When Larry Summers warned earlier this year that the Democrats’ $1.9 trillion COVID-rescue plan could spark a serious wave of inflation, I was among the first to dismiss him, calling the economist and former Treasury secretary’s concerns “overheated” and “a little bit weird.”
Obviously, those words haven’t aged very well. With the Consumer Price Index rising at its fastest pace since 1982 according to Friday’s report, inflation is arguably President Joe Biden’s chief economic and political challenge at the moment. Summers, for his part, has spent the last several weeks enjoying an I-told-you-so tour and warning of more trouble ahead, predicting a 30 to 40 percent chance of recession. “The probability that this will all work out smoothly, which was my hope but not my expectation in March, looks much fainter,” he said Tuesday at an event held by the Wall Street Journal.
Meanwhile, some who previously disagreed with Summers have begun to grudgingly concede the man perhaps had a point. “It brings me no pleasure to report this, but Larry Summers may have been right,” New York’s Jonathan Chait wrote recently.
But was he really? Yes and no. Summers was clearly correct about the short-term danger of inflation—vastly more so than his critics, including me—but not entirely for the reasons he anticipated, and some of his key predictions have yet to be borne out. That’s important to keep in mind as he makes the media rounds, since the man is now seemingly taking advantage of his status as a macroeconomic cassandra to try and beat back some of the most important changes in monetary-policy thinking of the last generation.
What Summers Actually Said
There’s been a fair bit of confusion about what Summers specifically predicted about inflation in the spring, which has led some critics to give him a bit less credit than deserved. He first began ringing the alarm in a series of op-eds and interviews in February and March. In the most memorable, he told Bloomberg TV that the U.S. had embarked on “the least responsible macroeconomic policies we’ve had in the last 40 years,” and laid out a three-part prediction:
I think there is about a one-third chance that inflation will accelerate significantly over the next several years, and we’ll be in a stagflationary situation, like the one that materialized between 1966 and 1969, where inflation went from the range of ones to the range of sixes. I think there’s a one-third chance that we won’t see inflation, but the reason we won’t see it is that the Fed hits the breaks hard, markets get very unstable, the economy skids downward close to recession. And I think there’s about a one-third chance that the Fed and the Treasury will get what they’re hoping for, and we’ll get rapid growth that will moderate in a non-inflationary way.
A more pithy version of Summers’ forecast soon flew around the economics world in the form of a tweet from Bloomberg reporter Steve Matthews.
Summers was promptly roasted at the time for making what to many sounded like a non-prediction. (As one Australian economist put it: “There’s a 100% chance that, whatever happens, Larry Summers will say ‘I told you so.’”) But that was unfair: Summers was saying he saw a two-in-three chance that something horrible would happen to the economy, either because inflation would spin out of control, or because the Federal Reserve would plunge the U.S. into a downturn trying to stamp it out. There was no real doubt that he was placing his chips on catastrophe.
More recently, there’s been some misunderstanding about Summers’ slightly awkward use of “stagflation.” The phrase usually refers to a period of poor growth and rising prices (it’s a portmanteau combining “stagnation” and “inflation”), and is typically associated with the economic malaise of the 1970s. As a result, some commentators have suggested that none of the scenarios Summers predicted actually came to pass, since at the moment, the U.S. is experiencing both high growth and high inflation. (“He tried so hard to hedge his bets, and missed the one scenario that actually happened,” the economics writer Noah Smith recently tweeted.)
But if you reread Summers’ comments, you’ll notice that he wasn’t talking about the Carter years. He was in fact referring to the late 1960s, a period of low unemployment when loose monetary policy and Vietnam War spending helped push up inflation. That moment is sometimes described as the spark that lit the era of stagflation, and there’s no question that Summers’ main concern was that the government was about to add more rocket fuel to an economy already set to take off as COVID’s effects faded (which many expected to happen back then). “To take a potentially booming economy, and to put on top of it $1.9 trillion of stimulus is to take real chances of a kind that I don’t think we need to take,” he said in February.
