Transcript: Larry Summers Gets His ‘Told You So’ Moment on Inflation

(Bloomberg) -- Larry Summers is having his “I told you so” moment.

The Harvard professor, former Treasury secretary and paid Bloomberg contributor rained on everyone’s parade last spring by warning that the U.S. government’s generous bailout payments might spawn inflation—a bogeyman many others discounted. Fast-forward to today and many economists are (sheepishly) admitting he was more right than wrong about rising prices. The Federal Reserve has jettisoned the word “transitory” from its vocabulary, and President Joe Biden’s approval rating is suffering as the nation endures 6.8% inflation.

On a special holiday edition of the Bloomberg podcast Stephanomics, host Stephanie Flanders talked with Summers about how he arrived at his inflationary prediction, why he thinks recession is a risk in the near term and why he fears longer-term “secular stagnation,” a period of weak economic growth and persistently low interest rates.

The below transcript has been edited for clarity.

Stephanie Flanders: Hello, and welcome to Stephanomics, the podcast that brings the global economy to you. And we have a special episode today in honor of the holiday season, a conversation with the economist Larry Summers—professor at Harvard, former Treasury secretary and frequent participant in the public debate about all things economic. Also my friend and former boss. Larry, I mean, it is the end of the year. I guess we can start with a little gloating. I mean, in any given year economists get a lot wrong. And this year, an especially large number of them wrongly assumed inflation was going to be a fleeting phenomenon. But you sounded the alarm early in the year and were considered a bit of a crank for doing so initially. But not anymore. What did you see that others didn’t see?

Larry Summers: Stephanie, you know, I’ve been right this year, but there have been plenty of years when I’ve been wrong. I did what I thought was a straightforward analysis of the situation. I looked at how short incomes were of trend. And I saw that they were about $25 billion or $30 billion short of trend each month. And that that number was declining. And then I saw that the proposed transfer payments and other stimulus represented close to $200 billion a month. And so I thought if you were filling a $30 billion hole with $200 billion of spending, there was likely to be some overflow and that overflow would translate into inflation. I did the same calculation essentially, looking at GDP, and I saw a 2% or 3% GDP gap, met with about 15% of stimulus. I had thought a lot about the Obama period, and I agreed with the concerns.

Indeed, I expressed them at the time, that that stimulus was too small. That stimulus in its first year was perhaps half of the GDP gap. This proposed stimulus was a significant multiple of the GDP gap. I thought there was a case that the Obama stimulus might have been low by 50%. It might have been low by 60%. It surely was not low by a factor of five to 10. So it seemed to me that we were overstimulating the economy and that people had not seen inflation in 40 years. So they assumed it was something you didn’t need to worry about, but that if you just did a straightforward analysis, demand was gonna run ahead of supply. And I have to say, I think that’s pretty much what we’ve seen. I don’t think that the analyses suggesting that this is all bottlenecks are right, 90% of CPI components show inflation above 3%, more than 50% above the Fed’s target. If I look at what’s happening in the labor market, it looks to me like we’ve got substantial labor shortages that push wages up, but only with a lag because wages aren’t reset constantly. We’ve got substantial pressures in the housing market that have not manifested themselves at all, really, in the official price indices yet. So I think we’ve got a fairly serious inflationary situation that’s been growing for quite some time.

Flanders: If wages do go up, and it’s true that we haven’t seen as much as you might have expected in the last few months. But if they, if they do go up—the last 20 years we haven’t seen a follow through from higher wages to higher inflation. Even the Fed’s own model doesn’t include much response from inflation. So why do you think this time will be different?

Summers: Well, there’s two different questions. One is the response of prices to wages, and the other is the response of wages to unemployment. With respect to wages to prices, we just haven’t seen very much variation in the level of wage growth, and therefore it would be hard to find a relationship with prices. I’m much more influenced by the experience of my own talking to businesses and even more people like those Bloomberg employees who spend their lives talking to companies, and they all say more or less the same thing. “We’re gonna have to push up wages because of labor shortages. And when we do, we have plenty of pricing power.” And I guess I trust those anecdotes more than I trust econometric relationships estimated over periods when there’s been very little variation. We did have some months in 2019 with low unemployment and not extremely rapid wage pressure, but that’s one several-month experience in 20 years. I don’t think there’s any support in the data for the view the Fed took that the economy can enjoy 3.5% unemployment for multiple years with significantly declining inflation. Indeed, the Fed’s forecasts call for unemployment below its estimates of the normal level, interest rates never reaching in the next few years its concept of the normal level and, nonetheless, continuous deceleration of inflation. That might happen. But it doesn’t seem to me that it is the most intuitive reading of our macroeconomic history.

