’t know; I much prefer the current situation in which individuals can choose the amount of risk they are willing to take.
The provisions for capping out-of-pocket costs are a wealth transfer plan between various low and middle income people. The only unambiguously bad thing about this plan is that it will probably discourage some people from carrying any Part D drug coverage.
Tax Law Changes
Without the changes in the tax law incorporated in the IRA, it could have been called the Inflation, Climate, and Health Care Act. If the spending on climate and health care incorporated in the IRA had not been accompanied by higher tax revenues, it would have constituted stimulative fiscal policy. Stimulative fiscal policy, in the face of a fixed monetary policy, is inflationary. If one accepts the wisdom of the climate and health care aspects of IRA, one has to conclude that increasing tax revenues was a good idea. But what about the way in which tax revenues were increased? Did those make sense, relative to other alternatives?
The Carried Interest Provision
One thing that was stripped from the bill at the insistence of Sen. Kyrsten Sinema (D-AZ), was the taxation of capital gains as ordinary income in the case of private equity managers. Taxing capital gains at a lower rate than ordinary income makes sense on a number of grounds that I won’t go into here. However, the carried interest compensation that private equity managers receive is much more analogous to ordinary income than it is to a capital gain on an investment. I think leaving the carried interest provision in the act would have improved the IRA.
Minimum Corporate Income Tax
Progressive Democrats love to rail against large corporations that pay no or little taxes in some years. They rarely mention the reasons why these corporations pay low taxes. The reasons for low or no taxes can include massive losses accumulated over years. These corporations may also have lowered their taxes by taking advantage of tax credits and accelerated depreciation supported by the very same progressive Democrats. To fix the offensive optics of large corporations paying low taxes in some years, the IRA provides a “book” based minimum tax system.
To understand this, one must realize that Generally Accepted Accounting Principles (GAAP) differ from the accounting rules used to calculate corporate income taxes. Reported corporate income is calculated using GAAP. Taxes are based using a different set of rules that generally result in lower taxable income because of things like accelerated depreciation and tax credits. I have not read the details of the bill, at this time, but I am guessing that, like the Alternative Minimum Tax for individuals, the Corporate Minimum Tax allows firms to roll forward their Alternative Minimum Tax payments as credits for future years. In large part, this results in front loading tax revenue, increasing it in the near term but lowering it in the future. If one focuses on the first ten years following adoption (as many analysts do), this aspect of the act will overstate the amount of revenues raised.
In response to complaints that the alternative minimum tax would hurt manufacturing, the Democrats allowed “manufacturers” to retain accelerated depreciation. This of course means that corporations must maintain essentially three sets of books. One set based on GAAP for SEC reporting purposes, one based on the regular tax code, and one based on a complicated hybrid of GAAP and tax accounting rules.
This is all incredibly complicated and largely pointless. In fact, the minimum corporate tax undermines the effectiveness of many of the tax credits included in the IRA to help on climate change.
Taxation of Stock Buybacks
The IRA includes a 1% excise tax on stock buybacks. Stock buybacks used to be considered a tax efficient way for corporations to return money to shareholders. It was tax efficient because it returned money to shareholders in the form of capital gains rather than as dividends which were taxed as ordinary income. Now that corporate dividends are typically treated as Qualified Dividends for tax purposes and receive the same treatment as capital gains, this is a moot point. Progressives, like Sen. Elizabeth Warren (D-MA), continue to complain about stock buybacks for reasons that elude me. All this accomplishes is to push corporations to return money to shareholders in the form of dividends. I expect that the Democrats are counting the revenue from this tax as part of their fiscal restraint. In all likelihood, there will be little to no revenue raised by this tax.
Fossil Fuel Taxes
The IRA imposes a number of taxes on fossil fuels. Some of these may make sense, but they are definitely suboptimal when compared to a broad based carbon tax. Some of these taxes are reasonable apart from their climate effects, such as making permanent an excise tax on coal mining that is the chief source of funding for the Black Lung Disability Trust Fund.
Additional Funding for the IRS
The IRA provides some funding to improve the audit capabilities of the IRS. I think this is a good thing, although some of the money will be wasted on ensuring compliance with the new Corporate Alternative Minimum Tax.
Obviously, we need to carefully monitor the IRS to ensure that it does not use its considerable powers to target political enemies. Nevertheless, our tax system is dependent on voluntary compliance and a robust audit capability helps to encourage that voluntary compliance.
Are the Tax Law Changes Good Public Policy?
In terms of taxation, I would have preferred a broad based carbon tax and tariff approach. Absent that, I would have preferred they leave in the carried interest provisions and accomplished the rest of the revenue gain with an across the board increase in all marginal tax rates both personal and corporate.
The best that can be said for the tax policies in the IRA is that these taxes finance the subsidies and tax credits in the act with some kind of tax revenue. That is at least better than the half hearted attempts to claim fiscal neutrality in the original Build Back Better plan.
The Bottom Line
If I had been presented with the IRA and told that I had a choice between it and nothing, I would have supported it. It is sad that it is our only choice.
Invitation for Comments
Finally, I have not had time to read the entire act and this analysis was prepared based on a number of summaries of the act. If the reader is aware of any inaccuracies, please let me know by commenting below. If there are any aspects of the IRA not mentioned here that you would like to address, please do so in the comment area below.
Inflation appears to be at the top of everyone’s mind lately. That is understandable given that current inflation rates are at 40 year highs. It is likely to play a major role in determining the outcome of the 2022 mid-term elections, despite the fact that there is much bi-partisan blame to be parceled out for the current high rates of inflation. There are, also, a lot of silly proposals on the table for combating it, e.g. price controls and gas tax holidays. There are also some ideas that may be reasonable policy suggestions, in their own right, but have nothing to do with inflation, e.g. lowering tariffs, allowing Medicare to negotiate some drug prices, or facilitating more domestic energy production.