Summers’ other key stance, which in many ways came to define this debate, was that the coming inflation wouldn’t just be a short blip, but a potentially persistent, self-perpetuating problem. Inflation doves and the Federal Reserve’s leadership expected the opposite: They thought some prices might jump for a brief “transitory” period as the economy reopened and rising demand collided with supply chain bottlenecks in a few sectors, before settling again on their own. Eventually, “team transitory vs. team persistent” became shorthand for the entire argument over inflation. (I tried to make it Team Larry vs. Team Jerome, as in Fed Chair Jerome Powell, but that didn’t go far.)
What Actually Happened
How did Summers’ predictions pan out? By some measures, they appear incredibly dead-on. Inflation is running at almost 6.8 percent for the year, and the unemployment rate is 4.2 percent, which is indeed similar to the Vietnam era. The comparison still works even if you take volatile food and gas prices out of the picture: The so-called core Consumer Price Index is up 4.9 percent over the last 12 months, versus a 5 percent increase in 1968. His guess was certainly better than the Fed’s: As of March, its leaders were predicting inflation around 2.4 percent. By June, after prices had begun their sudden climb, they bumped their guess up to just 3.4 percent. (The measure the Fed uses, the Personal Consumption Expenditure Index, is up 5 percent on its last reading.)
As for the the persistent vs. transitory debate, that’s a little trickier, but Summers seems to be winning where it counts. There are still good reasons to think much of what we’re experiencing is temporary, and investors still don’t seem to be anticipating extremely high inflation in the future. That’s important, because Summers’ argument hinges on the idea that businesses could start to expect higher inflation in the future, and raise their own prices accordingly. (He’s suggested recently that market measures of inflation expectations might be artificially low for “technical” reasons, or reflect that investors think the Fed will cause a recession if necessary to quell inflation.)
But in the end, we don’t know. And at this point, inflation pressures have clearly lasted longer, and are leaving more of an imprint on the economy, than Summer’s critics originally anticipated. In late November, Powell said the Fed would retire the word transitory from its statements, and seemed ready to take a more hawkish stance on policy. It’s possible Summers will turn out to be wrong in time, but the bottom line is that so far inflation has been persistent and high enough to scare the Fed into changing course, at least a bit.
All of this is to say that, when it comes to the basic issue of whether inflation was a real threat that the administration and policy makers should have taken more seriously, Summers was clearly more correct than his critics, myself included, who tended to play down that risk. In retrospect, the fact that some of us wrote off his concerns as essentially high-brow trolling probably speaks to a degree of overconfidence and groupthink earlier this year among part of the progressive economics world (and the people who cover it). Biden’s rescue plan may still be vindicated by history if jobs and economic growth stay strong and inflation mellows out over the coming year. But given the political backlash the Biden administration has experienced, I doubt most writers or policymakers would take the possibility that aggressive government spending might have unintended consequences quite so lightly again. If you dump a ton of money onto a weird economy, unexpected and unpleasant things might happen.
Summers Didn’t Predict the Supply-Chain Mess
That still leaves open two big questions, however. The first is whether Summers was right about why we’d face inflation. The answer, I think, is sort of, but not really.
As far as I know, Summers never really spelled out step by step how he thought inflation would take hold, but he pretty clearly seemed to have in mind a standard textbook model, where government spending would swamp the economy with demand and drive unemployment unsustainably low, creating pressure for higher wages and eventually inflation (and least, that seemed to be the case based on his frequent references to the Phillips Curve, the theoretical tradeoff between unemployment and inflation economists have long used in forecasting).
But, as the Wall Street Journal’s Greg Ip wrote Thursday, the inflation we’ve experienced so far doesn’t really fit the standard textbook models. Yes, labor shortages have led pay to rise faster than usual, but not enough to explain this year’s surge in prices—especially since inflation has been more moderate in labor-heavy service industries than in goods-producing sectors. Rather, they’ve resulted from massive, stimulus-fueled consumer demand running smack dab into supply chain problems related to the pandemic. That’s really not the toxic brew Summers expected. Moreover, there are signs that some of our supply chain problems are finally easing up—ocean freight rates are falling, manufacturers are picking up production—which could bode well for inflation next year.
