I’m Ezra Klein, and this is “The Ezra Klein Show.”
For the last year or so, Larry Summers, the economist and former Treasury Secretary, has been this relentless, loud, frustrating economic Cassandra. He’s been saying often and to everyone that the risk of inflation was way higher than most economists believed. He flayed President Biden’s American Rescue Plan for being way too much stimulus too fast.
Month after month, he said that the inflation— it wasn’t just transitory. It wasn’t just going to go away. These weren’t just supply chain problems that would unkink. That this wasn’t just going to be a problem of autos and energy. That the markets were wrong, and the forecasters were wrong, and the pundits were wrong, and the Fed was wrong, and we were headed for a serious bout of inflation.
And damn it, he was more right than he was wrong. You can debate, and people do, if he was right for the right reasons or right for some of the wrong reasons, or its contingency, or luck, or what will happen next. But things he was saying six months ago are conventional wisdom now. Inflation is still here. It seems in many ways to be getting worse, even as the economy is weakening a bit. The idea of transitory inflation— that is gone. That has been retired. The data now shows that the inflation is pretty broad-based. It’s not just in a few goods.
The Fed is raising rates much, much faster than it had intended, or projected, or said it would be. Though, to be fair, still not nearly fast enough for Summers. Fear of inflation is now a central risk to Democrats in the midterms and a really big challenge for the rest of Biden’s agenda. We are, unfortunately, living much more in the world Larry Summers predicted than in the world I’d hoped to be inhabiting right now. And it could be about to get worse.
If I was telling you not just my optimistic story a few months ago but the thing I thought would happen, my baseline scenario, I would have said that the inflation did reflect too much demand in an economy that was more constrained and warped and made weird by the pandemic than we’d expected. But as the pandemic eased, those disruptions and constraints would lift, inflation would calm. We’d have more workers. We’d have more production. Things would get a lot better.
But then Russia invaded Ukraine, creating a whole new disaster in the energy and commodity markets. Omicron began battering China. And we’ve seen huge lockdowns in regions like Shenzhen, which are critical for global manufacturing supply chains. So the disruptions— they may not be ending. They may be about to get worse.
I think a criticism Summers is made of many of us is that we have taken an optimistic prediction of how the world would go as a baseline prediction. And I think this is a moment when I’m really reflecting on that idea, because we’re really seeing how much could go wrong that either wasn’t well-predicted or just wasn’t built in to enough of our forecasts.
So I asked Larry Summers to come on the show. I still hope he’s too pessimistic. I still hope much of what he’s recommending will prove unnecessary. But my hopes here have been dashed before. And at the very least, he has earned a hearing and then some for his grim forecast. As always, my email firstname.lastname@example.org.
Larry Summers, welcome to the show.
Good to be with you, Ezra.
So I would say it’s fair to say that over the past year, year and change, you’ve been more worried about the economic downside, more worried about inflation, more worried about things going wrong than a lot of other people. And then in the past couple of weeks, we have seen Russia’s invasion of Ukraine, we have seen new pandemic lockdowns in China. So where is your level of worry now? How is the Larry Summers’ forecasting function changed in the past month?
I’m probably as apprehensive about the prospects for a soft landing of the U.S. economy as I have been any time in the last year. Probably actually a bit more apprehensive. In a way, the situation continues to resemble the 1970s, Ezra. In the late ‘60s and in the early ‘70s, we made mistakes of excessive demand expansion that created an inflationary environment.
And then we caught really terrible luck with bad supply shocks from OPEC, bad supply shocks from elsewhere. And it all added up to a macroeconomic mess. And in many ways, that’s the right analogy for now. Just as L.B.J.‘s guns and butter created excessive and dangerous inflationary pressure, the macroeconomic over-expansion of 2021 created those problems, and then layered on with something entirely separate, in terms of the further supply shocks we’ve seen in oil and in food.
And so now I think we’ve got a real problem of high underlying inflation that I don’t think will come down to anything like acceptable levels of its own accord. And so very difficult dilemmas as to whether to accept economic restraint or to live with high and quite possibly accelerating inflation. So I don’t envy the tasks that the Fed has before it.
So I want to pull some pieces of this apart and get some of this into more natural language. So inflation can have a demand side and a supply side. And the demand side is too much money chasing too few goods, or even just chasing the normal amount of goods. But too much money, too much— people are buying too much.
And then there’s a supply side. We are not being able to produce the goods. Factories are not being able to do things. There’s a war where an important natural resource is developed or there’s a lockdown where there’s a lot of manufacturing capacity.
And the argument you’ve been having with a lot of other economists, to some degree with the Fed over the past year, is whether 2021’s inflation was coming from demand— we did too much stimulus— or supply— the pandemic had just messed up supply chains. But now, in addition to that argument, there’s also the question of new supply shocks is what you’re saying. That Russia and China are adding more supply problems onto whatever we already had. Is that the right way to think about it?
I think that’s right in part, but I think it restates what I think is a bit of a popular confusion in the following sense— supply is what it is. Monetary policy can’t change it. Fiscal policy can’t change it, except in the long-run. And so given what supply is, it’s the task of demand to balance supply. And if demand is greater than supply, then you’re going to have excess inflation and you’re going to have the problems of financial excess.
So the job of the demand managers, principally the Fed, is to judge what supply is and calibrate appropriately. It’s not an excuse for inflation to blame it on supply. It’s a reality in the environment that you have to deal with. And so the job is to look for measures of overheating, and when you see measures of overheating, to apply restraint.
