Martin A. Sullivan, Tax Analysts’ chief economist, provides an overview of the U.S. economy before and during the COVID-19 pandemic, explaining the drastic increase in inflation and what is needed to curb it.
This transcript has been edited for length and clarity.
David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: the road to inflation.
Over the last two years, as the United States has weathered the COVID-19 pandemic, the economy has seen its share of lows and highs. At the beginning, when everything was shut down, experts were predicting a coming recession. But, as things opened up again and relief was passed, the economy seemed to bounce back rather quickly.
So much so, that now the U.S. is facing a different problem: inflation. In fact, the U.S. just posted the highest inflation number in four decades. As the country looks to emerge on the other side of the COVID-19 pandemic, one question keeps popping up: What, if anything, needs to be done to keep inflation in check?
Here to talk more about this is Tax Analysts' chief economist and contributing editor Martin Sullivan. Marty, welcome back to the podcast.
Martin A. Sullivan: Thanks for having me, David.
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David D. Stewart: Before we delve into the economy since the COVID-19 pandemic, let's take a step back. Could you tell us what the economy looked like before COVID-19?
Martin A. Sullivan: It's really important to do that because you really can't understand what's going on with COVID-19 until you understand what was going on before COVID-19.
Let's review some amazing facts about the economy before COVID-19. Before COVID-19, interest rates were incredibly low. They dropped from 12 percent to 14 percent in the mid 1980s to about 2 percent in the current environment. The economy was growing at a much slower rate than over the historical post-war period.
Instead of growing at 3.3 percent and 1.5 percent, as it did from 1945 to 2010, it was growing at 2 percent. That was very strange because we had very expansionary fiscal policy. We were running huge deficits, and also we had very expansionary monetary policy. The Fed was buying bonds all over the place.
What was going on, and what was very hard to understand, was that we were stepping on the gas with fiscal policy and monetary policy, but we were still going only 15 miles an hour. This caused a lot of top economists to start thinking, "Maybe we're entering an era of long term stagnation like Japan had."
If you recall, Japan had two decades of zero growth. The low interest rates are an indication of that. A very important factor that people forget about are low birth rates equals low population growth. Economic growth depends on capital, it depends on productivity, but also depends on people, and when there are less people in the workforce, economic growth slows down.
Where did that leave us before COVID-19? Well, we were looking at a high debt-to-GDP ratio. The federal debt was very high, but interest rates were very low. The net cost of supporting our debt actually went down. What economists were talking about was the need to greatly expand fiscal policy. To increase deficits — contrary to what you always hear — you need to reduce the deficit, because the Fed couldn't reduce interest rates any lower.
On the eve of COVID-19, which was March 2020, we were looking at slow growth. We were looking at — if anything — increasing our deficit in order to expand the economy, but then came COVID-19.
David D. Stewart: Let's turn to the beginning of the COVID-19 pandemic. We actually had you on the podcast in March 2020, just at the beginning of the pandemic, right at the time our offices shut down. You did say you saw a recession coming. How did your prediction play out?
Martin A. Sullivan: Well, I don't remember the timing on my prediction, but what I would like to emphasize is that the economic events that took place in March 2020 were absolutely unprecedented. The reduction in jobs was 25 million people were out of work. The reduction in GDP was enormous. We had in 2007 to 2009 what we called, "The Great Recession." That was one-third the size of the job losses and the reduction in GDP that you saw during COVID-19.
It's just absolutely amazing, unprecedented, and it should not be swept under the rug that the economic effects of COVID-19 were just like nothing we'd ever seen before. But then we had the government response, which was also like nothing we've ever seen before.
David D. Stewart: Let's look at that. We saw Congress react in a big way with the Coronavirus Aid, Relief, and Economic Security Act in April 2020. Looking back now, what was the impact of that historical package on the economy?
Martin A. Sullivan: It's actually a very interesting story, or as interesting as economics can be. When you go to economic school, they teach you government is usually so slow about responding to recessions. There's a recession in March and maybe by December they'll get around to doing something.
Not this time. Congress and the president acted with remarkable swiftness with the CARES Act and other associated legislation, which greatly increased transfer payments and support to businesses very, very quickly. You have to give the government very, very high marks for the rapidity of their response to the recession.
David D. Stewart: Looking toward the end of that year, it seemed the economy was bouncing back. Could you tell us about how things looked at that point? Were we seeing inflation then?
Martin A. Sullivan: Right. Let's just remember it was March 2020 when COVID-19 hit and we all left our offices and so forth. During 2020, Congress passed a series of four or five laws pumping lots of money into the economy. The snapback was almost as remarkable as the decline.
The 25 million jobs that were lost almost entirely came back. Employment levels were still low, but most of that deficit in employment snapped back. Same thing with GDP; it snapped back at an incredibly high rate.
