Why Inflation Erupted: Two Top Economists Have the Answer
Former Fed chair, IMF chief economist say it wasn’t pandemic or stimulus; it was the pandemic, then the stimulus
4 min
For two years debate has raged over what caused the highest inflation since the 1980s: government stimulus or pandemic-related disruptions.
Now two of the country’s top economists have an answer: It’s both. Pandemic-related supply shocks explain why inflation shot up in 2021. An economy overheated by fiscal stimulus and low interest rates explain why it has stayed high ever since. The conclusion: For inflation to fade, the economy has to cool off, which means a weaker labour market.
The study, released Tuesday, is by Ben Bernanke, former chair of the Federal Reserve, and Olivier Blanchard, former chief economist of the International Monetary Fund. Bernanke is now at the Brookings Institution and Blanchard is at the Peterson Institute for International Economics. The two are among the world’s most cited academic economists.
When Congress passed President Biden’s $1.9 trillion American Rescue Plan in early 2021, which included checks to households, enhanced jobless benefits and aid to state and local governments, inflation was around 2% and unemployment, though coming down, still above 6%.
At the time many forecasters thought the stimulus could push demand above the economy’s potential to supply goods and services and unemployment below its long-run natural rate of around 4%. Yet few thought this would meaningfully raise inflation. In previous decades unemployment had remained similarly low without raising price pressures.
A few disagreed, notably former Treasury Secretary Lawrence Summers and Blanchard. Both warned the stimulus was so large it would push the economy dangerously into overheating territory.
Not the inflation critics expected
Inflation did shoot up, hitting 7% that December, 5.5% excluding food and energy. “The critics’ forecasts of higher inflation would prove to be correct—indeed, even too optimistic—but, in substantial part, the sources of the inflation would prove to be different from those they warned about,” Blanchard, one of those critics, and Bernanke write in their study.
To tease out the sources of inflation, Bernanke and Blanchard build a relatively conventional model in which inflation is a function of, among other things, the gap between the supply and demand for labor, the public’s expectations of inflation, and commodity prices. They include a variable for supply-chain disruptions derived from Google searches for “shortage.”
Usually economists judge labor market tightness from how far unemployment is above or below its natural rate. But this time the labor market heated up before unemployment got that low. So instead, Bernanke and Blanchard use the ratio of job vacancies to unemployed workers. Finally, their model lets all these factors interact, with varying lags.
If stimulus had overheated the economy, it should have shown up in the labor market, i.e., an unusually high ratio of vacancies to unemployed. In fact, labor market conditions put downward pressure on inflation through the third quarter of 2021, the authors concluded. Instead, the inflation that year was driven almost entirely by shortages and energy prices. (To be sure, many shortages reflected restricted supply interacting with demand boosted by stimulus.)
Demand shifted abruptly from services to goods in the early months of the pandemic. The overall effect should have been a wash as prices rose for goods and fell for services. It wasn’t, because goods producers faced supply constraints, which caused costs and prices to spike, while costs to service producers didn’t decline much. “These sectoral mismatches between demand and supply proved more intractable and longer-lasting than many had expected,” the authors note.
The legacy of stimulus
These pandemic disruptions did eventually subside. Why didn’t inflation then fall? The reason, the authors conclude, is that by this point demand was so strong, reflecting the legacy of low interest rates and fiscal largess, the labor market was significantly overheated with the ratio of vacancies to unemployed up dramatically. Moreover, the initial surge of inflation had an echo: It lifted workers’ expectations of short-term inflation, which then partly found its way into their wages.
If anything, the study might understate the effect of pandemic disruptions. The labor market didn’t just overheat because of excess demand, but reduced supply, as well. The rising ratio of vacancies to unemployed, which the model equates with a tighter labor market, reflects employers struggling to fill vacancies. The authors note much of that struggle was because of the pandemic: Firms that had laid off employees had to find new ones, while some workers left the labor force because of family obligations, illness or work-life balance priorities.
This decline in supply-side potential hasn’t gotten much attention in the inflation debate, but its role could be significant. John Williams, president of the Federal Reserve Bank of New York, last week estimated that potential was 4.2% lower at the end of 2022 than its pre pandemic trend.
That stimulus wasn’t the inflation culprit it is often made out to be doesn’t entirely absolve the Fed and Biden. Arguably, they should have anticipated supply disruptions would amplify the risks of stoking demand. In 2020 the Fed introduced a new framework and guidance under which interest rates would stay near zero until maximum employment was restored, even if inflation topped its 2% target. That “contributed to delayed action and the inflation overshoot,” former Fed Vice Chair Donald Kohn and Brown University economist Gauti B. Eggertsson say in another paper to be presented Tuesday.
Bernanke and Blanchard conclude that because inflation today reflects a too-hot labor market, the solution is to cool it off. To bring inflation back to the Fed’s target, they estimate unemployment would have to rise above 4.3% from its current 3.4% assuming vacancies remain difficult to fill. But, they say, inflation could drop without a significant increase in unemployment if the ease of hiring returns to pre pandemic norms. The good news: There are tentative signs that is happening.