And it’s those measures that I saw as developing through 2021 that were not being responded to that led to my being quite alarmed and led to a situation where before we had the Ukraine war, before we had the new problems in China, wage inflation in the United States was running at above a 6 percent rate and the labor market was only getting tighter. So we had a problem that was of excess demand, whether the extent to which the excess demand was related to supply being different than someone might have forecast years before is a second-order question. The job is to manage so as to avoid excess demand.
But one of the things happening in demand now— so let’s start a couple of weeks ago before some of the newer problems fully emerged. If you believed— and I think you did believe— that a big driver of what we’re calling here excess demand was stimulus policies, credit policies, the Fed being really, really stimulative in the economy, the Biden administration putting out the stimulus checks, the American Rescue Plan being much bigger in relationship to the economic shortfall than say the Obama stimulus plan was.
A lot of that is draining out in certain ways. So we’re not doing more stimulus checks. The child tax credit has expired. We’re not giving more money to state and local governments. There isn’t more— this is not recurrent stimulus. And the Fed is beginning to certainly signal, and, in fact, to do smaller, but nevertheless signal that there are a lot more coming— to begin rate increases. So if demand was the problem alone, you might look at some of these drivers and say, well, shouldn’t that be turning the ship around?
That’s a fair question and I’d respond in a couple of ways, Ezra. First, the stimulus was short-run, but its acts were long-term. People estimate that only about 30 percent of the stimulus checks were spent. So in terms of the impact on the economy, we’re feeling very substantial stimulus on a continuing basis for the next several years. Monetary policy acts with a substantial lag. And the rising inflation meant more expansionary monetary policy because of lower real interest rates and that’s feeding through to affect the economy today.
Third, the stimulus had the effect of kick-starting the economy. You got a lot of people hired. Then those people were earning incomes. Then those people spent. Then other people invested. And the cycle continued. So I think the stimulative impact, both because of the lags in the effects of stimulus and because of the kick-starting effect, is something that was very much present.
That’s why almost all forecasts of growth this year are forecast to say that the economy is going to grow more rapidly than its potential. They say that the unemployment rate is going to decline. And so if you have an economy where this year the forecast is that demand is going to grow faster than supply normally grows, that’s an economy where the inflation problems are potentially going to get worse, not, in their fundamental sense, going to get better. And that’s why I have been so concerned.
So I know you’re a hard-nosed economist who looks at the numbers here. But I want to locate, I think, the emotional and to some degree even political frustration of this conversation, because a lot of the dynamics you’re talking about that then get framed as excess demand, there are things that feel just, that many of us have wanted for a long time. More hiring, wage increases, particularly at the bottom end, stimulus checks for people who have had a lot of bad years and didn’t have a lot of cushion behind them, child tax credit for families that could really use that. And so there are a lot of policies that came together— I mean, there was a reason the Biden administration wanted to run the economy hot. There was a long period when it didn’t just feel, the economic data showed, that expansions were not reaching people on the margins. And it felt, finally, like we were reaching people on the margins. We were putting a lot of firepower to do that. But even in this terrible time, this horrifying pandemic, we were giving people who needed it quite a bit of help.
And then for that to then turn into this horrifying inflation problem, which is now eating back those wage increases, potentially going to require much sharper action from the Fed— I recognize the world doesn’t have to please me, but it is maddening. And I think one of the hard questions, before we even get into Ukraine and China— I think one of the hard questions is, does it have to be this way? Did it have to be this way? Is there some way for this to end without the people we were finally helping suffering?
Ezra, it’s the question I think about every night. The first academic papers that I wrote as a late graduate student in the 1970s were about the benefits of high pressure labor markets. They highlighted, for example, that at that time a 1 percent increase in the employment ratio for white males went with a 6 percent increase in the employment ratio for African-American teenagers.
And I highlighted that much of unemployment was not just frictional unemployment but was long-term structural unemployment that destroyed families. And so it was terribly, terribly important to avoid recessions. I went into economics because I believe that by controlling recessions and preventing downturns, you could change livelihoods for millions of families.
So I share completely the emotional feelings that you describe around the benefits of a strong economy. But I think it’s very important not to be shortsighted and to recognize that what we care about is not just the level of employment this year, but the level of employment averaged over the next 10 years. That we care not just about wages and opportunities this year, but we care about wages and opportunities over the long-term.
And the doctor who prescribes you painkillers that make you feel good to which you become addicted is generous and compassionate, but ultimately is very damaging to you. And while the example is a bit melodramatic, the pursuit of excessively expansionary policies that ultimately lead to inflation, which reduces people’s purchasing power, and the need for sharply contractionary policies, which hurt the biggest victims, the most disadvantaged in the society, that’s not doing the people we care most about any favor. It’s, in fact, hurting them.
The excessively inflationary policies of the 1970s were, in a political sense, what brought Ronald Reagan and brought Margaret Thatcher to power. So I share your desires. I think the purpose of all of this is to help people who would otherwise have difficulty. That is what it’s all about in terms of making economic policy. But if you don’t respect the basic constraints of situations, you find yourself doing things that are counterproductive and that in the long-run prove to be harmful.
You raise an interesting example when you talk about wage increases. If you look at the rate of wage increases, percentage wage increases each year for the American economy, and then you look at the increase in the purchasing power of workers each year, what you find is that as wage increases go up, the growth of purchasing power increases until you get to 4 percent or 5 percent. And when wage increases start getting above 4 percent or 5 percent, then you start having serious inflation problems and actually the purchasing power of workers is going down.