To be clear, there are some people who take this point a bit too far, and try to argue that inflation has been caused entirely by supply-chain tangles, rather than government relief spending, which pretty clearly isn’t right either. There are industries where tangled-up supply chains really have little to nothing to do with the fact that so many Americans had stimulus checks to spend down; most notably, the auto industry has been partially crippled by a lack of semiconductors, which began when carmakers panicked and canceled orders for parts early in 2020, and chip makers moved on to different clients. But other “supply chain” issues have really been driven by the sheer amount of goods Americans bought in recent months; much of the reason our ports ended up overwhelmed, with lines of container ships docked out at sea waiting to unload, was that the country has been importing more physical stuff on a square footage basis than ever before, and the deluge overwhelmed our capacity to move it all. The relief checks also fed spending on big-ticket durable items like used cars that were already experiencing shortages, which have played a disproportionate role driving inflation as they’ve shot up rapidly in price this year.
There were, in fact, some economists who worried about this precise sort of thing happening, though their voices sometimes got lost in the Twitter scrum. Adam Ozimek, an economist at Upwork who’s long been a popular monetary policy and labor market commentator, worried at length about “sectoral overheating”—basically, that everyone was going to spend their stimmies on cars and couches, and send durables prices skyrocketing. These voices tended to occupy a space between “team transitory” and “team persistent”—arguing that the country could see much more inflation than anybody would like in the near term, and the Fed might have to act as a result, but that it wasn’t likely to become a lingering, years-long problem. Call it team “more than we bargained for.”
The best you could say about Summers was that he was directionally right that government spending was more than the economy could absorb without resulting in serious inflation. And that would be fine, if he left it at that. The problem is that, lately, Summers has been using his media victory lap to press the idea that the tight labor market is really a core problem right now. In October, he suggested that unemployment was probably already below the so-called “natural rate” at which inflation starts to accelerate. And at the the Wall Street Journal conference, he launched a broadside against the Fed’s entire intellectual revolution under Powell, which has seen it start to focus more on maximizing employment, while being somewhat less hyper-focused on inflation, and urged it to worry more about how falling unemployment might cause prices to rise as it did in the past.
“Using lower unemployment as a tool of social policy, that this is a long-term sustainable strategy—this is not a proper reading of what economics and long-term historical experience teach,” Summers said. “I think what we have to hope is that the Fed focuses on regaining credibility. Because I think that is the best way to minimize the average unemployment rate over time.”
It is not an exaggeration to say that the Federal Reserve’s realization over the last 10 years—that it needed to be less monomaniacal about battling inflation and focus more on fostering a healthy labor market—was one of the most important and healthy ideological developments of the past generation in economics. Nothing about America’s experience over the last nine months actually suggests that the Fed needs a return to its old hawkishness at times when the federal government isn’t preparing to spend $1.9 trillion on a stimulus program amid the bizarro-world economy of a pandemic. It would be a pity if Summers’ latest take was accepted as gospel in Washington because some of his predictions came true this time around.
Summers Didn’t Only Predict That Inflation Would Happen
The other dangling question is simply this: Can the Federal Reserve now tamp down on inflation without tipping the economy back into a recession?
Summers suspects it can’t, and in fact that was a crucial plank of his argument back in February. “Can and will the Fed control the situation effectively if inflation starts to rise? History is not encouraging,” he wrote at the time. “Every past significant inflation acceleration has been quickly followed by recession. Tamping down inflation will require allowing unemployment to rise, and engineering a soft landing is difficult: Unemployment has never risen by half a percentage point without then rising by almost two points, or more.”
Historically speaking, Summers wasn’t wrong. The Federal Reserve’s most famous inflation fighting efforts, like Paul Volcker’s efforts in the 1980s, entailed driving up the unemployment rate to cool spending. And when joblessness rises a little, it then tends to rise a lot (he’s just reciting a fact known as the Sahm Rule). But the Fed also famously managed a so-called “soft landing” in 1995, where it raised rates to prevent the economy from overheating without significantly bumping up the unemployment rate. Under Powell, the Fed raised rates between 2015 and 2018 to head off potential inflation, but unemployment continued to drop. It’s far from a foregone conclusion that the central bank has to tank the economy to tame the Consumer Price Index.
Looking back, Summers’ fears weren’t actually “weird” at all. But they still may turn out to have been overblown.