COVID-19 Is Straining A Lot of Things

At Bloomberg Noah Smith has noticed that COVID-19 (or governments’ response to it) is not just threatening our lives, health, livelihoods, and social fabric. It’s challenging economic doctrine as well:

The big question is when, if ever, this aggressive government action starts to incur negative consequences, such as rapid inflation. Macroeconomists should be investigating this question vigorously. But so far, interest in the question has seemed strangely muted among mainstream academics.

Before the financial crisis of 2008, the dominant academic model of the business cycle held that there was a tradeoff between inflation and unemployment — a new version of what’s known in economics as the Philips Curve. By managing interest rates, mainstream theorists argued, the central bank would navigate serenely between the rocks of inflation and the shoals of unemployment. There was not much room for government debt in that model.

The 2008 recession seemed like it might present a huge challenge for this paradigm, but most macroeconomists met the challenge by simply patching up the old models. They shoehorned in a financial sector, and allowed that when nominal interest rates approached zero, fiscal stimulus along with quantitative easing would have to be brought in.

But that still left the question of what the limits of stimulus and QE would be. Mainstream economists realized that because the government can use monetary policy to lower interest rates and even finance government borrowing directly, there would never be a real risk of sovereign default; if private investors stopped buying Treasuries and rates started to rise, the Fed could pick up the slack. The only real constraint on government action was the possibility of inflation, if the Fed created too much money.

He presents a few graphs to support his point but, for one reason or another, neglects to include what I would think is the one that’s most interesting:

As you can see from the graph above there’s a lot more money than just one year ago. Where’s the inflation? There are several possibilities. Maybe we’re in a “Wile E. Coyote” moment, suspended in mid-air, just waiting for the inevitable crash landing, as depicted in the illustration at the top of this post.

There are rather clearly increases in some commodity prices, e.g. gold, but not in others, e.g. oil, wheat, or in the DJIA. Maybe inflation is there and showing up just in a few places. Note that graph of M3—the enormous increase in the money supply over the last few months isn’t that large when placed in perspective.

Mr. Smith does consider my greater fear—hyperinflation:

Instead of spinning theories that effectively just say that hyperinflation will happen at some unknown point, macroeconomists could look at countries that do experience hyperinflation, or come close but manage to avert it. They should use these historical and international examples to learn lessons about when and where and why this sort of catastrophe happens, and how it can be prevented. But the seminal work on hyperinflation continues to be economist Thomas Sargent’s 1982 paper “The End of Four Big Inflations.” This paper, in addition to being four decades old, draws all its examples from Central European economies in the aftermath of World War I — very different circumstances than the economies of today.

New work on hyperinflation is urgently needed. One key question is whether runaway inflation happens slowly enough that the government can reverse course in time, or whether it’s instantaneous and catastrophic. Another question is whether direct monetary financing of new government borrowing is a trigger for hyperinflation. A third is whether and how capital flight is involved. A fourth is how the type of government spending changes whether markets expect deficits to be temporary or permanent. There are many other important questions besides these.

I can answer the first of those questions. The historic record suggests that the onset of hyperinflation is likely to be sudden. I can’t answer the other three questions.

Something else that the federal government’s response to COVID-19 is challenging is what I have deemed “folk Keynesianism”—the idea that you can spur economic growth just by putting more money into people’s pockets. That hasn’t happened, either. That doesn’t surprise me because you can’t spur greater personal consumption by putting money into people’s products while preventing them from buying by closing down retail stores and doctors’ offices and expect to maintain the health of the economy at the same time.