So my disagreement with policies that were pursued last year had nothing to do with ends. I completely shared the end. I did not care about inflation for its own sake. But what I did care about was real wage growth over time, average levels of employment and opportunity over time, and a sense of social trust that would permit progressive policies.
And I thought those vital ends were being compromised by those with good intentions but a reluctance to do calculations. And I have to say that the early evidence at this point— and it gives me no pleasure to say this— but the evidence at this moment in terms of what’s happened to real wages, in terms of what’s happened to concerns about recession, in terms of what political prognosticators are saying, suggests that those fears may, to an important extent, have been justified.
Yeah, it gives me no pleasure to say I’ve come to the same view. Let me go back a month into the optimistic story that people were telling— the more optimistic story about how 2022 could go— which is maybe Larry Summers is right to a large degree about 2021. And I think others felt that the problem had been that supply was more constrained because of the pandemic for all kinds of reasons than policymakers had realized.
But things were getting better. And what was going to happen over the next year was there was not going to be nearly as stimulative fiscal policy from Congress or the White House, not going to be a stimulative monetary policy from the Fed, and the kinks in supply chains were going to iron themselves out, that production was going to go up as companies adjusted to where the economy was now, as production adjusted to the kind of demand people were seeing. And we were going to manage this landing after in certain ways a good, but in certain other inflationary ways a tough 2021.
But then you get Russia’s invasion of Ukraine. Then you get huge lockdowns in key manufacturing regions of China because Omicron is hitting China very hard now. And so if you were hoping that what was going to happen was supply was going to normalize, now all of a sudden it looks like it won’t. So I want to talk a bit about those risks and how they change the outlook. What does Russia’s invasion of Ukraine mean for the global economic outlook?
With your permission, I’ll interrupt to say that I don’t think the characterization of where things were prior to these shocks was hugely plausible. It wasn’t hugely plausible because the forecasts were all for unemployment to keep falling. They were all for growth to be faster than the economy’s potential. They weren’t terribly plausible because, in a sense, wages are the ultimate measure of core inflation. Most costs go back to labor.
And so who knows what’s going to happen to used car prices, who knows what’s going to happen in some month to semiconductor prices or to the price of asparagus. But in some sense the growth rate of wages is what ultimately is determining inflation over time. And wage growth had ratcheted up to a 6-plus percent rate by the end of the year. And there were desperate labor shortages, worse than we’ve ever had. And they were forecast to continue.
And the response that, frankly, the progressives who had advocated all of this were saying was that this labor shortage was fantastic because it was going to lead to even more wage increases for workers. So the theory of how this was all going to work out to moderate inflation with even lower unemployment, it would all make sense if there was an element of wage restraint. But when it was all happening with accelerating wage growth, I found it difficult, even before what we have seen, to see the scenario to soft landing.
Just as in the 1970s, excessively inflationary policies were followed by bad luck, and just as in the 1970s, the authors of the expansionary policies chose to interpret all the problems as being a consequence of the bad luck, even though some of it was a consequence of their policies. I think it’s pretty clear that we’re going to have significantly higher inflation this year because of the increase in oil prices, and because of the increase in food prices, and because of what’s happened in China. The long-predicted return to normal in used car prices, for example, is now substantially deferred.
The big question is whether the increase we’re going to have this year is going to feed through into medium-term inflation expectations or whether it’s not. And the good news— and this is highlighted by Paul Krugman and others— and they make an important point is that as of right now people are forecasting way accelerated inflation for this year. The market forecast is close to 6 percent. But they’re still forecasting more limited inflation beyond. And the question is, what’s going to happen to those inflation expectations?
And the reason I felt that it was so important for the Fed to send strong signals of its determination to contain inflation, even with increases in unemployment, if that’s necessary, is that that I think will ultimately make it much easier to contain inflation than if we allow high inflation expectations to become entrenched. It’s precisely because it hasn’t happened yet that I think it is so important to be sending strong signals right now.
Before we get to Russia and China for a minute, I want to untangle something here that may not be totally intuitive to people. So there is inflation as a tangible, noticeable phenomenon that we are living through right now. There is inflation, as you mentioned, that can come from people are buying too much and we don’t have enough of the thing they want to buy or the things they want to buy. There’s inflation that can come from there is some kind of supply problem, and as such we are raising prices or rationing the good because we can’t make enough of it.
Then there’s this other thing, which is what economists worry more about, which is inflation expectations, which is when the tangible inflationary phenomena we’re seeing right now become something people assume will happen far into the future. And so corporations begin building price increases into their planning, wage negotiations begin tying themselves to inflation, and then you get into a kind of spiral.
So can you say a bit about what turns inflation from an economic phenomenon into this psychological economic phenomenon? How does inflation become an expectation? And I guess why does it matter when it does?
We don’t really know and we don’t really completely understand the process. But I think a consensus view would be that people learn from the past, because what else would you learn from? And so people form their expectations based on what they’ve observed recently and based on what they think is going to happen in the future.
And so when they look around them and they see that people’s wages have been going up at 6 percent or 7 percent, and they see that prices have been going up rapidly, they tend to think, gosh, just in order to stay still, since I’m only going to get a wage increase once a year, I better get that wage increase at 6 percent or 7 percent, otherwise I’m not going to stand still. And when their boss thinks about what wage increase to give them, they think, oh my god, this guy’s pretty valuable, I better not let him leave. And so I better pay him enough to satisfy him.
