Larry Summers Is Right About Inflation, But …
Back in February, I thought Summers went too far in his analysis. Now I think he doesn’t go far enough. I am prepared to concede that I was mostly wrong then if he will consider the possibility that he is partially wrong now.
In the broader debate over whether inflation is “transitory,” I have been a member of Team Transitory, though with waning enthusiasm. Summers makes a strong case that this debate is over: This inflation is not transitory. He is on weaker ground when he argues the president’s Build Back Better legislation wouldn’t lead to higher inflation; it almost certainly would.
In an article published Monday in the Washington Post, Summers lists five factors cited last August by Federal Reserve Chair Jerome Powell as reasons to believe inflation was transitory. Now all five are “wobbly at best,” Summers writes. The data is strongly on Summers’s side on two points and heading in his direction on two more.
But what really has me questioning my membership in Team Transitory is the continued strength of the U.S. consumer in the face of continually rising prices.
That may sound odd. In normal economic times, consumer strength is a good sign. But these are not normal times. After an initial dip when the pandemic first hit, retail sales not only recovered in 2020 but rose above their long-term trend as consumers transferred spending from services to goods. This much is well known.
What’s less appreciated is how much spending soared again — from a seasonally adjusted rate of $536 billion in December 2020 to $628 billion in April 2021 — as stimulus checks hit the economy. For a few months, the surge subsided, then spending turned upward again in August. By October, it had reached a new record of $638 billion.
This persistently high spending, not supply-chain bottlenecks, is the reason that inflation continues rise. If this were purely a supply-side issue, then higher prices in one area could be expected to mute consumer spending in another.
The reason overall spending has remained so strong in the face of rising prices is that stimulus checks and other relief measures, such as the increase in the child tax credit, have allowed households to build up more than $2.6 trillion in excess (that is, above normal) savings. According to Bloomberg Economics, the savings rate was still elevated in October even with record levels of retail sales.
Whatever one thinks of these measures, as long as they stay in place the pressure on inflation is likely to remain. Build Back Better not only extends the child tax credit but includes additional spending on child care, pre-K, expansions of the Affordable Care Act and increasing the cap on state and local tax deductions.
Summers argues that the inflationary impact will be muted by revenue-raising offsets, which drain money from the economy. Congress only needs to be sure, he suggests, to pay for the expansion of the many temporary provisions in the bill.
There are two problems with this argument. First, the Tax Foundation estimates that, in the first few years of the plan, all of the proposed revenue increases will add up to less than the cost of raising the cap on SALT deductions. As currently written, the Build Back Better plan would pump hundreds of billions of dollars into the economy in the next few years. And as the Committee for a Responsible Federal Budget points out, the assumption is that the temporary provisions will be extended, potentially adding $2 trillion to bill’s cost.
In addition, the bill presumes that raising the SALT cap would actually increase revenues in later years, a pure budgetary fiction. In reality, the legislation sets the stage for ever-increasing amounts of stimulus until 2032.
The truth is that Build Back Better would increase inflationary pressures in the near and medium terms. Given the immediate and sustained impact on inflation that this year’s stimulus produced, it’s hard to see how the legislation wouldn’t set the stage for either permanently higher inflation or a sharp increase in interest rates as the Fed attempted to bring inflation under control.
Summers was prescient earlier this year in warning that stimulus would not only increase inflation but also crowd out plans for longer-term spending. Now that inflation has come to pass, he should accept the other part of his argument: The economy can’t absorb additional spending on anything like the scale that House Democrats propose.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Karl W. Smith is a Bloomberg Opinion columnist. He was formerly vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina. He is also co-founder of the economics blog Modeled Behavior.
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