No Big Surprise - July 31, 2022

Well, there you go. We now have two consecutive quarters of GDP decline. 

The National Bureau of Economic Research will now meet to decide if they will, for the first time, depart from the traditional measure of a recession and instead declare that other ingredients of a recession are missing. I expect they will determine this is not a recession, although all will surely agree we are in a stagflation as we were in the 1979-81 era. 

The NBER will look at the tight labor market and conclude that the economy remains somewhat healthy and consumption remains sufficiently strong. They may not probe so deep to observe that the reason for the tight labor market has been the mass exodus of discouraged or fearful workers from the labor market. Hence, the low unemployment rate is actually a symptom of other problems that will surely impinge on consumption at some point. 

In addition, there are signs that consumption is indeed faltering as people fear an economic downturn and because their flatlined income does not allow them to purchase as much stuff, given that stuff now costs more. 

There is another reason why consumption may falter. When the economy is booming and the stock market is soaring, people feel wealthier, even when they don’t cash in. This wealth effect induces them to be a little more liberal with their consumption because they feel that they have a greater capacity to cover their expenses, should that be necessary. 

Not only will the recent collapse of crypto markets and the pullback of stock markets have a delayed effect on reducing consumption, but the economy is also experiencing increasing income inequalities. 

Such inequalities are recessionary, ironically enough. If income is diverted from low income households to those of the highest income, consumption falters. Those on low income spend almost all they earn, and hence their income translates into consumption. But, those of high income find it necessary to spend only a small share of their income. The rest is reinvested to purchase the assets shed by those of lower income spooked by declining stock markets. 

This week, Senators Manchin and Schumer relabelled President Biden’s infrastructure bill as the “Inflation Reduction Act.”

This renaming sounds a bit like spin, but there is some sense to it. As we have discussed in previous blogs, much of the economic malaise over the past few years has been rooted in too much fiscal demand stimulus chasing too few goods constricted by a broken supply chain. You can’t repeal the law of supply and demand. If there was one bill Biden should have passed, it was a way to free up supply constraints by fixing the electric grid, stimulate sustainable energy supply, and improve our depreciating public infrastructure. 

While I lament that we are not doing nearly enough, for instance in rebuilding a dysfunctional electric grid, Manchin’s bill is a start on repairing the supply chain, especially in concert with the recently passed domestic silicon chip stimulus bill. 

What might be missed, though, is the sound decision to pay for these improvements not with debt but with increased taxes on the wealthy. Those who earn their income primarily from investment will find it more difficult to avoid the higher income tax rate by spending and paying taxes on capital gains, or by borrowing against their wealth. Increasing taxes on the wealthy, and requiring our largest corporations to pay at least a 15% tax, will ensure we don’t artificially create more spending through borrowing. 

Ultimately, to discern whether our economic acts are inflationary, we must first analyze their effects on supply and demand, and hence prices. Then, we must figure out who pays, and whether these payments induce greater income inequality. We aren’t done with inflation yet, and indeed we are likely to respond to economic variables as we would during a recession, even if it is not so named. But, at least we are finally looking closely at supply constraints today and our reduction in dependence on unsustainable fuels in the future. 

When it comes to Congress and sound economics, baby steps are better than no steps at all. We face more economic pain in the near future, but we are sowing the seeds to repair the supply chain, and we are no longer indiscriminately pumping cash into the economy at an unprecedented and untargetted manner. Efforts to bring costs down on the supply side and to stop artificially increase demand will someday allow us to moderate inflation. While these effects come with unavoidable lags, as will the monetary effects of the Fed's increase in interest rates, they are the correct things to do, even if a bit late.

Unrealistic hope can be a dangerous thing, but anything we can do to tamp down expectations for future price increases will help us avoid an inflationary spiral. Certainly it also helps that we are no longer throwing fuel on the fiscal fire with indiscriminant spending or subsidizing interest rates and market signals through the Fed's quantitative easing policy. We are getting on the right track, but there is much more that needs to be done. For now, though, we have bougbt a moment of optimism as fiscal and monetary policy are finally working together and in the right direction. Let's savor this moment as it is rare indeed.