And besides that, it’s probably going to be OK because we’ve been raising prices every couple of months and looks like we’re able to do that. We’re able to make our price increases stick. So I’ll be able to raise prices. So the whole thing becomes sort of self-fulfilling. A little bit like if you want to gain ground walking next to a treadmill, you have to walk faster and faster as the treadmill gets faster. So that’s the kind of process.
Economists used to think that it was just the kind of trade-off that you talked about before. If we would just live with a little more inflation, we could have lower unemployment and that would do so much for social justice. That was the prevailing macroeconomic theory of the 1960s. And that theory ended in the stagflation of the 1970s where we got the inflation, we got the acceleration in inflation, and we didn’t get any enduring benefit in terms of lower unemployment.
And so that’s when economists revised their theory. That’s when credibility became so important. That’s what led Paul Volcker to be celebrated. And that’s why we’ve had 40 years when the problems have not been of the inflation overheat variety. That when we’ve had downturns, they’ve had to do with a different subject— huge problems in the financial sector.
And that’s really what the crucial issue is today. Are we going to keep things under control or are we going to allow expectations to fully increase and create a need to do again what Paul Volcker did, at enormous cost, from 1979 to 1982. Most people don’t remember it today, but unemployment got to a much higher level in 1982 than it reached even during the financial crisis of 2008.
And so just real quick, Paul Volcker, being the Federal Reserve Chair who jacked up interest rates to— I believe it was 19 percent— engineering a massive, although very quick recession, and break in the back of inflation. But I want to go back to what we were talking about a second ago, which is going back to the story and the way people were looking at it, I understand one of the divisions between Larry Summers and people who disagreed with Larry Summers over the past year.
The people who disagreed with you, believing that the pandemic period was more of a special case, that it was an artificial constraint on supply, that that constraint would lift more quickly. That we were in this kind of one to two to three-ish, maybe, year period where things were going to be very weird, weirder than maybe we had hoped, but we were going to get out of it.
And without getting into the question here of whether they were right, one of the things that struck me as important from the expectations view on this is that if you believed that, then the reason you might not expect inflation that we’re seeing now to persist in five years or in 10 years is because you expect the pandemic to be more or less settled by then. One of the things that worries me about the moment we’re in is that other ways the world might just be continuously different are emerging.
So I want to talk a bit about Russia-Ukraine on that dimension, but also the way the pandemic is just, particularly in Asia, maybe going to have a very different life cycle than was projected if you’re in the West. And if people begin to think the world is different in the future in a way that feeds into inflation, I mean then your expectations become a real problem.
But let’s begin here for a bit with Russia and Ukraine. What do you understand the consequences on the near and slightly longer-term global economy to be from Russia’s invasion of Ukraine?
I think the near-term impact is $25 or $30 a barrel higher oil prices, and the equivalent with respect to grains, and significant increases also with respect to a range of other commodities. I think that’s a meaningful contributor to the inflation process, perhaps a 1 and a half percentage points, perhaps a little more, perhaps a little bit less, coming at a time when we already had an inflation problem.
How severe it is will depend upon how long commodity prices remain elevated. It will depend upon how big the spike in commodity prices is. I think the developments in China, which suggest continuing interruptions in supply of a whole variety of goods have a reasonable chance of being with us for as much as another year.
I think one of the general principles to have is that things take longer than you think they will and then they happen faster than you thought they could. And so I suspect that relief is going to be slower in terms of supply chains than people expect. But I do think that at some point, it will come in the future.
And then all of this is going to make the task of containing inflation that much more difficult. People are going to look and they’re going to say, let’s see, my neighbor got a 6 percent wage increase. Things looked awfully expensive at the grocery store. The gas prices are way up. I read in the paper that they’re closing down Shanghai. But maybe this is all temporary and so inflation is going to come down and so I shouldn’t ask for a big wage increase.
Seems like everybody’s going to plan for the worst and hope for the best. And that’s going to mean wanting higher wage increases and wanting higher price increases, unless there’s some strong counter-pressure to that. And the strong counter-pressure has to be less money floating around and a sense that there may be excess supply caused by a reduction in demand. And so I think the vision that has been held out— that with no reduction in demand we can somehow get inflation down in the midst of this— was unlikely prior to the recent supply shocks and is now extremely unlikely.
So the counterargument you’ll hear to this is that as much as telling the grimmer story makes sense to you, to me, the subject of the show, actually, that there is a place where you can look to see if, particularly, markets are telling the grimmer story. And as you gestured at, they’re really not yet— at least not yet.
So one-year inflation expectations have shot up. But you look at three, you look at five, you look at 10-year expectations, they haven’t moved all that much. And so the idea is if the long-term market expectations haven’t moved, maybe we don’t need to slam the brakes on the economy so hard. Maybe people aren’t telling that longer story and they’re still open to this being as the now buried adjective goes— transient.
So, look, Ezra, I’d love for all that stuff to be true. I spent 20 years pushing various kinds of strongly Keynesian theories that were directed at the idea that we should promote demand more and promote demand permanently. I was one of the prominent people pushing the idea of secular stagnation, which was a whole theory about how we should need more demand. So these are ideas that are emotionally very attractive to me.
But I think you have to look at the facts. And the facts are that if you look at five-year expected inflation right now, it is about 3 and a half percent, detached from the 2 percent target. And if you look at 10-year expected inflation, it is at close to 3 percent. So we actually are a bit detached from our target levels of inflation, point one.
