A central lesson of economics is that there is rarely a free lunch. Most political choices involve trade-offs or benefit some people while incurring costs for others. From time to time, exceptions arise – cases of market failures due to asymmetric information or incomplete markets – in which government can improve the welfare of all. But most of the time, government intervention in markets creates winners, losers and distortions. Behaviors change in response to policy, creating long-term costs and unintended consequences.
This guiding principle is conspicuously absent from most economic policies today. Instead, policymakers operate on the assumption that government intervention is always a net good, however ill-conceived. In recent years, members of Congress have not only cited Modern Monetary Theory, but acted on its recommendations. During the pandemic, the federal government sent unconditional checks to almost everyone and expanded unemployment insurance without considering how these policies would discourage work or worsen inflation (let alone respond who could pay for it one day). In the meantime, the Fed continued an accommodative monetary policy to support financial markets and bought many of the bonds issued.
Some of these decisions were justified, at least at the height of the pandemic. But now we are seeing the consequences: a labor shortage and inflation at its highest level in 40 years. Under such circumstances, the Fed’s unpleasant task is to raise rates and blow the economy. Currently, inflation is at 7% and the unemployment rate has fallen to 4% – by any definition, the economy is running full steam ahead. And yet, nominal interest rates remain at zero and the Fed continues to buy long-term bonds (once considered an emergency measure).
As Fed Chairman Jerome Powell recently noted, the central bank plans to raise rates this year. But, he admits, the hope is to get monetary policy back to “neutral,” that is, when the fed funds rate is equal to the natural rate of interest. A neutral monetary policy won’t have much impact on the labor market or inflation expectations, however, and the Fed hasn’t explained why negative real interest rates are considered neutral. The Fed is shirking its duty to contain the fallout from one of the largest government interventions in US economic history. By moving slowly towards neutrality, the central bank apparently hopes that inflation will pick up on its own. If he just eases off the accelerator, no damage will be done to the labor market or asset prices.
This represents a significant change. After decades of magical thinking, economists came to accept in the 1980s that monetary policy also involved trade-offs. The economy can’t run hot forever without causing damage, and cleaning it up means even more pain. As Raghuram Rajan, a finance professor and former Indian central banker, notes, developed economies have created mechanisms – balanced budgets, inflation targets – to guard against the temptation to ignore trade-offs. Yet we seem to be suffering from a collective amnesia, once again hoping inflation will pick up once the economy recovers and supply chain disruptions are resolved. Inflation often starts with a supply shock, but once it sets in, it’s hard to shake off.
Who knows? Maybe this time will be different. Perhaps inflation will moderate on its own, despite an easy-to-neutral monetary policy. Perhaps shutting down the economy and then filling it with cash won’t distort labor markets and supply chains for years to come. But chances are we won’t be so lucky. Decision-makers will then have to relearn the hard way that there is no such thing as a free lunch.
Staff photo by Brianna Soukup/Portland Press Herald via Getty Images