Did Policy Error Cause the Recession?

The Inflation Reduction Act (IRA) of 2022 has reignited the debate over the root cause of today’s inflationary environment and recession.

From global supply chain snafus to Russia’s invasion of Ukraine, many economists and market analysts have alluded to a wide range of issues adding to the highest level of the Consumer Price Index (CPI) in 40 years. But some experts say that the source of rampant inflation was excessive pandemic-era government spending.

A year later, Washington voted for the $1.9 trillion American Rescue Plan (ARP). The legislation was significant because it distributed $1,400 to every American, expanded jobless benefits, extended billions in additional funds to state and local governments, and authorized emergency grants and loans to businesses.

Will a recession thus force the Fed to rethink its rate hikes and balance-sheet reduction?

“All told, inflation might be a greater danger precisely because it’s no longer perceived as such,” he wrote.

“Policymakers want to push it higher. Most households and businesses are not concerned about the risks. Once the pandemic abates, those risks will no longer be entirely on the downside. And given how completely financial markets have come to expect low inflation and interest rates, and how much support those expectations are providing to bond and stock prices, an upside surprise could prove nasty.”

“I think policy is rather overdoing it. The sense of serenity and complacency being projected by the economic policymakers—that this is all something that can easily be managed—is misplaced,” Summers said in recorded comments at the event. “We’re taking very substantial risks on the inflation side.”

“The Fed’s idea used to be that it removed the punchbowl before the party got good,” Summers added. “Now, the Fed’s doctrine is that it will only remove the punchbowl after it sees some people staggering around drunk.”

JPMorgan Chase CEO Jamie Dimon appeared before the U.S. Senate in May 2021, warning that the “unprecedented” fiscal and monetary policies “will raise inflation.”

Sen. Rob Portman (R-Ohio) had also cautioned that the ARP “risks overheating an already recovering economy” that would lead to higher inflation and threaten long-term growth.

Now that analysts are crunching the numbers and assessing the situation, they see that expansionary fiscal policy played an enormous role in 40-year high inflation rate. Robert Koopman, the chief economist at the World Trade Organization (WTO), for example, noted in February 2022 that government spending inflated demand for durable goods, contributing greatly to worldwide scarcity.

They found that U.S. inflation had risen faster than other Organisation for Economic Co-operation and Development (OECD) countries. The Bay Area economists also noted that their models discovered that “throughout 2020 and 2021, U.S. households experienced significantly higher increases in their disposable income relative to their OECD peers,” which exacerbated demand levels.

“The vast majority of the experts, including Wall Street, are suggesting that it’s highly unlikely that it’s going to be long-term inflation that’s going to get out of hand,” Biden said at a CNN town hall meeting last summer. “There will be near-term inflation, because everything is now trying to be picked back up.”

Treasury Secretary Janet Yellen then retired the term in a congressional hearing alongside Federal Reserve Chair Jerome Powell.

“I think I was wrong then about the path that inflation would take,” she said in May. “As I mentioned, there have been unanticipated and large shocks to the economy that have boosted energy and food prices, and supply bottlenecks that have affected our economy badly, that I didn’t at the time fully understand. But we recognize that now the Federal Reserve is taking the steps that it needs to take.”

Economist Murray Rothbard explained in his seminal book, America’s Great Depression (published in 1963), that the quantity of money is not the sole component to monitor. Instead, it is important to determine where the freshly printed dollars travel and what businesses and consumers do with the funds.

Even if inflation has reached its zenith, the damage may already have been done to the economy. With the personal savings rate collapsing, credit growth surging, and 7.5 million people working two jobs, consumers are extremely concerned about the cost of living. When this occurs, it leads to widespread fears and an impact on consumer demand, effectively weighing on growth prospects.

For example, fuel consumption has fallen as motorists struggled to afford prices at the pump. While the trend has allowed energy prices to come down, this has also produced demand destruction. If drivers are not willing to pay for more than $4 for a gallon of gasoline, what else are they giving up in the marketplace?

With an economy that is driven by two-thirds consumption, inflation may have become too onerous for the average consumer. Pandemic-era savings have been exhausted, and consumers are relying more on credit cards to endure this environment. The U.S. government has slimmed down its COVID-19-induced fiscal stimulus campaign, even as the country slips into a technical recession. Now American must further brace themselves to endure the next economic downturn.