Some don’t like the economy hot

Business Insider has a very nice run down of the most positive development in economic policymaking in a generation: the willingness of the Fed (spearheaded by Yellen, continued by Powell) and the Biden administration to run the economy hot in the face of a once in a century economic crisis. Enter the backlash — concerns about inflation from Larry Summers, shortages of lumber and computer chips, and a moral panic over a “worker shortage”. To this bruhaha I want to make three simple points:

  1. The risk of a slow recovery vastly outweighs the risks of moderately higher inflation. Total employment is still 10.2 million jobs below the pre-crisis trend. Even at the rate of this very large monthly increase, it could take two years or more for the the labor market to recover from the pandemic. In a nightmare scenario, job growth slows down, and there is a repeat of the post-financial crisis anemic recovery.

2. Running the economy hot, and yes, accepting some inflation, is likely necessary for there to be a sufficient recovery in the labor market. Within the sectors hardest hit by the pandemic, there is a strong relationship between consumer demand and employment.

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3. It may be necessary to run the economy hot for significant period in order to coordinate the economy to a high level of output. In certain sectors demand has been extremely high, yet employment has stabilized well below pre-pandemic levels. Take employment in motor vehicle production. Although consumer demand has surged, employment is still down more than 10% from February 2020. Chip shortages have undoubtedly contributed to this laggard behavior, yet the fact remains that the major auto producers have been slow to respond to increased consumer demand. This suggests that (a) firms are understandably reluctant to vastly increase operations in what they may expect to be a temporary surge in demand (b) the economy faces a coordination problem in moving from an equilibrium of low output to an equilibrium of high output. Policy makers should be clear they will not hold back the economy until full employment is reached.

The US economic response to the Covid-19 crisis has been nothing sort of revolutionary. As J.W. Mason pointed out, The massive government payouts of unemployment and stimulus payments ensured that for the first time ever, personal income rose substantially during a recession. Low interest rates and the stimulus payments have likewise boosted both stock and housing markets, again leading to an unprecedented increase in household net worth during a recession. This is in stark contrast to the 2007 recession, where personal income fell by more than 5%. The administration and the Fed need to hold the course, and ensure the mistakes of 2007 are not repeated.