Point two— and this is the key point— the Fed has done more signaling of tightening in the last two months than any time in the last 40 years. So the only reason why we have kept inflation expectations under control is that belatedly the Fed has done the things that those of us who are anxious about inflation were recommending for the past nine months. And the Fed has moved to rejecting the advice of the people who were serene.
If the monetary policy recommendations contained in Jay Powell’s Jackson Hole speech in August, or your colleague, Paul Krugman’s recommendations through the fall had been adhered to, we would have much higher inflation expectations today. Now, I think the Fed has adjusted quite significantly. I think it has adjusted insufficiently to the new reality, which is why I think what we’re likely to see is inflation expectations rising. And we’re likely to see further evidence of Fed tightening.
But let’s not confuse massive Fed signaling of tightening. The Fed going from saying that it was not going to raise interest rates at all until 2024, which was their position a year ago, to saying that they’re going to raise interest rates to 2 percent in 2022— let’s not say that expectations have become anchored and that’s some kind of triumph for team transitory. That’s evidence on the efficacy of the recommendations of those of us who felt that the Fed should have begun the tightening much sooner.
And I think at this point, Federal Reserve Chair Jay Powell has said that’s true. That they should have begun sooner. He, I think, said that over the last week. I think the question now is how tight? And I want to make sure we get into what tightening is, because I worry sometimes we use language that is a little too bloodless in all this. But you’re still pretty unhappy with them. Some of the people have been more aligned with you.
So Jason Furman, say, he seemed pretty happy with the Fed. He said that they were going in the direction he thought they should go. You wrote this column where you blasted them for, quote, “wishful and delusional thinking,” particularly in their economic forecasting. And I want to sit in that space of economic forecasting for a minute. So why? Why do you think what they are saying is going to happen doesn’t make economic sense?
Because they are predicting that the unemployment rate is going to fall to 3 and a half percent, remain at 3 and a half percent for three years, and that while that’s happening inflation is going to fall from its current north of 6 percent level to the neighborhood of 2 percent. And nothing like that has ever happened in the last, roughly, 60 years. There have only been very rare occasions when unemployment has fallen below 4 percent. And when that has happened, inflation has accelerated rather than decelerated.
So I think they’re postulating a set of circumstances that have never come together at a moment when it’s particularly difficult for those circumstances to come together. De facto unemployment is more like 2 percent than like 3 and a half percent if you take account of what’s happening to vacancies. Supply shock pressures are much greater than they were in the previous historical episodes when we had low unemployment.
So I think the combined idea that we’re going to have 3 and a half percent unemployment for the next three years and that while that’s happening inflation is going to decline substantially is not something that is supported by anything in the relevant economic history, nor is it consistent at all with market inflation expectations, which are substantially greater than what they’re forecasting, nor is it consistent with what one can infer from the market about unemployment expectations, which is significantly higher unemployment than they’re forecasting. I think that it is hard to see the forecast as anything other than— to use an old political term— rosy scenario economics.
You’ve said, in an interview, that we’re going to need 4 percent to 5 percent interest rates, levels we’re not even thinking of as conceivable. When you say that, at what time-frame are you thinking about that? Are you saying they should be going to 4 percent to 5 percent by the end of 2022? You’re saying that they’ll be there by the end of 2024? Tell me about that prediction.
First of all, Ezra, I just want to emphasize that I am always careful to say what I think is likely or what I think is the preponderant probability, never to say that I know what’s going to happen. And there are always a variety of reasons that I try to keep in mind and to watch for why I could be wrong.
My basis is simply this— we think about the effects of monetary policy in terms of what economists call real interest rates— interest rates minus the rate of inflation. And the idea is that when real interest rates go up, people want to save more, people want to spend less, because capital is more expensive.
And so in order to restrain the economy, you have to raise the level of real interest rates. Real interest rates right now over every horizon are substantially negative. Not just over one year. Not just over five years. They’re actually negative over 30 years.
Can you say, just because I think it’s unintuitive, what it means for a real interest rate to be negative?
A real interest rate to be negative means that if I buy a bond, the money I will get back from the bond will have less purchasing power than the money that I put into the bond. If the interest rate were negative, that would mean I get less money back than I put into the bond. If the real interest rate— that is the interest rate adjusted for purchasing power— is negative, that means I get less purchasing power, less ability to buy things back.
And so when you have an economy where you can get more for your money today than you can if you put it aside or where you can borrow money at lower cost than you’re going to have to pay back when the bond comes due, that’s an economy that’s going to encourage spending today, and it’s going to encourage spending today at a substantial rate.
I don’t think we’re going to avoid and bring down the rate of inflation until we get to positive real interest rates. And I don’t think we’re going to get to positive real interest rates without, over the next couple of years, getting interest rates north of 4 percent. What happens to real interest rates depends both on what the Fed does and on what happens to inflation.
My sense of this is that given the likely paths of inflation, we’re likely to have a need for nominal interest rates, basic Fed interest rates, to rise to the 4 percent to 5 percent range over the next couple of years. If they don’t do that, I think we’ll get higher inflation. And then over time, it will be necessary for them to get to still higher levels and cause even greater dislocations.
