Inflation from multiple causes requires multiple cures

Consider all the relevant and important factors that have generated our current inflation.

First, the pandemic has played an important role in interfering with our unexpectedly fragile supply chain. Other commentators have already pointed out that too much emphasis on efficiency created our rather unstable “just-in-time” system. This needs to be replaced with a more secure “just-in-case” system that is robust and resilient to disruptions.

Second, many economists have reported that COVID-19 also caused people to cut way back on services (e.g., travel and dining) and to use those savings to increase demand for durable goods such as automobiles. This occurred just as the vehicle computer chips were in short supply. There has also been a significant increase in demand for housing driving up prices partially due to a new, widespread effort by some Wall Street investors to buy up single family homes around the country and turn them into rental units. Perhaps you have received a phone call recently from one of them offering to buy your home.

Third, consider the stimulus packages. Larry Summers was among the first to point out that the Biden stimulus package was too big and would result in too strong consumer demand. Ironically, President Obama had made the opposite mistake in 2009 in trying to compromise with Republicans who sought to minimize the stimulus to minimize the role of government in recovering from the Great Recession. Ultimately, Obama failed to gain bipartisan support for his stimulus package anyway. Obama’s stimulus bill was too small, but President Biden went too far in the other direction and produced a stimulus that was too big.

The pandemic also discouraged some people from going to work so the workforce was reduced just when more supply was needed to meet an increase in demand. At the same time demand increased for medical and other essential workers. The surge in demand led to a shortage of workers in general and truck drivers in particular who are needed to provide the corresponding increase in supply. The increase in wages due to the shortage of workers helped raise prices of many commodities including food and fuel. President Trump had better relations with the OPEC countries, especially Saudi Arabia, than President Biden, due, in part, to their different reactions to the murder of Jamal Khashoggi, which didn’t seem to bother Trump, but deeply upset Biden. Biden’s pleas to the OPEC countries to increase the supply of oil have gone largely unanswered. Obviously, the war in Ukraine will only make things worse so expect prices (especially food and oil prices) to continue to rise substantially.

On top of all this is an economy dominated by less than fully competitive firms which took advantage of the new inflationary environment to raise their prices even if not justified by supply shortages or excessive demand. Jonathan Tepper wrote “The Myth of Capitalism” to reveal the amazing amount of concentration in American industries. For example, our patent laws have allowed the production of eye glasses to be dominated by just two companies. You would think that a small amount of glass and plastic would cost just a few dollars, but glasses typically cost close to 100 dollars or more. Patent laws originally were intended to encourage innovation, but in many cases have suppressed both competition and innovation. Adam Smith actually provided us with two invisible hands: (1) the explicit invisible hand of competition to increase quality and lower prices, and (2) the implicit invisible hand of economic power where firms conspired together to suppress competition and raise prices. It is this second invisible hand that has become so active in our current inflationary economy. To restore competition and reduce prices patent laws must be severely limited in their application and large dominant firms must be broken up. Some import duties may be necessary to avoid excessive dependence on production in overseas countries. 

Our politicians have been reluctant to take responsibility for all this and have instead relied on the Federal Reserve to stop excessive inflation. The Fed, in turn, has emphasized the need to ‘’stay in its lane” by limiting its action to cutting back or even reversing its purchases of securities and raising interest rates. This means increasing the cost of borrowing. Unfortunately the Fed’s restrictive policies suppress both supply and demand. To meet excessive demand for its products, a firm may want to add another line of production. This requires investment. Borrowing the money to invest in another line of production may turn out to be too expensive after the Federal  Reserve raises interest rates to suppress borrowing. This approach to stopping inflation slows the economy to the point of causing a recession.

It would be much better if the Fed could target demand by those people with the highest marginal propensities to consume (hundreds of millions of poor and middle class Americans). The whole point of the existence of interest rates is to pay someone to delay consumption. Private banks cannot afford to offer a higher interest rate on savings than the interest rate they charge on borrowing. But the Federal Reserve could offer a high interest rate on savings if it was limited to relatively small balances aimed at reducing consumer demand by those most likely to spend any extra dollars. Such small balances would not have much effect on private banks or the rates that they set for borrowing and saving. Most of the money in our banking system is owned by a few thousand wealthy families who have very low marginal propensities to consume and would probably not bother taking the time to move such a relatively small amount of money. However, the total increase in savings by hundreds of millions of Americans could amount to billions of dollars in reduced spending. Most prices would stabilize in the face of such a substantial reduction in consumer demand.

Too often policy is devised by politicians, who interact with the bankers, doctors, and lawyers who represent the small minority of Americans who are exceptionally wealthy. Instead we need to target middle class families who would save more money and spend less if offered a high enough interest rate on relatively small amounts of savings. This could be done by creating Federal Reserve digital currency bank accounts for every American. To combat excessive inflation very high interest rates could be offered on small balances for only one account per Social Security number. Anyone else in the world would be allowed to have a digital currency account with the Federal Reserve (unless sanctioned by Congress) but they would not be allowed to earn interest on their account balance. The Federal Reserve is currently considering the possibility of offering such digital currency bank accounts, and I have answered the 22 questions they have asked on how this new policy tool could be implemented. Going forward we will see if they follow my never-too-humble advice.

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