It was the early 2010s. The global financial crisis had gone down in the history books, and the recession it had caused was long over. But the United States economy was still plagued by a number of chronic, interrelated problems: under-spending by consumers and businesses; too few jobs; and too low inflation.
The result was an economy that operated below its potential for years, at significant human costs.
When the government took action last year to respond to the economic crisis caused by the coronavirus pandemic, these experiences were most recently remembered. Key decision-makers in Congress, two presidential administrations, and the Federal Reserve were determined to avoid the missteps that prolonged problems from a decade ago.
The good news is that they succeeded. The bad news is that it is starting to look like they fought the last war on essential points. Your focus on the challenges of the last crisis fueled some of the challenges of this crisis.
A decade ago, the government was underpending to prevent American incomes from falling. This time around, the government has pumped enough money into the economy that incomes have risen above their pre-pandemic trend, and households have on average increased their savings.
During this crisis, state and local governments that did not get much bailout slowed the economy for years. This time, their rescue packages are so extensive that many states are deciding what to do with the record surpluses.
Last time, this inadequate spending resulted in a chronic lack of demand for goods and services, which meant there were more potential workers than jobs. With strong demand fueled by government policies, there are now labor shortages and rising wages. After years of focusing on preventing inflation from falling below its 2 percent target, inflation is now well above that target of around 6 percent.
More generally speaking, the last economic crisis was about oversupply of almost everything – including manufacturing and shipping capacity. The key challenge now is scarcity and supply constraints that cause high inflation and other frustrations.
“We had a double blow of very loose monetary policy and extremely supportive fiscal policy to combat this demand shock,” said Michelle Meyer, head of US economics at BofA Global Research. “The problem is that we are now facing a supply shock.”
To do justice to the people who set politics over the past two turbulent years, the economic crisis appeared to have dimensions similar to the last in the first few months of the pandemic. When millions of people lost their jobs and incomes plummeted in the spring of 2020, the central problem was actually a collapse in aggregate demand and a potential deflationary spiral that was even worse than in 2008 and 2009.
For example, the price of oil futures in May 2020 even went negative for a short time in April 2020, which means that someone with storage capacity could essentially be paid to extract oil. A wide range of commodity prices pointed to persistent recession-like conditions. And by the end of 2020, bond prices indicated that inflation would remain extremely low for years.
The government’s response was, in effect, aimed at preventing this from happening. The Fed pumped $ 120 billion in cash into the financial system every month through its quantitative easing program on bond purchases and promised to keep interest rates near zero well into the future.
The Fed also focused on a new policy framework that had been in the works for years known as the “flexible average inflation target”. She was essentially trying to reassure people that she was serious about not keeping inflation below her 2 percent target permanently. It did so by making it clear that it would be convenient to let inflation soar above this level after a downturn.
But there were big differences between the economic environment in 2010s and 2021. Among them: Fiscal policy was much more aggressive this time around to stimulate growth, while in the 2010s the Fed was in fact trying to mitigate the effects of fiscal austerity.
“The Fed thought it had to make up for weak fiscal policy when the opposite was the case,” said Jason Furman, the Harvard economist.
Now the Fed is just beginning to taper its bond purchases and is still keeping rates near zero in the face of low unemployment and high inflation. While central bank leaders acknowledge the pain caused by inflation, they expect the supply disruptions to heal in the months ahead.
“We understand the difficulties that high inflation creates for individuals and families, especially those who have limited resources to absorb higher prices for essential goods such as food and transportation,” said Chairman Jerome Powell in early November a press conference. “Like most forecasters, we continue to believe that our dynamic economy will adjust to supply and demand imbalances and that inflation will fall to levels much closer to our longer-term goal of 2 percent.”
An initial spike in federal spending in the spring of 2020, particularly the bipartisan CARES bill of $ 2.2 trillion, helped consumers and businesses avoid the types of steep income slumps that likely appeared when the economy first shut down in March was. Then, in December 2020, a bipartisan majority passed another $ 900 billion bailout package, followed by the US $ 1.9 trillion rescue plan signed by the Biden administration in March.
Those two combined meant that nearly $ 3 trillion was pumped into the economy in 2021, at a time when estimates of the “output gap” – underperforming economic potential – were far lower, at hundreds of billions of dollars .
The Biden administration and Democrats in Congress argued that this was a sensible strategy to reduce the risk of an ongoing crisis for families affected by the pandemic.
“I think the price of doing too little is much higher than the price of doing something big,” Treasury Secretary Janet Yellen said in a television interview in February. “We assume that the benefits will far outweigh the costs in the long run.”
Understand the supply chain crisis
In an appearance on CBS’s “Face the Nation,” aired on Sunday, she admitted that high inflation had caused economic pain – but argued that if the pandemic-induced distortions in spending patterns eased, inflation would fall .
“If labor supply and demand patterns normalize – and I would expect prices, if we are successful with the pandemic, to normalize again sometime in the second half of next year,” said Ms. Yellen. She added, “I just think the important thing is to put inflation in the context of an economy that is greatly improving and making progress from what we had right after the pandemic.”
State and local finances are a prime example of how, unlike in the early 2010s, federal action was geared towards overdoing it and not doing too little. In the previous recession, the states suffered severe loss of revenue through multiple channels. People lost their jobs and paid less income taxes. Investment losses meant less capital gains tax. Falling property values meant lower property taxes. And falling consumer spending meant less sales tax.
In this episode, the federal government showed little inclination to support the public finances. With states generally unable to manage budget deficits, this forced local governments to austerity, resulting in further job losses and slowing the recovery for years.
Pretty much everything was different this time. The federal government has curbed people’s incomes and helped keep income tax revenues flowing; the stock market has boomed and fueled capital gains; real estate prices have risen; and people have spent more on physical goods, which helps sales tax revenue.
Additionally, the US bailout included $ 350 billion in support of state and local budgets, reflecting Democrats’ fears of a lingering funding crisis a decade ago. When you add it all up, state and local governments are cashier than ever before – in a time of inflationary pressures and labor shortages.
In California, Governor Gavin Newsom warned last year that “we are facing a steep and unprecedented economic crisis.” Now the state is wondering what to do with a “historic budget surplus,” like Mr. Newsom called it, in the double-digit billions.
“The Biden government was very attuned to and wanted to prevent public sector job losses,” said Tracy Gordon, who studies state and local finance at the Urban Institute. “By the summer it became clear that the states were not doing as badly as we thought.”
There is a natural tendency to apply the lessons of history to the present. And the challenge was a moving target. The nature of the crisis changed in a relatively short space of time from a collapse in demand and a potential deflationary vortex to a period of constrained supply and excessive inflation.
“We fought the last war in several ways,” said Furman, a veteran of the Obama White House. “One of them saw this as a demand problem, not a supply problem. Another thinks that we always want to do too much when there is actually the right amount. “
The challenge now, for the Biden administration, Democratic allies and the Fed, is to find a way out of the inflationary, supply-restricted environment that will create a more comfortable economy sooner rather than later, without inadvertently triggering a recession.