Why the Inflation Reduction Act is not such a thing



One of the more enduring fallacies influencing discussions of the economy is that somewhere in Washington in a vault there are a few dials that officials can turn one way or the other to measure employment, production, inflation – even the price of gas check.

Every time something good happens, some politician inevitably steps forward to claim credit for getting the dials spot on. And every time something bad happens, you can be sure that the media and political opponents will blame the officials for setting the dials to the wrong settings.

That came earlier this year as inflation began to rise and the President, Congress and the Federal Reserve were criticized for overstimulating the economy in response to the pandemic. We heard it again late last month when the government reported a second quarterly contraction in gross domestic product, prompting dire and exaggerated forecasts of a recession by Republicans. And now Congressional Democrats are embracing the same fallacy as they push through a package of climate, tax and health initiatives imaginatively marketed as the “Inflation Reduction Act of 2022.”

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While all of these criticisms are laced with a grain of truth, they stem from a flawed mental model of the economy and how it works. So let’s take a step back and see what’s really going on.

In the spring of 2020, when a global pandemic was on the verge of plunging the world economy into a deep depression, central banks and governments around the world effectively printed trillions of dollars out of thin air to keep businesses from closing and laying off workers while they provide households with an income to live on. It worked: after a scary few months of falling stock prices and rising unemployment, financial markets recovered, most companies continued to operate and most people who were looking for work were able to find them.

Unfortunately, as some of us have warned, governments would give too much of this fiscal and monetary stimulus for too long.

The benign explanation, at least in the United States, was that officials were determined not to repeat what they believed—wrongly—to be the mistake of excessive shyness during the 2008 financial crisis and recession, and that every major surge in inflation does so would be short lived. An equally plausible explanation is that President Biden and a Democratic Congress, careful not to “let a good crisis go to waste,” used it to justify large increases in public spending and investment to promote economic, social, and environmental justice to reach.

What does the Inflation Reduction Act say – and how might it affect you?

At the same time, the Federal Reserve (whose chairman, not coincidentally, is up for re-appointment) was unwilling to begin winding down its extraordinary money printing for fear that the bubble it had created in stocks and real housing markets would burst, or weaken a labor market, strained enough to finally secure wage increases for low-skilled workers.

It is often forgotten that the US economy was already clearly out of balance before the pandemic and all these economic stimuli. For decades, the country had been living well beyond its means, running large and persistent trade and budget deficits made possible by an overvalued dollar, artificially low interest rates, and the willingness of trading partners to reinvest their surpluses in the American economy. In fact, these imbalances have existed for so long that almost everyone believed they were the new normal and could last forever.

Given that pre-pandemic prosperity already depended on large doses of fiscal and monetary stimulus, it should come as no surprise that pumping in trillions of dollars in additional stimulus would result in rising prices and wages over the next two years. Indeed, that was the point of this rescue effort – to prevent a deflationary spiral, set a floor for household income, stimulate investment and support the prices of stocks, bank loans and real estate.

In retrospect, it is clear that politicians ignored and exaggerated warnings. But it is also true that economic policy is not a science and the world economy is not a system that can be controlled by a few buttons in Washington.

US politicians misjudged the risk of inflation until it was too late

No less flimsy, of course, is Democrats’ claim that inflation will be significantly curbed by a slimmed-down tax and spending bill that closes corporate tax loopholes, expands and expands clean energy tax credits, and extends health insurance subsidies to the working class, and empowers Medicare to negotiate the prices of a dozen overpriced drugs.

The Congressional Budget Office estimates that the Inflation Reduction Act is likely to change the inflation rate by less than a tenth of a percent over the next two years — but it’s not sure if the change would be up or down.

Even in the next five years, the package going through Congress would reduce the federal budget deficit by a staggering $25 billion, according to the Federal Budget Committee — a rounding error in a $23 trillion economy. Regardless of the final figure, the measure will have little impact on an annual federal budget deficit projected run at the unsustainable rate of 5 percent of GDP for the next 10 years.

Equally stupid is Republican criticism that the same officials who mistakenly triggered inflation with too much stimulus have now lit the fuse for a long and deep recession by pulling it back.

First of all, most of us don’t have the sensitive economic antenna to tell the difference between an economy that produces 1 percent more goods and services than last year and one that produces 1 percent less. The measurement of GDP, the gross domestic product, is too imprecise, the difference too small. The partisan hyperventilation about whether or not we’re in a recession has more to do with politics than economics.

More importantly, with the economy and financial markets emerging from an intentionally induced sugar high, the fact that production, employment, home sales and stock prices may decline somewhat is both healthy and necessary. Last year, the economy “created” more than 6 million jobs, an increase of 4 percent. In an era of slow immigration and many baby boomer retirements, there simply isn’t enough labor to keep up this pace or even to fill the positions already open. And with government and budget spending and borrowing falling from the record levels created by all this stimulus, we shouldn’t be surprised if unemployment falls from its current historic – and unsustainable – low of 3.5 percent.

Yes, some workers may lose their jobs as the economy adjusts to more sustainable levels of spending and output, but employers are showing most should be able to find another. And the extent to which people aren’t finding jobs isn’t because some Washington officials got the macroeconomic dials wrong — it’s because workers are unwilling or unable to move to where the jobs are are. Or because educational and labor market institutions do not produce the skilled workers that companies need.

Adjusting to a more stable and sustainable economic equilibrium cannot and will not be painless.

Compared to other things, the value of stocks and real estate must go down and some of the loans that bought them are written off.

Some workers need to learn new skills and relocate to find work, while employers may need to relocate to find workers and spend more to train them.

Wages for low-skilled jobs must rise to attract and retain workers, while inflated wages for top workers must fall.

Government spending needs to be more closely aligned with government revenue. Households have to borrow less and save more. Interest rates must rise closer to historical levels while the value of the dollar must fall, raising the relative price of what we import while the apparent price of what we produce for the rest of the world falls.

The alternative to bring things back into balance is to continue living with the boom-and-bust cycle of the last 30 years. Such an economy will need ever larger doses of fiscal and monetary stimulus to prevent it from slipping into recession. It will also remain an economy in which the rich get richer and the poor get poorer. It will remain an economy that is increasingly and dangerously indebted to the rest of the world.

In short, a healthy, sustainable economy doesn’t require government officials to constantly and dramatically adjust Washington’s macroeconomic regulators to keep things in balance. Rather, it relies more on the natural self-corrective mechanisms of open, competitive, and well-regulated markets.

Steven Pearlstein was a longtime business columnist for the Washington Post and is the author of moral capitalism, published by St. Martin’s Press. He is the Robinson Professor of Public Affairs at George Mason University.


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