Commentary on Political Economy

Thursday 26 August 2021


Biden and the Fed wanted a hot economy. There’s risk of getting burned

By Neil Irwin

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There is a big idea in economic policy that has become ascendant in recent years: Great things can be achieved for American workers if the economy is allowed to run hot.

The notion of creating a “high-pressure” economy is that government should be willing to risk a bit of inflation in the near term to achieve conditions that will over the long run lift people out of poverty, prevent the scars of recessions from becoming permanent and make the nation’s economic potential stronger.

US President Joe Biden.


This idea has origins in a 1973 paper by Arthur M. Okun, and was largely confined to think tank conferences in the 2010s. Now, it is the intellectual underpinning of US economic policy, embraced at the highest levels by the Biden administration and the Federal Reserve.

It makes for a real-world test of a new approach to economic policy. The results so far show that pushing the economic accelerator to the floor has trade-offs, specifically the combination of trillions in federal spending with interest rates held near zero.

While that combination has created some important beneficial effects, the summer of 2021 has not produced quite the high-pressure economy its enthusiasts were hoping for.

The good news is that job openings are abundant, wages for people at the lower end of the pay scale are rising quickly, and it appears that the post-pandemic recovery will not be like the long slog that followed the three previous recessions.

But consumer prices have been rising faster than average wages — meaning that, on average, workers are seeing the purchasing power of their pay cheque fall. People looking to buy a car or build a house or obtain a wide variety of other products are finding it hard to do so. And while much of that reflects temporary supply disruptions that should abate in coming months, other forces could keep prices rising. These include soaring rents and the delayed effects of higher prices from companies having to pay higher wages.

“I don’t think of the last few months as either vindication or repudiation, yet,” said Josh Bivens, director of research at the Economic Policy Institute and a longtime enthusiast of policymakers seeking a high-pressure economy.

In effect, unlike the slow-moving developments of the 2010s, when the debates over running the economy hot took shape, things are moving so fast right now that it is hard to be sure how things will look as conditions stabilise.

Still, “I think the benefits of carrying on the go-for-growth strategy will come,” Bivens said, noting exceptionally strong job creation in recent months.

A more traditional view has been that it is unwise for policymakers to try to push unemployment too low because doing so will generate inflation. That thinking lost credibility as the 2010s progressed — the jobless rate fell ever lower, with few signs of an inflation spike.

But while the tight labor market from 2017-19 generated strong inflation-adjusted wage gains for workers, especially at the lower end of the pay scale, there is nothing automatic about that process. In a booming economy, if companies raise prices more rapidly than they increase worker pay — taking a higher mark-up on the products they sell — it will mean workers are effectively making less for each hour of work.

In the past, it has cut both ways. In the strong economies of the late 1960s and late 1990s, average hourly earnings for non-managerial workers persistently rose faster than inflation. In the late 1980s, the reverse was true.

And it is also true now. Wages and salaries in the private sector were up 3.6 per cent in the second quarter from a year earlier, according to Employment Cost Index data, the strongest since 2002. But the Consumer Price Index was up 4.8 per cent in that same span, meaning workers lost ground. Other measures of compensation and inflation tell a similar story.

People looking to buy a car or build a house or obtain a wide variety of other products are finding it hard to do so.

People looking to buy a car or build a house or obtain a wide variety of other products are finding it hard to do so.

One big question is whether elevated inflation is simply an unavoidable consequence of the reopening of the economy after a pandemic, or is at least partly a result of the aggressive use of fiscal and monetary policy to heat up the economy quickly.

For example, automobile prices are through the roof, which analysts attribute mainly to microchip shortages caused by production decisions made during the pandemic. But is part of the spike in prices also a result of high demand, spurred by stimulus cheques the government has sent and low interest rates that make car loans cheap?

Jason Furman, a Harvard University economist and former chairman of the White House Council of Economic Advisers, points out that the United States is experiencing significantly higher inflation than other countries that are facing the same supply problems. Consumer prices rose 2.2 per cent in the year ended in July in the euro area, compared with 5.4 per cent in the United States.

“My guess is that real wage growth is faring better right now in Europe than it is in the United States, and it’s faring better because there is less demand and thus less inflation,” Furman said.

The story is better when you look at how lower-paid workers in the United States are doing. The shortages of workers, especially in service industries, are translating into raises for people who do not make a lot. Data from the Federal Reserve Bank of Atlanta shows that median hourly wages for people in the bottom 25 per cent of earners have risen at a 4.6 per cent rate over the last year, compared with 2.8 per cent for the top 25 per cent.

And many of the benefits of a hot economy come in the form of pulling more people into the workforce and enabling them to work more hours. Employers have added an average of 617,000 jobs a month so far in 2021, versus 173,000 a month in 2011, in the aftermath of the global financial crisis. If sustained, the United States is on track to return to its pre-pandemic employment level two years after the recession ended. Such a recovery took five years after the previous recession.

Advocates of running a hot economy emphasize that a rapid recovery is good for reducing inequality, in part by ensuring there are plenty of job opportunities so that people do not have to be out of work for long stretches.

New car prices in th US are going through the roof.

New car prices in th US are going through the roof.

“We are seeing ongoing stimulus and expanded income support programs doing what they’re supposed to do,” said J.W. Mason, a fellow at the Roosevelt Institute and a longtime proponent of running the economy hot. “The numbers we should really be looking at are employment growth and wage growth, especially at the low end, and those trends are positive and encouraging. They’re the numbers we would have hoped to see at the beginning of the year.”

In the late years of the last expansion, employment gains were particularly strong for racial minorities, people with low levels of education, and some others who often have a hard time getting hired.

“The thing we know for certain is that when you run a hot economy, people get jobs who wouldn’t otherwise get jobs,” Furman said. “That by itself is sufficient reason to want to run a hot economy. You’re talking about some of the most vulnerable workers getting hired, and that’s a wonderful thing.”

Still, even some supporters of running the economy hot see risk that the scale and pace of stimulus actions have been too much.

“It’s not that my commitment to a tight labor market has weakened,” said Michael Strain of the American Enterprise Institute, one of the centre-right voices who favoured the approach. “It’s that the specific policy mix is a mistake, for a bunch of reasons. There is such a thing as too much stimulus, which becomes counterproductive, either because inflation eats away wage gains or the supply side of the economy can’t keep up.”

Even people who believe in a high-pressure economy, in other words, would do well to keep an eye on just how high that pressure is getting, and how sustainable it really is.

New York Times

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