I Am Still Terrified: The Lamentations of a Simple Economist

Bad economic times are here, and worse times are coming. And it was all predictable. Worse, it was avoidable. 

Two years ago, I authored an article for the TNM conveying my fears about the impact of the economic policies implemented in response to the pandemic. Before I update my analysis of the current and future state of the national and global economies, let me explain first how I was able to accurately predict what would happen when they shut down the global economy. It was not because I am smarter than everyone else – far from it.

I am a simple academic economist. Despite all the advanced study of the economy I undertook in college and grad school to be qualified in the eyes of the education gods to teach college economics, I teach only courses in introductory economic theory and concepts. That is all the economics I have ever taught.

My analyses are not based on an advanced understanding of complex economic theory; it is based on what I teach in every macroeconomics course. This is a crucial point because every economist, academic or otherwise, knows the basic mechanics and theory behind the aggregate supply / aggregate demand (ASAD) model. We all learned in our very first macroeconomics course how to use the ASAD model to predict the outcome of most any economic policy (ceteris parabus – all things being equal – notwithstanding). 

Every entry level economist should have known the outcome of shutting down the global economy. Nothing I learned in intermediate or advanced economic classes was required to predict the outcome of shutting down the economy. The reason most chose to ignore what seemed so obvious to me (and others) is not because they are stupid or because I am especially clairvoyant or possess some special insight. It is because economists are humans. Selfish, corruptible humans. As such, they are as likely as anyone – perhaps more so because of the hubris required to believe we have tamed the animal spirits – to make mistakes and engage in partisan hackery or propaganda.

People dismiss the study of macroeconomics as junk science, equating it to astrology. Others, perhaps the same people, dismiss the ASAD model specifically, as a relic of outdated Keynesianism. However, they do so at their own peril. Throwing the baby out with the bath water is never a good idea, particularly in economics. Afterall, I was able to use the ASAD model to paint a reasonably accurate picture of our current situation two years before those aforementioned policy choices had even fully ripened. If a simple economist who teaches simple economics can do that using the ASAD model, it seems shortsighted at best to dismiss out of hand that model and the macroeconomic theoretical framework it helps codify.

In the article I penned more than two years ago now, I suggested we were headed for 70s-style stagflation because of the staggeringly moronic decision to shut down the global economy. The shutdowns created a massive worldwide aggregate supply shock, which in turn led to an increase in the price level (inflation) and a decrease in output (recession). This is the result of what we call “cost-push inflation” and is easily modeled using ASAD.

Many people claim, as famed monetarist Milton Friedman did, that inflation is always a monetary phenomenon, and therefore there is no such thing as cost-push inflation. Fine! It does not matter what you call it, the effect is the same – prices went up, output went down. Period. Most economists call that cost-push inflation, and I will do so here as well.

Sadly, my fears proved prescient and much of what I wrote has come to fruition. We learned in June 2020 – a month after my article was published – that our economy peaked four months earlier in February. This marked an end to the longest expansion in economic history – 128 months – dating back to 1854. The economy began expanding just two short months later, however. How did it recover so quickly, or had it in fact recovered at all?

As I explained in that earlier article, the challenge with cost-push inflation is that not only are prices rising, but output is falling at the same time. This is where the name stagflation comes from: an economy that is not growing due to reduced output, known as a stagnant economy, AND inflation due to elevated price levels. As I pointed out in my last article, because our Keynesian policy tools are centered around demand rather than supply, you can only address one of these issues at a time – recession or inflation. However, doing so inevitably makes the other issue worse. 

As an example, consider the oil crisis of the Seventies. The Organization of Petroleum Exporting Countries (OPEC), a cartel that colludes to set global oil prices, cut oil production sending oil prices higher and causing a supply shock in the oil market. However, a supply shock in the market for oil is a contagion that infects many sectors of the economy. This is because oil is a direct input resource used in the production of many goods, and an indirect input resource used in the transportation of those and most other goods and services to and from their respective markets. Because oil costs more, production costs more, effectively reducing the supply of a large swath of goods and services across many economic sectors. In other words, OPEC caused an aggregate supply shock.

There are only three ways you can deal with an aggregate supply shock (cost-push inflation): (1) you can either increase (aggregate) supply to meet current (aggregate) demand, (2) decrease (aggregate) demand to meet current (aggregate) supply, or (3) a combination of the two. Since increasing (aggregate) supply would require subsidizing production by reducing regulations and cutting corporate tax rates further, this is a non-starter in the modern anti-intellectual, anti-capitalist, anti-wealth political climate. However – unfortunately, some might say – we have all sorts of Keynesian ways we can decrease demand, not the least of which is by increasing interest rates. The purpose in hiking interest rates is to make borrowing more expensive, which will reduce business and consumer spending across much of the economy. The goal is to reduce aggregate demand and close the inflationary gap that had opened between short-run equilibrium and long-run equilibrium.

By 1980, inflation had soared to 14.6%, the highest level on record. In December 1980, the Fed hiked interest rates two full percentage points to almost 20%, its highest ever. In other words, to pull prices back down during stagflationary times, the Fed had to jack up interest rates higher than the rate of inflation, shrinking the economy so profoundly that it promptly contracted for sixteen months straight, leading to double-digit unemployment for the first time since the Great Depression. 