Milton Friedman, a Noble prize winning economist famous for his work on monetary theory and policy, said that “inflation is always and everywhere a monetary phenomenon.” Things like supply chain problems, higher oil and gas prices, Russia’s invasion of Ukraine, the rapid snap back from the Covid 19 induced recession, and aggressive fiscal policy did play a role. They helped to kick start the current inflation, but in the absence of accommodating monetary policy they would not have caused persistent inflation.
The Theory
In theory, all of the above would have resulted in some things becoming more expensive. Absent monetary accommodation, these price increases would have been accompanied by declining prices for other goods and services. If those price declines did not materialize, because of “sticky wages and prices” we would have seen a recession until the under-employment of labor and other resources forced a relative price adjustment.
Evidence Backing the Theory
Those who think this is just theory should take a look at the inflation rates in Switzerland. The inflation rate in Switzerland (3.4%) is about half that of the rest of Europe (8.6%), yet virtually all of the litany of other factors listed above were present for Switzerland. What is different? Switzerland does not use the Euro and Switzerland’s monetary policy is not controlled by the European Central Bank (the European version of the Fed). Also of note is Turkey, which runs its own, extremely loose, monetary policy and has an inflation rate of 78.6%.
The History: The Fed, The Energy Crisis, and Monetary Policy in the 1970’s
In the 1970’s the Federal Reserve Board attempted to avert a recession, in the aftermath of that decade’s oil price shocks, by expanding the money supply. The idea was to produce just enough inflation so that wages and prices for non-energy intensive goods could decline in real terms (but stay constant in nominal terms) while prices in energy intensive industries could increase in real and nominal terms. Done just right this results in mild inflation and no recession. Sadly, the strategy is nearly impossible to execute properly. The problem is that inflation, once started is devilishly difficult to stop. The result was the “stagflation” of the 1970’s, high inflation and low growth. It was not until Paul Volcker really put the screws to the system, in the early 1980’s, and drove interest rates over 20%, that inflation was finally crushed.
What Should the Fed Do Now?
The policy solution is straight forward, if somewhat distasteful. The Fed needs to reduce the rate of growth of the money supply and quickly raise real interest rates with all of the tools it has at its disposal.
Calculation of Real Interest Rates
Real interest rates are the difference between the nominal interest rate and the expected rate of inflation.
The 10 Year Real Interest Rate
In calculating real interest rates it is important to subtract an estimate of inflationary expectations rather than a historical inflation rate, like the CPI, from current interest rates. The problem with using calculated measures of inflation, like the Consumer Price Index (CPI), is that they are backward looking and the current interest rate is forward looking. If we use the current nominal yield on 10 year Treasuries of 2.9% and the Federal Reserve Bank of St. Louis’ estimate of average inflationary expectations over 10 years of 2.34%, the real 10 year interest rate is 0.56% (2.9 minus 2.34), or nearly zero.
However you look at it, real interest rates, despite recent Fed action, are still either extremely low or significantly negative.
What Should the Target Be?
How high should the Fed push real interest rates? Reasonable people can disagree about the target and the speed for getting there. My own preference would be to see real short-term (1 year) interest rates at about 1-2% and long term (10-30 year) real rates of 3-4%. Getting there will require nominal interest rates in the high single digits or possibly higher. I am not sure what the appropriate speed should be to reach this target but I am sure that it is faster than the Fed is currently moving.
Will this Mean a Recession?
Maybe, but the longer we wait before trying to bring inflation down, the deeper and longer lasting the recession will be. We have already waited too long.
Sen. Elizabeth Warren has grabbed the spotlight with another foolish idea: price controls. She calls it “Anti-Price Gouging.”
Why are Price Controls Bad?
Those of you, who are old enough, will remember waiting in line, for hours sometimes, to fill up your gas tank in the late 1970’s. Why did that happen: price controls. What happened when price controls were abandoned: no lines. This isn’t complicated. Anyone who manages to make it to the mid-term exam in the first micro-economics course can explain why. Draw a demand curve and a supply curve. Where they intersect is the market price. Now draw a line horizontally across below the market price at the controlled price. Note the difference between the quantity demanded, at that controlled price, and the quantity supplied. That difference is the shortage you have just created with price controls.
Anti-price gouging has no meaning, unless it means imposing price controls.
Who is Pushing for Price Controls?
Warren wants to combat “price-gouging.” which means she either wants to engage in meaningless political posturing or she wants the FTC to impose price controls. She has some allies in the Senate and House. The legislation is cosponsored by Senators Bob Casey (D-Pa.), Sheldon Whitehouse (D-R.I.), Bernie Sanders (I-Vt.), Ed Markey (D-Mass.), Jeff Merkley (D-Ore.), Tammy Duckworth (D-Ill.), and Dianne Feinstein (D-Ca.). In the U.S. House of Representatives, this legislation is cosponsored by Chairman Jerrold Nadler (D-N.Y.) Rep. David Cicilline (D-R.I.), Val Demings (D-Fla.), Katie Porter (D-Calif.), Ro Khanna (D-Calif.), and Bobby L. Rush (D-Ill.).
If you follow the Centrist Independent Voters Rogues Gallery of candidates (ones we would find it difficult to ever endorse) you will recognize many of these names.
For the purpose of completeness, I will be adding Warren and her co-sponsors to the list, most of them, including Warren, all already there.