Flanders: Just to follow up briefly on the, on the wages and prices thing. You’re obviously right that companies have been complaining about labor shortages, have been talking archly about rising costs, meaning they were gonna have to push up prices. And they clearly do have pricing power. All the data that we’ve looked at, and we discussed it on the podcast a few weeks ago, suggested that they’ve already used that power to raise profit margins this year well beyond any increase in costs. And, it’s not obvious that they couldn’t absorb some of these increased wages in profit margins. I mean, inherently that wouldn’t be such a bad thing, right, if you had more wages for workers and companies absorb some of it in profit margins, which in some cases are historically high?

Summers: Certainly if you look at analysts’ forecasts of profits over the next year, the last time I looked the forecast was for 2022 profits to rise 18% relative to 2021 profits, which suggests as a predictive matter that that’s not mostly what is going to happen. You know, Stephanie, prices are set by supply and demand, and we are seeing in a very wide range of sectors rising demand. For example, retailers are engaged apparently, as best one can tell from the anecdotes, in much less promotional activity this Christmas than they have been in previous Christmases. That’s showing up in higher margins for them and for their suppliers. I don’t think there’s anything nefarious about that. That’s just what goes with an economy where stores are full. I think the diagnosis that you are implicitly offering is the one that the Nixon administration rather unsuccessfully offered, that rising prices necessitate price controls so as to contain profits and reduce inflation. That worked out rather spectacularly badly. And fortunately, that’s not an idea we’ve heard this time around. I think trying to restrict prices would be the best way I could imagine to lengthen the period of shortages, bottlenecks and disillusionment. We tried that strategy with respect to gasoline in the late 1970s. I don’t know why businesses would not be pushing on prices when they had shortages of goods and supply.

Flanders: I guess what I’m tripping over is that you’ve written quite a lot in the past in important academic papers, actually, about the decline in labor bargaining power and the impact that this had had. And that particularly how the scales had shifted in favor of employers in many parts of the labor market. I don’t recall you accused me of proposing price controls. I don’t recall ever saying that, but I’ll check the transcript. But the description you’re giving suggests there is no way to reset that balance or perhaps even in the sort of macro terms, start having a higher share of national income going to labor relative to capital. You know, a reversal of what we’ve had in the last few years. Because if wages go up faster than productivity, you’re saying the Fed should definitely put on the brakes in response to that. And if it doesn’t, companies will inevitably just pass on any wage increase and it’ll just result in more and more inflation. It doesn’t feel like there’s any way to reverse that cycle we’ve seen over the last few decades.

Summers: That’s really not what I’m saying, Stephanie. I mean, first just on the facts, this period of high inflation has coincided with more rapid, real wage reduction than we had seen previously. So for the majority of workers it’s working out badly so far, not working out well. That’s a political response to inflation that we’re observing. Second, I am a strong supporter of the type of labor law reforms that the administration has worked on. My colleague in the labor power paper that you referred to, Anna Stansbury, has done very important work showing that when you put reasonable penalties on, it influences behavior and allows union organizing to take place. I am a strong supporter of measures to strengthen labor through the labor movement in unions, through a range of innovations that would encourage labor power. What I don’t agree with is the idea that simply running the economy hot on an unlimited basis can do it.

If I thought we could sustainably run the economy in a red-hot way, that would be a wonderful thing. But the consequence, and this is the excruciating lesson we learned in the 1970s, the consequence of an overheating economy is not merely elevated inflation, but constantly rising inflation. And that’s why my fear is that we are already reaching a point where it will be challenging to reduce inflation without giving rise to recession. Should we do all kinds of things? Should we raise the minimum wage? Absolutely. Should we empower unions? Yes. But this kind of policy—there are no examples of successful inflationary policy that has worked out to the benefit of workers. And there are dozens of examples from the Labor Party in Britain in the 1970s to multiple Latin American experiences to our own experience in the ‘60s and ‘70s where it backfired with respect to the very people it was trying to help.

Flanders: Do you think Bidenomics deserves a dictionary entry or will deserve a dictionary entry when the dictionaries get rewritten or revised? Does it amount to anything in your view? I mean, we’ve had nearly 12 months.

Summers: I think we’ll have to see what happens down the road. The hope would be that it represents a kind of progressive supply side economics that emphasizes supply and does so through public investment. Unfortunately, the share of the spending that represents transfer payments rather than public investments has been sufficiently high that I’m not sure how great the benefits will be. And I’m concerned that there’s been insufficient impulse to making the public investments cost effective, streamlining infrastructure investment, for example. On the other hand, Stephanie, I think that the recognition that we have—on the one hand, on your flight you can now watch television in the seat in front of you in a way that would’ve been inconceivable 30 years ago. On the other hand, it takes half an hour more to get from Boston to Washington than it did 30 years ago, just because of the decaying infrastructure. That’s a kind of misplaced priority and it’s a metaphor for what’s gone wrong in important parts of the way our economic system has functioned.

