It’s not common. But every now and then, a prominent economist will make a strong near-term prediction that flies in the face of both mainstream wisdom and their known political loyalties. Lawrence Summers did that back in March 2021. As background, Summers was Secretary of the Treasury for a couple of years during the Clinton administration and head of the National Economic Council for a couple of years in the Obama administration. Moreover, he is someone who has been arguing for some years that the US economy needs a bigger boost in demand from the federal government to counter the forces of “secular stagnation” (for discussion, see here and here). Thus, you might assume that Summers would have been a supporter of the American Rescue Plan Act of 2021, backed by the Biden administration and signed into law in March 2021.
Instead, Summers almost immediately warned that this rescue package, when added to the previous pandemic relief legislation, would increase demand in the economy in a way that would be likely to set off a wave of inflation. There was some historical irony here. Back during the early years of the Obama administration when the US economy was struggling to rebound from the Great Recession, Summers was a prominent supporter of increased federal spending at that time–often warning that the problem was likely to be doing too little rather than doing too much. Some opponents of the 2009 legislation predicted that it would cause inflation, but it didn’t happen. Now in March 2021, Summers was on the “it’s too big and will cause inflation” side of the fence.
Jump forward a year to March 2022, and Summers looks prescient. Yes, one can always argue that someone made a correct prediction, but that they did so for the wrong reasons, and events just evolved so that their prediction luckily turned out to be true. And one can also argue that all those making the wrong prediction about inflation back in spring 2021 were actually correct, but events just evolved in an unexpected way so that just by bad luck they turned out to be wrong. But maybe, just maybe, those who were wrong have something to learn from those who were right.
Ezra Klein has an hour-plus interview with Larry Summers, which Klein titles “I Keep Hoping Larry Summers Is Wrong. What if He’s Not?” (New York Times website, March 28, transcript and audio available). Here are some points that caught my eye.
On the current economic dangers
I’m probably as apprehensive about the prospects for a soft landing of the U.S. economy as I have been any time in the last year. Probably actually a bit more apprehensive. In a way, the situation continues to resemble the 1970s, Ezra. In the late ’60s and in the early ’70s, we made mistakes of excessive demand expansion that created an inflationary environment.
And then we caught really terrible luck with bad supply shocks from OPEC, bad supply shocks from elsewhere. And it all added up to a macroeconomic mess. And in many ways, that’s the right analogy for now. Just as L.B.J.’s guns and butter created excessive and dangerous inflationary pressure, the macroeconomic overexpansion of 2021 created those problems, and then layered on with something entirely separate, in terms of the further supply shocks we’ve seen in oil and in food.
And so now I think we’ve got a real problem of high underlying inflation that I don’t think will come down to anything like acceptable levels of its own accord. And so very difficult dilemmas as to whether to accept economic restraint or to live with high and quite possibly accelerating inflation. So I don’t envy the tasks that the Fed has before it. …
On how short-term stimulus can be a bad idea if it leads to long-term costs
I share completely the emotional feelings that you describe around the benefits of a strong economy. But I think it’s very important not to be shortsighted and to recognize that what we care about is not just the level of employment this year, but the level of employment averaged over the next 10 years. That we care not just about wages and opportunities this year, but we care about wages and opportunities over the long-term.
And the doctor who prescribes you painkillers that make you feel good to which you become addicted is generous and compassionate, but ultimately is very damaging to you. And while the example is a bit melodramatic, the pursuit of excessively expansionary policies that ultimately lead to inflation, which reduces people’s purchasing power, and the need for sharply contractionary policies, which hurt the biggest victims, the most disadvantaged in the society, that’s not doing the people we care most about any favor. It’s, in fact, hurting them.
The excessively inflationary policies of the 1970s were, in a political sense, what brought Ronald Reagan and brought Margaret Thatcher to power. So I share your desires. I think the purpose of all of this is to help people who would otherwise have difficulty. That is what it’s all about in terms of making economic policy. But if you don’t respect the basic constraints of situations, you find yourself doing things that are counterproductive and that in the long-run prove to be harmful.
You raise an interesting example when you talk about wage increases. If you look at the rate of wage increases, percentage wage increases each year for the American economy, and then you look at the increase in the purchasing power of workers each year, what you find is that as wage increases go up, the growth of purchasing power increases until you get to 4 percent or 5 percent. And when wage increases start getting above 4 percent or 5 percent, then you start having serious inflation problems and actually the purchasing power of workers is going down.
So my disagreement with policies that were pursued last year had nothing to do with ends. I completely shared the end. I did not care about inflation for its own sake. But what I did care about was real wage growth over time, average levels of employment and opportunity over time, and a sense of social trust that would permit progressive policies.
And I thought those vital ends were being compromised by those with good intentions but a reluctance to do calculations. And I have to say that the early evidence at this point — and it gives me no pleasure to say this — but the evidence at this moment in terms of what’s happened to real wages, in terms of what’s happened to concerns about recession, in terms of what political prognosticators are saying, suggests that those fears may, to an important extent, have been justified.
What does the Federal Reserve need to do?
I don’t think we’re going to avoid and bring down the rate of inflation until we get to positive real interest rates. And I don’t think we’re going to get to positive real interest rates without, over the next couple of years, getting interest rates north of 4 percent. What happens to real interest rates depends both on what the Fed does and on what happens to inflation.
My sense of this is that given the likely paths of inflation, we’re likely to have a need for nominal interest rates, basic Fed interest rates, to rise to the 4 percent to 5 percent range over the next couple of years. If they don’t do that, I think we’ll get higher inflation. And then over time, it will be necessary for them to get to still higher levels and cause even greater dislocations.