As I wrote in that column you mentioned, Paul Volcker would not have had to do what he did if others earlier had taken stronger steps to contain inflation. And the 10.8 percent unemployment that America suffered in 1982 was something that was completely avoidable if we had been prepared to take prompter action. It was something that was completely avoidable if we had not sought to blame inflation on a range of specific issues rather than on the overall level of demand in the economy.
Do you think the level of Fed tightening that you’re talking about would demand a recession or do you think at this point the path is possible to slow inflation without actually putting the economy into recession?
I think the likelihood is that we will not return to 2 percent inflation without having at least a mild recession. I think that the magnitude of the imbalances and excess demand in the labor market are sufficiently great that the odds are probably three and four that we will not get inflation down without running a recession.
Here’s a simple fact for your listeners to consider— if you look at the last 75 years of American business cycle history and you just ask the question— suppose that the unemployment rate is below 4 and the inflation rate is above 4, what are the odds that the economy will go into a recession in the next year and what are the odds that the economy will go into recession in the next two years? Depending on just how you calculate the answer, it’s about 50 percent that it will go in the next year and about 75 percent that it will go in in the next two years.
One of the things we’ve heard from the Biden administration has been a view that, of course, we need to do a lot on inflation, but the correct way to do it— recognizing the Fed has its own job here— but the Biden administration has said and Biden himself has said, what we really want to do is try to rapidly increase supply. And I think you’re hearing that more a couple of months ago than you’re hearing that right now.
But that rather than putting the brakes on demand, rather than slowing the economy down, rather than potentially cutting a lot of people off from gains they could have made, is there some way that we can open up the gates on supply quickly such that there’s more of the things people need and inflation goes down from that direction? Do you think the government has the tools to affect supply dramatically on the one to two-year time-frame?
Mostly the tools are pretty limited. And the tools that there are are tools that the Biden administration has so far been very reluctant to adopt. If we reduce tariffs, that would make more goods available at lower prices and perhaps reduce the consumer price index by 1 percent or more. But their rhetoric has gone the other way on tariffs.
If we decided to do public procurement as inexpensively as possible, that would reduce prices of a whole set of things the government buys and increase competitive pressure. But we’ve instead indicated a desire to shift from buying cheap to buying America and buying in ways that protect certain key constituencies.
If we acted to reduce various regulatory restrictions— we took away requirements that people be licensed to cut other people’s hair, or we allowed foreign companies to ship things from Houston to Newark, or we allowed foreign airlines to fly people from Boston to Los Angeles as a continuation of a flight coming from Europe— all these kinds of things would operate in very short runs to reduce prices. I don’t think the effects would be large. I don’t think it’s remotely realistic to think that programs of public investment are going to increase supply in a relevant horizon for the current inflation.
One of the questions that I think should be more front and center in politics than it is is raising interest rates sharply, which to some degree is going to happen over the next couple of years, whether on your path or on another. It’s a pretty blunt tool. In fact, it’s a very blunt tool. And, of course, the people who get hurt worst are the people who always get hurt worst.
Are there ways to protect them? Are there ways to more progressively slow the economy down? You don’t hear people talking in these moments about progressive consumption taxes, which are hard to do quickly but are not an impossible idea. You don’t hear people talking about ways to soften the blow at the bottom ends. Are there ways to do that? Can we put restraint on the economy without the people who actually bear the burden of the strain most being the people who have also borne the burden of our economic failures the most?
Let me say a couple of things about that. First, I’ll say the hard edge things, then I’ll say some things that perhaps will seem less hard edge to you. Interest rates had their greatest impact on long-lived investments. And that kind of makes sense.
We’ve got a big housing stock. What happens to one year’s housing spending doesn’t have nearly as big an effect on the availability of housing as what happens to one year’s asparagus. Production does. So interest rates are a tool targeted at different categories of spending in response to how long-lived they are, which is exactly the way you would want to organize things.
I think the question of interest rates and distribution is a very complicated one. Interest rate increases tend to have, as their major impact— a major impact— declines in asset prices. And assets are disproportionately held by the most wealthy people in the society. So I don’t think that interest rates are quite as poorly designed a tool for applying economic restraint as the tone of your question suggested.
I think if you want to apply economic restraint, interest rates are actually a pretty good way to do it. And the evidence is that changes in the interest rates have much more impact on the investment opportunities of wealthy people than they do on the payday loans received by poor people that actually aren’t that sensitive to changes in Fed interest rates. Of course, when we have downturns, we should extend unemployment insurance, and have more automatic stabilizers, and do a set of things.
So I wouldn’t necessarily say that interest rates are such a bad countercyclical tool. I would say that you’re completely right— and this is something I’ve advocated for a long time— that we need a much more progressive tax system in the United States. But I would be hesitant about the excessive embrace of fiscal policy as a tool of countercyclical management. It is difficult to move spending up and down quickly. Temporary tax changes on wealthy people almost all economists will tell you will not have large effects on the level of spending.
Let me give you then another question where you’ll like the underlying assumptions even less. So one of the arguments being made on the left is that part of what is driving inflation right now is that corporations are using this moment almost as cover to make pretty significant pricing increases. So if you look back to say 2019, non-financial corporations had roughly a trillion dollars in profits. That had been more or less stable for a while. By 2021, they were a lot closer to $2 trillion.
So there’s a lot going wrong in the economy but corporations are making a lot of money in it. And while what you do about this is hard— I’m not here advocating for price controls— is there legitimacy, or at least how do you answer the view that part of what’s going on here is we’re now going to slow down the economy because corporations have taken this moment to squeeze people for what they’re worth and that that should strike people as unfair and strike people’s demanding a response.
