Global Economics and Management

Inflation Acceleration

The inflation numbers that came out of the BLS this morning should be a source of grave concern to all. Inflation seems to be accelerating, which is a clear sign that a wage-price spiral may have begun. Once that cat is out of the bag, it can be extremely costly to put it back in. We had better hope that the FED has the fortitude to do what is needed (i.e. slam on the brakes). Given the erosion of its independence in recent years, and the ongoing debates on who should occupy the senior FED posts that are vacant or soon to be vacated, one is allowed to have doubts. If the FED does not act decisively to curb inflation, we will live with dire consequences in the years ahead. And politicians will have to deal with irate voters who will surely punish the incumbents at the polls. Such an environment would create conditions for a return to power of the populists, and that will not make the situation any better.

A lot of people have egg on their face for not seeing this coming, including many of my fellow economists. This inflationary explosion should have been apparent to all who observed economic data closely. One does not inject trillions of dollars of liquidity into the economy, coupled with an unprecedented fiscal expansion, without creating inflationary pressures. This was clear to me, as I noted on several occasions (1, 2, 3). It was also very clear to one of my favorite economists, Larry Summers. He took a lot of flak for it when he warned about inflation, but as Politico notes he has been vindicated. That's because Summers is unusual among economists in that he generally does not let his political priors get the best of his professional judgment. In contrast, most other mainstream economists wanted so badly for the government to spend trillions of dollars on redistributive transfers that they minimized the likely negative consequences of these policies.

Another institution that will suffer a loss of credibility is the FED itself. Back in August of 2020 they announced that rates would be kept at zero for five years. There is no way now that this will be the case. The FED will therefore have announced a policy that they must renege on. Should we believe any pronouncement they will now make?

One last point. The last two major shocks to the US economy were the mortgage crisis of 2008 and the COVID crisis of 2020. Policies to address these two shocks involved giving good stuff to voters - liquidity and government transfers. In contrast, addressing the inflationary shock of 2021 will entail taking good stuff away from voters - liquidity, and government transfers - in order to tamp down demand. Not only is the shock itself likely to anger voters, who dislike variable and increasing prices, but the policy solution also is likely to invite more voter dissatisfaction.

Bernie Sanders is Right

Senator Sanders came out very strongly today against a proposed reinstatement of the SALT deduction for five years, to be part of the proposed reconciliation package. He is right to oppose the SALT deduction. It is a provision that has no redeeming features. As a reminder, the SALT deduction allows taxpayers to deduct their state and local taxes from their taxable income. The 2017 Paul Ryan tax reform capped the deduction at $10,000 per taxpayer. Some Democrats in Congress now want to restore the full deduction for five years.

The reason the deduction has no redeeming features is that: 1) It is distortive: it implies a federal subsidy for state and local tax increases - voters don't pay the full cost of tax increases, so politicians face incentives to raise them beyond what would otherwise be the case. The distortion extends to the type of taxes that policymakers might adopt: the deduction encourages income taxes rather than sales taxes, i.e. it encourages taxes that distort work and innovation incentives, to the detriment of taxes that encourage thrift and capital accumulation (as is the case with consumption taxes). 2) It is regressive. Those who benefit the most from the SALT deduction are taxpayers who own a lot of property (local taxes) or who earn a lot of income (state income taxes). Essentially, under the SALT deduction, the poor have to pay more taxes to finance a tax cut for rich people. Indeed, according to the bipartisan Committee for a Responsible Federal Budget, about 80% of the tax cut would go to the top 5% of taxpayers. It would also be the biggest line item in the Build Back Better plan.

The proposal to restore the SALT deduction is symptomatic of the newfound tendency of center-left parties in advanced industrial democracies to cater to moneyed interests. This tendency was recently documented in admirable detail by Thomas Piketty and his coauthors. The populist right understands this and has made huge inroads with the working class.

Not only should Congress not restore the full deduction, they should also reduce or eliminate the partial deduction that now exists. While they are at it, they should also completely get rid of the mortgage interest deduction, which is similarly distortive and regressive.