The case against stimulating demand and restricting supply

The New York Times asks ten economists about the risks of “overheating.” I don’t go along with the mainstream macro paradigm, but several of the responses resonated with me, especially Olivier Blanchard’s.

I shall plead Knightian uncertainty. I have no clue as to what happens to inflation and rates, because it is in a part of the space we have not been in for a very long time. Uncertainty about multipliers, uncertainty about the Phillips curve, uncertainty about the dovishness of the Fed, uncertainty about how much of the $1.9 trillion package will turn out to be permanent, uncertainty about the size and the financing of the infrastructure plan. All I know is that any of these pieces could go wrong.

I would have answered the question this way:

1. During the pandemic, many Americans accumulated a lot of paper wealth, as the government printed paper wealth in the form of bonds and the stock market returned to a state of possibly-irrational exuberance. This wealth now hangs over an economy with some supply bottlenecks and a progressive Administration that is likely to exacerbate those bottlenecks. The only way that we avoid price increases is if the people with the wealth choose to spend it very, very gradually.

2. If spending and inflation do pick up, we are going to find that the Fed’s brake pedal does not work. The Fed can try to raise interest rates by, for example, raising the interest rate that it pays on Fedcoin (digital bank reserves). But higher rates will be politically unpalatable, because the interest bill for the government will be too much to bear.

Suppose that the Fed can get past the political objections. Then we will have an experiment to test my heterodox view that government bonds are as inflationary as money. If rates were allowed to rise, the interest bill would send the government’s deficit up. So the government will have to issue more bonds, which in my view are inflationary fuel themselves. In my view, it is up to Congress to stop inflation by cutting deficits.

It’s not that I don’t understand the conventional (monetarist) view of inflation or that I have missed some argument in its favor. So don’t waste your breath calling out my ignorance. We’ll see what happens if and when we run the experiment.

3. As to the question of “overheating,” I think of inflation in terms of phase changes. Just as water changes properties when it boils, an economy changes properties when it goes from low and steady inflation to high and variable inflation. By the time it has changed phases, it is too late to deal with it using mild measures.

Although economists won’t see overheating until it’s too late, historians of this episode will go back and see that in hindsight signs of overheating were evident by early 2021. The digital currency mania and the rally in GameStop will be seen as emblematic of the distortions caused by excessive creation of paper wealth.