Maybe an alternative way of understanding this is I’m a furniture store, and at my furniture store there used to only be a few customers. And if I raised my prices, I’d have even fewer customers and my inventory would sit. And now I’m having difficulty keeping my inventory stocked because there’s so many people in my store demanding new furniture.
And so in order to keep supply and demand balanced, I raise prices more than I used to. And so I’m able to raise prices now because there’s so much demand. So I think that the way to understand a business person who says they have pricing power is not that somehow they now feel they can be greedy where before they couldn’t be greedy. It’s that economic conditions mean that the supply-demand balance has tilted in their favor.
And there’s evidence, for my view— I would cite the fact that inventories fell to super low levels. I would cite the fact that they were experiencing more and more lags and inability to get deliveries. I would cite the fact that their costs were increasing substantially in terms of labor costs. And that they were seeing that happen to all their competitors as well. So if I raised my price before by 10 percent, everybody would have gone to the store next door. But today, in a world of excess demand, that’s not true.
So I think the way one has to understand the inflation is as reflecting the tendency to have more demand. If you take the most basic introductory economics model of an industry that we teach, it has as a central element that as demand increases, prices rise, and that as demand increases particularly egregiously, supply is limited in the short run and so prices rise more.
So I think it’s, frankly, ridiculous to take businesses saying on a earnings call that they have pricing power as some kind of evidence of perfidy. I just don’t think that is supported by any serious understanding of how the business process works.
And by the way, another way of looking at this is, again, to look at what’s happening to wages. Wage inflation is as pronounced a phenomenon as price inflation. And we don’t think workers have huge pricing power. Or another way to look at this is as relations in terms of what Amazon is paying its suppliers or what Walmart is paying its suppliers. Surely if there’s market power in the relationship between Walmart and its suppliers or between Amazon and its suppliers, the power is on the side of Amazon and Walmart. And they’re paying much higher prices to their suppliers.
So are there market power problems in the American economy? Yes. Is it a good idea to attack those problems? Yes. Is it fine if we use the motivation provided by inflation to do some of that? Yes. Does it make any sense at all to blame inflation on market power? No. That’s not serious economic reasoning and the judgments and forecasts of those who engage in that reasoning should be taken less seriously as a consequence.
So we talked a few minutes ago about how the federal government doesn’t have very good tools to work with supply on the one to two-year time-frame. But this more they can do to expand it or also change the kind of supply the economy offers on the five, 10, 15-year time-frame. A good example being investments in green energy. If you send the right signals and make the right investments, you can create a lot more green energy in 10 years than you would have had otherwise.
There are a number of these investments in the legislative package, maybe formerly known as Build Back Better. But inflation risk has become very much part of why folks like Joe Manchin and Kyrsten Sinema have shot it down. Do you think that’s the right way to think about Build Back Better? That it’s something we should not do because there is higher inflation now. Or do you think there are real ways we can increase the supply of the economy in 10 years and these should be seen as non-contradictory?
Ezra, the record is clear. I endorsed Build Back Better. I re-endorsed Build Back Better. I was a strong supporter of Build Back Better for exactly the reason you say that I think there are a set of fundamental investments that we need to make in our economy that start from infrastructure and include a range of human investments.
There are ways in which I think the design could be better. I’d like to see emphasis on efficiency and building infrastructure as well as more money into infrastructure, for example. But I was a strong supporter of Build Back Better. I did think we should design it so that it didn’t represent a net contribution to demand in the first few years for the reasons that you were talking about earlier, that I didn’t want too much burden to fall on monetary policy.
But my view is that we should pay for fundamental public investments that are worth it, that there are a lot of fundamental public investments that are worth it, that have very high returns. That many of the ways of raising revenue probably would be good ideas even if we didn’t need the money, such as improving tax compliance. So I’m very much with the general orientation of the progressives on that in believing that there are a whole set of public investments that would be very, very valuable for us to make, and I think will over time increase the capacity of the economy.
What is not being considered as a policy proposal, including quite big ones, that you think would do the most to increase supply on the 10 or 15-year time-frame? If you want either productive capacity to be bigger in 10 years or prices to be lower in 10 years, and you could put anything into the window of political possibility that is not currently there, what would it be?
I think probably the greatest scope in the horizon that you spoke about, Ezra, is probably immigration policy, where if we could find a way to admit substantially more, particularly, but not only, high-skilled immigrants into the country, I think the benefits in terms of growth would really be very substantial. I also think there are a variety of jobs where we could contain costs without doing damage to the interests of working Americans by enhanced immigration. And so finding a better synthesis on immigration policy that allowed more immigration and probably involved more insistence on the Americanization of immigrants would, I think, be something that would be very desirable.
Second, I think that we as a country have under-invested substantially in place-based policies. I think that we have red hot markets in some places— the places where you live and the places where I live. And we have rather stone cold markets in a variety of other places. And I don’t think we’ve applied enough imagination about how we could shift demand from the red hot places to the stone cold places. I think if we did that, we would do an enormous amount of good in the stone cold places. And I think we would also enable there to be more total demand with less total pressure on prices.
Third, I think the risks that we are under-investing in technology vastly exceed the risks that we are over-investing in technology. And I think we are way under-spending on fundamental research as a country, and by doing that are shortchanging one of our most fundamental strengths as a country. So those would probably be the three places that are not right at the edge of the horizon that I would emphasize.
