China Is Missing from the Great Inflation Debate

Once again, massive fiscal spending in the United States has invited warnings of inflation and triggered dark memories of the 1970s. But these fears are based on a model that has since been obliterated by economic realities – not least the rise of China, which has fundamentally reshaped the US and global economies.

AUSTIN – The scale of US President Joe Biden’s American Rescue Plan (ARP) – $1 trillion in spending for this year, another $900 billion after that, plus a $3 trillion infrastructure and energy program that has been promised – has spooked many macroeconomists. Are their fears justified?

The bank and bond-market economists, having cried wolf before, can be disregarded. A year ago, many of them warned that the $2.2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act would incite hyperinflation by massively increasing the money supply. It didn’t happen.

More notable among the critics are neo-Keynesians like Lawrence H. Summers of Harvard University and his numerous acolytes. Summers has a different analysis. It was his uncle, Paul Samuelson, who with fellow future-Nobel laureate Robert Solow launched the Phillips curve in 1960. This simple model offered some of the most successful empirical predictions in economic history during its first decade, and has been an economic rule of thumb ever since.

Drawing on data from late-nineteenth-century Britain and the postwar United States, the Phillips curve postulated an inverse relationship between inflation and unemployment: as one fell, the other would rise. This is what seems to be bothering Summers today. The various rescue and federal support packages are indeed enormous, with the ARP alone accounting for about 6% of GDP. The full scale of federal spending is even larger, reaching 13% of GDP by one estimate. By comparison, the conventionally estimated “output gap” (the amount of slack in the economy) comes to only one-quarter of that, perhaps less.

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Moreover, the official unemployment rate, at 6.2%, is not terribly far from the 4% level conventionally thought to represent “full employment.” Those receiving government relief payments are concentrated at the bottom of the income distribution, and thus should, in theory, spend more and save less of the cash disbursement, especially given that many households already have some savings held over from the CARES Act. By old-fashioned Phillips-curve logic, the new “stimulus” could drive the unemployment rate down to full employment and the inflation rate up from 0.6% in 2020 to at least 2-3%.

But the Phillips curve has had a rough ride since 1969. For about 25 years after that, the dominant economic thinking held that it was not a downward-sloping curve but a vertical line, at least “in the long run.” The implication was that any attempt to reduce unemployment below a “natural rate” or “non-accelerating inflation rate of unemployment” (NAIRU) would produce hyperinflation. Summers, I’m fairly sure, has more confidence in American capitalism than this view implies; and yet, he always hewed close to this skittish school of thought.

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