As an overheated economy sends prices skyrocketing, alarms are already blaring that the next stop is over a cliff. The economic team at Goldman Sachs has declared a 35 percent chance of recession in the next two years. Moody’s chief economist has forecasted the same. These warnings seem anachronistic when all indicators point to a red-hot economy. But that is precisely the problem. The US economy is too hot, with demand – whether for houses or labor — far outstripping supply. The Fed’s only tools to respond are demand dampeners like interest rate hikes. And those in turn threaten to over-cool the economy.
In other words, the real problem here – the real economic mismatch that we should be concerned with – is that the US faces a supply-side problem but leverages only demand-side answers. Those might be necessary for addressing immediate concerns. But they are not the way actually to solve inflation or to avoid a recession. Doing that requires pairing the Fed’s monetary policy band-aids with investment in supply; in critical resources ranging from food to energy, the processing and manufacturing built on top of them, and the systems of exchange, like shipping logistics and pipelines, to transport them.
In other words, the real problem here – the real economic mismatch that we should be concerned with – is that the US faces a supply-side problem but leverages only demand-side answers.
The forces creating inflation are – almost across the board – matters of inadequate supply. The US does not have enough labor, houses, semiconductors, or critical minerals. Part of that is a function of pandemic-induced changes in patterns of life and the market’s delay in catching up: Remote work means people want to live in houses not studios; building houses takes time. Much of the supply shortage is a function of cracks appearing in the globalization model: We’ve built an economy dependent on convoluted, international supply chains that rely disproportionately on geopolitical adversaries and that assume the world is a rational, peaceful place. When it turns out that the world is precisely the opposite, goodbye cereals and semiconductor supply.
But a sizeable share of the supply shortage driving inflation is also the US reliance on demand side industrial policy. When global pandemic sent the US economy – and broader society – spiraling, the immediate government reaction was to issue a host of demand-side band-aids: Stimulus checks, low interest rates, loan freezes. Yes, those measures saved a whole lot of people from a whole lot of misery. But they were lopsided. They did not solve the fundamental industrial deficit that COVID-19 was laying bare. They weren’t paired with adequate, or really any, investment in US production to ensure that potential home buyers armed with low interest rates actually had homes to buy. We juiced one side of the economy without shoring up the other.
Now, the Fed is trying to walk things back. But its tools are still demand side. Which means that the US is trying to fix inflation not by raising supply to meet demand, but by lowering demand to wallow with supply.
What if, instead, the US government was to promote supply-side growth? What if, in addition to immediate monetary policy quick fixes, Washington was to set about investing in production of critical inputs, manufacturing facilities, and improved logistics systems? It might sound like a pie in the sky idealistic vision. But it’s entirely possible, and necessary.
The first step is upstream: Identification of the most critical inputs into today’s, and tomorrow’s, industry – think buzzword areas like cobalt and lithium, but also the unignorable basics like agricultural products, pharmaceuticals, steel – and investment in those. The next step is the manufacturing, processing, and distribution infrastructure necessary to take advantage of those; pipelines to transport natural gas, say, but also solar panel module factories. And the third step is investment in improved freight and logistics systems to connect and protect the supply chain.
None of this program is something that the US government should, or can, undertake alone. These are projects for the private sector. But the private sector needs a push from Washington: Tax credits (and penalties), regulatory flexibility, and public private partnerships, for example, that ever so slightly adjust short term incentives to align them with long-term interests – of companies and of the country.
This is also a program that demands allied cooperation. America’s northern and southern neighbors have critical roles to play: Canada is a natural resource giant and, increasingly, a source of cutting-edge industrial advance. Mexico offers manufacturing prowess and labor at a time when both are scarce in the US. Europe, directly challenged by the disruptions of the Russia-Ukraine war, is more incentivized than ever to flex its industrial policy measure. And America’s East Asian allies are leading the charge in new energy technologies critical to securing a robust industrial future.
Jerome Powell announced last week that his goal is to “get inflation down without a recession.” The Fed’s mandate is absolutely to undertake immediate, reactive measures like that. But at the same time, the US must realize that, ultimately, getting supply up is the way to avoid recession.