On the place-based policy idea, what do you think about the idea that comes up every so often, which I’ve always been somewhat partial to, that the federal government should break more of its agencies across the country. Department of Transportation— you can be in Indiana somewhere. Department of Commerce can be in Kentucky. Department— I mean, I’m just pulling places out of thin air here.
But that instead of it all being concentrated in Washington D.C., that one thing that could generate a lot of activity in different places, and the government actually does have control over it, is where some of its important high-wage, high-labor force and also just economically activating functions go.
Of course, we do have one part of the government that in a way does that, which is the Defense Department. Because if you look at the location of our military bases, the military bases don’t tend to be in the places that you or I would most naturally think about living, Ezra.
And I think that probably is on net a positive thing from which we derive economic benefit. I am basically sympathetic to the idea and think that we probably do too little of it rather than too much of it. I think there are three problems that you have to recognize as you go in this direction.
One is some places it’s going to be hard. When I was at Treasury, we had some kind of center for resisting cyber financial crime that was headquartered, because of political pressure and because of these kinds of arguments, somewhere in Western Pennsylvania. Well, it just turned out to be kind of hard to get people who were great at cyber things to go to Western Pennsylvania and live and work at that center. And so I’m not sure the innovation was on net successful.
Second, as the military bases suggest, once you do it, it’s very hard to change it. And so you have to think very hard about that. Third, I think you have to think about the synergies and the dis-synergies associated with isolation. When these things get into the political process, you don’t always get the most rational outcomes.
I was very much impressed by a study I read some years ago— I don’t remember who did it— by some political scientists who looked at the degree of corruption in states where the state capital was a major city, like Boston, and states where the state capital was an otherwise periphery kind of place, like Albany, New York. And the evidence was very strong. The government was more dysfunctional and corruption was greater when you had isolated state capitals.
And I think that is just something one needs to be cautious about in thinking about this. But could we do more of it? Yes, we could.
We’ve talked a lot about monetary policy and the rate of interest rate increases over the year. But if you were advising the president— and it could be Joe Biden or the hypothetical president— as to how to build a policy and a message agenda for 2022, a year where you have all of the economic problems that gathered force in 2021 now running into Russia or running into China, what would it be? What is the political either argument or actual proposals that seem to you, on the executive side, merited for the moment?
First of all, since I tend not to think so well of the economics that’s embodied in a lot of political people’s advice, I have the symmetrical humility to recognize that perhaps people should not pay great attention to my political advice, but instead should give more weight to my views about what economic science says about what the consequences of policies will be and undertake their own political evaluations.
It seems to me, though, that if there is a silver lining in what has happened in the global arena over the last couple of years— I mean that to embrace both the pandemic challenge, and what has happened in Ukraine, and rising concerns about China, and the continuing threat of global climate change. It seems to me if there’s any silver lining in any of that, it is to make an argument that goes back to what might be called a Kennedy-esque tradition of national unity around national challenges. The words that inspired me when they were explained to me when I was in first grade about ask not what you can do for your country— what your country can do for you. Ask what you can do for your country.
It seems to me that points to an emphasis on public investment, that points to an emphasis on unity and inclusion as a source of strength and excellence, that points to an emphasis on competitiveness and the need for competitiveness as a motivation for collaboration. And it points, I think, away from more divisive agendas. It points towards cooperation between business and government in the solution of problems rather than vilification of profiteers. It points towards calling on people to do their part rather than asking what you can deliver directly for them.
I’m struck by two public opinion poll findings. I’m struck by the fact that those cash payments that were fought after and were seen as so politically central have been forgotten and were little lamented when they disappeared. And I’m struck that when you ask the American people are you prepared to pay higher gas prices in order to sanction Putin, they overwhelmingly answer the question yes. And so I think a sense of collective endeavor that appeals to the most contributing instincts that people have, rather than a sense of delivering for constituencies, is the direction I would want to take that conversation.
And then always our final question— what are three books that have influenced you that you would recommend to the audience?
I was very much influenced— some would probably say I didn’t absorb the message well enough— by David Halberstam’s “The Best and the Brightest” as an avocation of how the well-intentioned but overconfident, and overly dogmatic, and unwilling to hear contrary evidence led to disastrous outcomes.
Second, I was very influenced by Zachary Carter’s recent biography of Keynes, which I think demonstrates that ideas and even economic models ultimately, and over time, have larger impacts than maneuvers and machinations in small rooms, despite the fact that the latter seem more important at any particular moment in time.
And third, a book that will come out in the next several months, Brad DeLong’s “Slouching Towards Utopia,” which is, I think, a really remarkable and powerful placing of all of economic history in perspective, that gives a sense that at some level I had known but never appreciated of how profoundly different the 20th century was than all other centuries and points towards the combined power of science and markets to change the world profoundly, and sometimes, in some ways, for good, and sometimes, in some ways, for ill. I think anybody who wants to propound about economic policy should read that book.
I feel like I’ve been waiting for Brad’s big economic history opus for a long time now. So I will agree that I’m very excited for that one to hit my desk. Larry Summers, thank you very much.
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“The Ezra Klein Show” is a production of New York Times Opinion. It is produced by Rogé Karma, Annie Galvin, and Jeff Geld. This episode was fact-checked by Michelle Harris and Mary Marge Locker. Original music by Isaac Jones. Mixing and engineering by Jeff Geld. Our executive producer is Irene Noguchi. And special thanks to Shannon Busta, Kristina Samulewski, and Kristin Lin.