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Chris Dixon, a partner who led the charge, says he has a ‘very long-term horizon’
Americans now think they need at least $1.25 million for retirement, a 20% increase from a year ago, according to a survey by Northwestern Mutual
Competitive pressure and creativity have made Chinese-designed and -built electric cars formidable competitors
4 min
China rocked the auto world twice this year. First, its electric vehicles stunned Western rivals at the Shanghai auto show with their quality, features and price. Then came reports that in the first quarter of 2023 it dethroned Japan as the world’s largest auto exporter.
How is China in contention to lead the world’s most lucrative and prestigious consumer goods market, one long dominated by American, European, Japanese and South Korean nameplates? The answer is a unique combination of industrial policy, protectionism and homegrown competitive dynamism. Western policy makers and business leaders are better prepared for the first two than the third.
Start with industrial policy—the use of government resources to help favoured sectors. China has practiced industrial policy for decades. While it’s finding increased favour even in the U.S., the concept remains controversial. Governments have a poor record of identifying winning technologies and often end up subsidising inferior and wasteful capacity, including in China.
But in the case of EVs, Chinese industrial policy had a couple of things going for it. First, governments around the world saw climate change as an enduring threat that would require decade-long interventions to transition away from fossil fuels. China bet correctly that in transportation, the transition would favour electric vehicles.
In 2009, China started handing out generous subsidies to buyers of EVs. Public procurement of taxis and buses was targeted to electric vehicles, rechargers were subsidised, and provincial governments stumped up capital for lithium mining and refining for EV batteries. In 2020 NIO, at the time an aspiring challenger to Tesla, avoided bankruptcy thanks to a government-led bailout.
While industrial policy guaranteed a demand for EVs, protectionism ensured those EVs would be made in China, by Chinese companies. To qualify for subsidies, cars had to be domestically made, although foreign brands did qualify. They also had to have batteries made by Chinese companies, giving Chinese national champions like Contemporary Amperex Technology and BYD an advantage over then-market leaders from Japan and South Korea.
To sell in China, foreign automakers had to abide by conditions intended to upgrade the local industry’s skills. State-owned Guangzhou Automobile Group developed the manufacturing know-how necessary to become a player in EVs thanks to joint ventures with Toyota and Honda, said Gregor Sebastian, an analyst at Germany’s Mercator Institute for China Studies.
Despite all that government support, sales of EVs remained weak until 2019, when China let Tesla open a wholly owned factory in Shanghai. “It took this catalyst…to boost interest and increase the level of competitiveness of the local Chinese makers,” said Tu Le, managing director of Sino Auto Insights, a research service specialising in the Chinese auto industry.
Back in 2011 Pony Ma, the founder of Tencent, explained what set Chinese capitalism apart from its American counterpart. “In America, when you bring an idea to market you usually have several months before competition pops up, allowing you to capture significant market share,” he said, according to Fast Company, a technology magazine. “In China, you can have hundreds of competitors within the first hours of going live. Ideas are not important in China—execution is.”
Thanks to that competition and focus on execution, the EV industry went from a niche industrial-policy project to a sprawling ecosystem of predominantly private companies. Much of this happened below the Western radar while China was cut off from the world because of Covid-19 restrictions.
When Western auto executives flew in for April’s Shanghai auto show, “they saw a sea of green plates, a sea of Chinese brands,” said Le, referring to the green license plates assigned to clean-energy vehicles in China. “They hear the sounds of the door closing, sit inside and look at the quality of the materials, the fabric or the plastic on the console, that’s the other holy s— moment—they’ve caught up to us.”
Manufacturers of gasoline cars are product-oriented, whereas EV manufacturers, like tech companies, are user-oriented, Le said. Chinese EVs feature at least two, often three, display screens, one suitable for watching movies from the back seat, multiple lidars (laser-based sensors) for driver assistance, and even a microphone for karaoke (quickly copied by Tesla). Meanwhile, Chinese suppliers such as CATL have gone from laggard to leader.
Chinese dominance of EVs isn’t preordained. The low barriers to entry exploited by Chinese brands also open the door to future non-Chinese competitors. Nor does China’s success in EVs necessarily translate to other sectors where industrial policy matters less and creativity, privacy and deeply woven technological capability—such as software, cloud computing and semiconductors—matter more.
Still, the threat to Western auto market share posed by Chinese EVs is one for which Western policy makers have no obvious answer. “You can shut off your own market and to a certain extent that will shield production for your domestic needs,” said Sebastian. “The question really is, what are you going to do for the global south, countries that are still very happily trading with China?”
Western companies themselves are likely to respond by deepening their presence in China—not to sell cars, but for proximity to the most sophisticated customers and suppliers. Jörg Wuttke, the past president of the European Union Chamber of Commerce in China, calls China a “fitness centre.” Even as conditions there become steadily more difficult, Western multinationals “have to be there. It keeps you fit.”
Chris Dixon, a partner who led the charge, says he has a ‘very long-term horizon’
Americans now think they need at least $1.25 million for retirement, a 20% increase from a year ago, according to a survey by Northwestern Mutual
