How the US economic response to the pandemic fought the last war

This was in the early 2010s. The global financial crisis had entered the history books and the recession it caused was long over. But the US economy was still haunted by a series of chronic and interrelated issues: too little consumer and business spending; too few jobs; and too low inflation.

The result has been an economy that has operated below its potential for years, with severe human costs.

Last year, when the government took action to respond to the economic crisis caused by the coronavirus pandemic, it was with these experiences in recent memory. Key decision-makers in Congress, two presidential administrations and the Federal Reserve were determined to avoid repeating the missteps that had prolonged the problems of a decade ago.

The good news is that they have succeeded. The bad news is that it is increasingly apparent that they fought, in key ways, the last war. Their focus on the challenges of the latest crisis fueled some of the challenges of this crisis.

Ten years ago, the government spent too little money to keep Americans’ incomes from plunging. This time around, the government injected enough liquidity into the economy to push incomes above their pre-pandemic trend, and households, on average, boosted their savings.

During this crisis, state and local governments, which did not hinder bailouts much, weighed on the economy for years. This time around, their bailouts are so sweeping that many states are deciding what to do with record surpluses.

Last time around, this inadequate spending caused a chronic shortage of demand for goods and services, meaning there were more potential workers than jobs. Now, with strong demand fueled by government action, there are labor shortages and rising wages. After years of the Federal Reserve working to keep inflation from consistently falling below its 2% target, inflation is now well above that target, around 6%.

More generally, the last economic crisis was about a glut of almost everything, including manufacturing and shipping capacity. Now the central challenge is the supply shortages and constraints that cause high inflation and other frustrations.

“We have had a double punch of very accommodating monetary policy and extraordinarily favorable fiscal policy to combat this demand shock,” said Michelle Meyer, head of US economics at BofA Global Research. “The problem is, we are now facing a supply shock.”

In fairness to policymakers in the past two turbulent years, during the first months of the pandemic, the nature of the economic crisis seemed to have dimensions similar to the last. When millions of people lost their jobs and incomes plummeted in the spring of 2020, the central problem really was a collapse in aggregate demand and a potential deflationary spiral even more severe than that of 2008 and 2009.

The price of May 2020 oil futures, for example, actually briefly turned negative in April 2020, meaning that a person with storage capacity could essentially be paid to take oil. A wide range of commodity prices suggested sustained recession conditions. And until the end of 2020, bond prices suggested that inflation would remain extremely low for years to come.

The government’s response was in fact to prevent that. The Fed injected $ 120 billion in liquidity into the financial system each month through its quantitative easing program of bond purchases, pledging to keep interest rates close to zero into the future.

The Fed also focused on a new policy framework that had been in the works for years, known as “flexible targeting of average inflation”. He was basically trying to assure people that he was serious about not letting inflation constantly fall below his 2% target. He did so by pointing out that it would be comfortable to let inflation exceed this level following a slowdown.

But there were big differences between the economic environment of the 2010s and that of 2021. Among them: Budget makers this time around took much more aggressive measures to stimulate growth, whereas in the 2010s the Fed was indeed trying to offset the effects of fiscal austerity.

“The Fed thought it had to compensate for weak fiscal policy when it was the opposite,” said Jason Furman, the Harvard economist.

Today, the Fed is just starting to cut its bond purchases and is still keeping rates close to zero, amid low unemployment and high inflation. Central bank executives, while acknowledging the pain caused by inflation, say they expect the supply disruptions to subside in the coming months.

“We understand the challenges high inflation poses for individuals and families, especially those with limited means to absorb the higher prices of basic necessities such as food and transportation,” said President Jerome Powell during a press conference in early November. “Like most forecasters, we continue to believe that our vibrant economy will adjust to supply and demand imbalances, and in doing so, inflation will drop to levels much closer to our target at higher. long term of 2%. “

A first increase in federal spending in the spring of 2020, particularly the bipartisan $ 2.2 trillion CARES Act, helped consumers and businesses avoid the types of income collapses that seemed likely when the economy shut down for the first time in March. Then, in December 2020, a bipartisan majority passed another $ 900 billion aid package, followed by the $ 1.9 trillion US bailout package signed by the Biden administration in March.

These two combined meant that nearly $ 3 trillion was pumped into the economy in 2021, at a time when estimates of the “output gap” – the shortfall in relation to the potential of the economy – were. much lower, running into the hundreds of billions of dollars.

The Biden administration and Congressional Democrats have argued that this is a sensible strategy to reduce the risk of a protracted crisis for families affected by the pandemic.

“I think the price of doing too little is much higher than the price of doing something big,” Treasury Secretary Janet Yellen said in a TV interview in February. “We believe the benefits will far outweigh the costs in the long run. “

In an appearance on CBS’s “Face the Nation” which aired on Sunday, she acknowledged that high inflation had caused economic hardship – but argued that inflation would fall as the pandemic-induced distortions in spending habits were fading.

“When the supply of labor normalizes and the pattern of demand normalizes – and I would expect that, if we are successful with the pandemic, it will be in the second half of the year next – I would expect prices to return to normal, ”Ms. Yellen said. She added: “I just think it’s important to put inflation in the context of an economy that’s improving a lot from what we had right after the pandemic and progressing.”

State finances and local finances are a prime example of how federal action, unlike in the early 2010s, has been geared towards hype rather than under-execution. In the previous recession, states suffered severe revenue losses through several channels. People lost their jobs and paid less income tax. Investment losses meant less capital gains tax. Falling real estate values ​​meant lower property taxes. And the fall in consumer spending meant less sales taxes.

In this episode, the federal government was reluctant to support the state’s finances. Because states generally cannot run budget deficits, this has forced local governments to adopt austerity mode, causing further job losses and slowing the recovery for years.

This time pretty much everything was different. The federal government has supported people’s incomes, helping to keep the flow of tax revenue; the stock market exploded, fueling capital gains; real estate prices have gone up; and people spent more on physical goods, supporting sales tax revenue.

On top of that, the US bailout provided $ 350 billion to support state and local budgets, mirroring Democrats’ fears of the kind of prolonged funding crunch ten years ago. Add it all up, and state and local governments are richer than ever – in an age of inflationary pressures and labor shortages.

In California last year, Governor Gavin Newsom warned that “we are facing an abrupt and unprecedented economic crisis.” Now the state is wondering what to do with a “historic budget surplus” as Mr Newsom called it, in the tens of billions of dollars.

“The Biden administration was very sensitive to the loss of public sector jobs and wanted to prevent that from happening,” said Tracy Gordon, who studies public and local finance at the Urban Institute. “By the summer it was becoming clear that the states were not doing as badly as we thought. “

It is a natural tendency to apply the lessons of history to the present. And the challenge was a moving target. The nature of the crisis changed in a relatively short period of time from a collapse in demand and a potential deflationary vortex to a period of excess inflation constrained by supply.

“We fought the last war in many ways,” said Mr. Furman, an Obama White House veteran. “One of them saw this as a problem of demand, not a problem of supply. Another is to think that we always want to overdo it when there is actually a right amount. “

The challenge now – for the Biden administration, Democratic allies and the Fed – is to find a way out of the inflationary, supply-constrained environment that creates a more comfortable economy as soon as possible, and without accidentally causing a recession in the process.


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