We are faced with a similar economic situation now – an aggregate supply shock caused by the staggeringly moronic decision to shut the global economy down that caused both a recessionary gap AND an inflationary gap to open. This time policy makers, including the Fed, chose a vastly different option. Instead of reining in inflation before it worsened, they decided to close the recessionary gap by increasing government spending and subsidizing consumption with direct payments to consumers. The goal was to increase aggregate demand and close the recessionary gap that had opened.

It worked! By the end of 2020, the unemployment rate had fallen to 6.5%. Output likewise regained its footing, increasing by 38.6% in the third quarter and returning us to the so-called full employment output level before the end of 2021. However, here again, and quite predictably, the consumer subsidies made inflation even worse. This is the more traditional inflation – demand-pull inflation – that even Friedman acolytes and general monetarists and Libertarians believe is very real: too much money chasing too few goods. In other words, we stacked demand-pull inflation on top of cost-push inflation, which closed the recessionary gap, but widened the inflationary gap.

Inflation is not likely to improve any time soon. Many economists are skeptical that the Fed’s tepid rate hikes thus far will effectively end inflation. Despite their rate hike of three-quarters of a percentage point in June, aggressive by today’s standards (that was the single largest hike in almost thirty years) and again in July, many believe the Fed is still a day late and many dollars short. If the Fed’s goal is to avoid a hard landing, which is an economic euphemism for a bad recession, and return inflation to no more than 2%, the Fed will need to act more aggressively. 

As recently as April it was widely reported that U.S. household cash exceeded debt for the first time in three decades, thanks to massive government handouts throughout 2020 and 2021. With households holding so much cash, spending may not slow enough to reduce demand and curb inflationary pressures any time soon, which will force the Fed to assail interest rates with even more vigor. Further, in the current context, our tight labor market is not a sign that the economy is healthy, it is a sign that the Fed will have to be much more aggressive to rein in inflation.

Are we on the cusp of seeing another two percent point hike in rates, which will likely send the economy into the depths of another bad recession? Indubitably. A recent report by the National Association of Home Builders (NAHB) notes a rapid decline in homebuilding and demand for new homes as additional rate hikes are anticipated. Housing activity contributes between 15% to 18% of output every year, and housing activity is a leading indicator – it leads every recession since the last world war. Output data just released shows the economy shrank for the second quarter in a row, a common rule of thumb for determining whether we are in a recession or not. 

Some are warning that the stock market’s post-Fed rate hike bounce is a trap, and the markets will soon signal that we are already in or nearing a recession. Bank of America is questioning the Fed’s ability to stick a soft landing and are forecasting a formal recession by year’s end. They are also warning of a “recession shock” following the worst first-half for the Standard & Poor’s (S&P) 500 in more than 50 years. And it is not just those stocks listed in the S&P 500 that are losing ground – both Nasdaq and the New York Stock Exchange are showing similar losses.

You may think this only matters to the uber wealthy who buy and sell stocks like the rest of us change our socks but be careful – stocks are not just a playground for the wealthy looking for a good return on their investments. Do you have a retirement account, perhaps through your employer? Does your mother or father, your grandparents? What about siblings or your own children? Friends and neighbors? Trust me, a bad stock market affects you and your family and friends. If not directly (check your retirement account balances), then indirectly. Baby boomers, a generation that includes everyone alive today older than 58 years of age, are all retired or nearing retirement and in many cases their livelihoods are or will be dependent in large part upon returns from stocks, bonds, and other similar investments. 

We are facing the strongest recessionary headwinds in over a decade. The shutdown of the global economy exposed the fault lines in the global supply chain. While many attribute some of our economic woes to these fault lines, the issues with the supply chain existed long before the pandemic. The shutdown merely exposed these fault lines. Regardless, there is no doubt that supply chain issues are a contributing factor in our current predicament. 

Sadly, there is every reason to believe the situation will get much, much worse before it improves. As a Deutsche Bank economist, Jim Reid, points out, aggressive rate hikes by the Fed aside, a deep, deep recession is likely unavoidable before the end of President Biden’s first term. Russia’s invasion of Ukraine and foreign policy decisions by the U.S. and its United Nations partners is making these shutdown-induced recessionary headwinds seem mild in comparison to what we may be facing before the end of the year and beyond: a return of a 70s era oil crisis and a second round of cost-push inflation stacked on top of demand-pull inflation that was stacked on top of the first round of cost-push inflation. 

Predictions abound that a recession is unavoidable, but many of us have already begun feeling the effects of this “pending” recession. It may take the next two years for the wealthy to truly feel the impact of it, but the effects of this recession will inevitably move up the socio-economic ladder and spare only those wealthy few who were smart enough early enough to have absconded to any number of safe havens with their wealth, a decision that will surely hasten the economic fall for the rest of us who cannot or who refuse to see what is coming. I may be exaggerating a bit there, but not by much, I fear. Bad times are here, and worse times are coming. And it was all predictable. Worse, it was avoidable. 

Editor’s note: Dr. Jack Reynolds is an economist who teaches at the college level in North Texas. He writes a weekly Texas Economic Report for the Partisan that highlights the week’s economic news with a Texas emphasis. He is on the advisory board of the TNM and a Local Coordinator.