US moving towards normalcy, not recession

The inflation vs recession debate in the US is missing the larger point

The consumer price inflation rate in the US touched 9.1 per cent this year. The Fed has raised the federal funds rate all the way from 0.25 per cent to 2.5 per cent so far this year, and more is expected. It is now feared that this check on inflation will bring about a recession. The debate is primarily about how fast the so-called recession will come, how severe it will be, and how long it will last. However, this is, in my view, missing the larger point.

Let us step back a bit. The Trump administration, and later even the Biden administration for a while, provided a huge fiscal stimulus. And, the Fed more or less went along. Overall, the result was that the economy did well. Anything wrong?

Let us remember that there has to be an economic loss related to the supply-side disruptions due to the Covid-19 situation and later due to the geo-politics; that loss is hardly avoidable. The economy then got to a new normal. Under the circumstances, it is actually impressive that the real gross domestic product (GDP) grew by more than 3 per cent over a three-year period in the US; many other countries fared much worse. How come the US did so well? This is because the US fiscal deficit rose roughly from $1 trillion in 2019 to as much as $3 trillion in 2020. Consequently, there was an artificial boom. This was obviously not sustainable. The economy is now very likely to see a fall from the artificially-elevated level of output, and not from the normal level of output. Accordingly, the US is moving towards normalcy, not a recession.

It will help to provide a perspective. Given the supply-side issues, demand-side economics does not quite help initially. At a slightly later stage, a stimulus to demand is useful. But it can help only to the extent that a reduction in aggregate demand is induced as a consequence of a fall in GDP and employment, which is basically due to supply-side factors. So, there is a role for a demand stimulus in preventing a bad situation from becoming worse. The demand stimulus cannot convert a bad situation into a good situation. That is why the stimulus needed to be up to a point only. But it was excessive.

With an extraordinary stimulus for a while, economic growth is positively affected only to fall back later. Yet, there can be an overall loss to the economy. Why? The subsequent fall can be more than the initial rise. More importantly, the US economy has gone through high inflation in the process. This inflation is basically due to the earlier extraordinary stimulus; the invasion of Ukraine and the other geo-political tensions in the world were only the aggravating factors in the US inflation story.

There is no free lunch — even in macroeconomics. The apparent free lunch in the form of higher output and employment initially is an illusion. The benefits disappear subsequently after the extraordinary stimulus is discontinued. And, there is an overall loss, given the economic costs of the substantially higher inflation.

The stimulus should have been smaller. But this is not to say that the unemployed or those affected by the Covid-19 crisis and the related economic shock did not need help. They did. And, the help should have been provided, and provided generously. However, if the required help was more than what was available with the optimal stimulus, then a part of the help could have come from, what may be called, a re-allocative or a re-distributive fiscal policy that may be used in a difficult period.

Some may argue that all this is in the context of controlling inflation; we should stop worrying about high inflation and just enjoy the benefits of the real boom. This view is, as history shows, mistaken. It is extremely hard to let inflation rise from 2 per cent to 9 per cent, and not any further. Also, it is a presumption that the real economic boom can continue by maintaining inflation at a somewhat constant high rate. Moreover, the inflation tax on the public is very high, if the inflation rate is 9 per cent.

Many observers invoke the famous Phillips Curve to say that we can reduce inflation only by reducing output and employment. In other words, recession is inevitable if the inflation rate is to be brought down. Well, while the original Phillips Curve was an important contribution, its lessons are sometimes, if not often, misapplied in practice. The current situation is a good example. The issue is one of returning to normalcy, and not moving into a recession.

The writer is visiting faculty, Indian Statistical Institute, Delhi Centre. gurbachan.arti@gmail.com