Flanders: I’ve known you for a long time and through a lot of that time, and certainly when you and I were at the Treasury Department in the late '90s, the kind of default view of most governments was that governments should meddle as little as possible in markets—set the rules for markets, but then let the chips fall where they may, especially on trade and potentially the environment, industrial policy, all those things where the sort of default was to be suspicious of these things. Have you had a change of heart on those things? I mean, I noticed that Janet Yellen recently talked about needing to be less reliant on other countries for critical goods. And I’ve seen, you have talked a bit about in the environment of wanting a more sort of muscular approach to government. Are you, are you rethinking your view of government?

Summers: I think that there’s been this extraordinary change in relative prices, Stephanie. If you look at the relative price of a day in a hospital and a television set, it’s changed by a factor of 100 since the ‘80s. That means we’re in a very different economy and a much larger share of the economy, a much larger share of the people working are in sectors that have a range of market failures. And certainly there’s a case for government involvement in those. But I think what needs to be very, very careful about how government will carry out any kind of industrial policy intervention. And I have to say that when I hear about industrial policy in the name of achieving green objectives, I’m much more sympathetic, for example, than when I hear about it in the name of preserving a job. I think the available evidence on protectionist strategies is that they mostly cost $1 million a job saved or more once you work through their full impacts. Take, for example, steel protection. Steel protection operates to save potentially 50,000 jobs of steel workers, one-sixth as many as we have manicurists in the U.S. But it makes industries with 5 million people that use steel less competitive than they otherwise would be.

Flanders:  Going back with the Janet Yellen comments, a lot of people look at the supply chain, snarl ups, the lines of container ships outside Long Beach, California, and other big ports and say, “Donald Trump was right. We should be less reliant on all these foreign manufacturers.”

Summers: It’s important to understand why we have those supply, why we have those long lines. It is not because of anything that China is doing. It is because our demand for goods surged and I would much rather see us be better at expanding port capacity quickly. Do we need to pay attention to rare earths and other goods that are highly concentrated in the world for our national security? Yes, we do. Should we institute some broader program of non-reliance on trade? I suspect there would be very substantial inefficiencies from doing that. I do think we need to manage the global economy much more than we have. That’s why I was such a strong supporter of the initiatives that Secretary Yellen brought to completion to harmonize corporate taxes around the world so capital could run, but it couldn't hide and would be taxed in reasonable ways.

Summers:  That’s why I think the right trade agreements pay attention also to the context in which trade takes place. What kinds of regulations there are. What kinds of rules there are for workers. What kind of exchange rate arrangements there are. But I think a strategy of actively pursuing disintegration is not likely to make us more secure. And certainly the first order effect of stopping us from buying goods from abroad when they are cheapest will be to exacerbate inflation rather than to reduce inflation. So the idea of cutting off cheap supply as a strategy for reducing inflation at a moment when that’s our principle economic problem seems to short run economic problem seems to me bizarre.

Flanders:  And two very quick ones, because you mentioned trade. One of the areas where President Biden has been probably most similar to his predecessor is in relations to China, general attitude to China. Do you basically agree with that?

Summers: I think we have not yet formulated a satisfactory China strategy. I don’t think President Trump had one. I think gratuitous truculence is very risky and we have had a lot of that. And I hope we’ll see evolution in the months ahead.

Flanders:  Just going back to what we were talking about at the beginning, and you painted a picture where you thought it was much more likely than not that we were ending a period, where we’re starting a period that was going to be quite hard to control inflation, and inflation could continue for some time. You know, people will remember for many years you were talking about secular stagnation. If you look at the bond market, very low interest rates still out into the long-term future, the suggestion seems to be from them that secular stagnation is still here, that we still have structurally low growth prospects. Do you still believe in secular stagnation? Do you now believe in secular stagflation?

Summers: I think secular stagnation’s a real risk looking out a few years. I certainly think that’s what the market is, as you say, Stephanie, pricing in. I’m surprised by how low long-term interest rates are. That’s something I didn’t get right. I would have forecast larger increases in interest rates, given conditions. I think part of it is that markets are foreseeing that we will do what’s necessary to contain inflation and that process will be quite contractionary. And that’s part of what I think is being factored into the level of markets. But I do think there’s a real chance that there will be a return to secular stagnation. I’m not sure, you know, in some ways, Stephanie, this current episode of a very large infusion of spending brings back memories of World War II. And there was an expectation that after World War II, the economy would return to the kind of secular stagnation, depression that it had been. And for a variety of reasons that never materialized. I’m really not sure what’s gonna come after this current episode. I’m certainly not confident that we’re gonna have sustained excess demand for many years. I think the challenge is that we’ve pumped up aggregate demand now, and then who knows how we’re gonna work our way through back to more normal levels of demand.

Flanders:  Well, you've painted a, a pretty worrying picture for the next year for 2022. So I kind of hope for all our sakes that you are more wrong next year than you were this year, but I hope you have a happy new year and thank you very much, Larry Summers.

Summers: Thank you.

©2021 Bloomberg L.P.