Immediately following the monumental amazing shock to the economy, the economy snapped back most of the way. The stock market, which declined by 30 percent with COVID-19, by November 4, 2020, had entirely bounced back. Before COVID-19, the Dow was at about 30,000 high, and it's about 34,000 now.
We have housing prices up, we have stock market up, we have the economy almost back to normal. There was an amazing comeback right after the initial shock.
David D. Stewart: Were there signs of inflation at that point?
Martin A. Sullivan: Very interesting. I was making a presentation to a class at Georgetown, and I was surprised to see that there was no significant increase in inflation in 2020. It didn't happen. It didn't really start to kick in until a little later.
Here's the other amazing fact that I stumbled upon. Remember I told you that there was this enormous decline in employment and this enormous decline in GDP, which is the way we normally measure the economy? But you know what didn't decline was personal income.
What is personal income? Personal income is money that people have, disposable income that households have. During the great contraction caused by the pandemic, personal income actually went up. It was just so stunning to me that could possibly be true. The reason it was true was that personal income has two components.
One is market income. That is wages, what you get from working, and what you might get from dividends and so forth. That went down. But more than compensating for that were government transfer payments. The government pumped into the economy over $650 billion in one quarter.
Certainly not everybody was better off, but if you look at the economy as a whole, the economy was better off because of the incredible injection of this massive amount of money into the economy. This is all happening in 2020, and there's no inflation yet. That's a remarkable turn of events for a nine-month period.
David D. Stewart: All right, so then turning to last March. A new president is in office and we have the passage of the American Rescue Plan Act, which we also had you on the podcast to discuss.
A year ago you said that additional stimulus was needed, but you said that maybe it was too much for the economy. What are your thoughts on that package now looking back a year later?
Martin A. Sullivan: Well, the CARES Act, the 2020 assistance, injected a great amount of stimulus into the economy and increased personal income. So then we get to the beginning of 2021 with the Biden administration, and now the economy's almost recovered, depending on where you look at it, and now we do another massive injection into the economy.
What happens is even though the economy is recovering, we have another massive injection, and there's so much money in the economy that people aren't able to spend it. People are saving it. There was a massive increase in savings that occurred during this period. That is at the beginning of 2021, and this is when inflation started.
The story you can tell is that the first round of relief from the pandemic, the CARES Act and associated legislation, was sort of necessary to get the economy back on its feet and did not create inflationary pressure. But then ARPA gave us another jolt, but it was in the aggregate. Certainly many individuals needed it, but in the aggregate was too much for the economy, and that's what caused inflation.
Before COVID-19, the average U.S. citizen — man, woman, and child — on average had about $3,000 of cash, let's say in the checking accounts. After these injections from the CARES Act in 2020 and from ARPA in 2021, the average American had $11,000 in their checking account.
Trying to put it in plain human terms, again, this is an average, obviously there's a lot of variation around that average, but if you were walking around saying, "Oh, I need about $3,000 in my account. That's the buffer I like to have." Then all of a sudden you have $11,000, something's going on.
The story that you can tell, which makes sense when you look at all of the data, is that people have more money than they can spend on average, and that's what's driving inflation up. In an incredible development, the amount of checkable deposits held by households in the United States in a 12-month period went from $1 trillion to $3 trillion after being at $1 trillion consistently for a decade. Just an enormous increase.
This pent-up savings is creating this inflationary pressure, and until those savings are dissipated, we probably will continue to have the inflationary pressure. What could cause that to dissipate is that people need to be able to spend that money.
I use the example, I was cleaning my stove a few months ago, and somehow, when I turned on the automatic cleaning button, basically my stove blew up. Now I don't have a stove. I want to order a new stove, but I can't get one. I can't even see one until next April. There's just pent-up demand. The stove manufacturers are not going to reduce their prices in that circ*mstance.
That's a case study, but the data reflects that throughout the economy. People have a lot of spending power, they don't have any place to spend it, and that's driving up prices.
Again, I want to stress, obviously low-income families may not be in this situation, where they need every dollar they have and they're spending every dollar that they have because they're living hand to mouth. But in general, there is this pent-up inflationary demand.
David D. Stewart: Is the microchip shortage that we heard a lot about part of this problem?
Martin A. Sullivan: Yeah. All of the shortages — the microchip, gasoline — it all contributes.
What we have going on with the pandemic is both the supply side and the demand side problem. The demand side is we have too much demand. That's what I was talking about, where the average person went from $3,000 to $11,000 in their bank account, and that is a lot of extra demand in the economy.
Then we have supply chain shortages, like the chips, which actually predated the pandemic, that's also going to contribute to inflation. You have both of those things going on at the same time.
The way out of this is either to reduce demand, so let's have a big tax increase. No, I'm just kidding. Obviously that's not going to happen.
The way out of this is for the supply chains to get fixed to allow me to buy my oven, to get those computer chips to the car manufacturers in Detroit. Until folks are able to use up that extraordinary excess amount of saving that's been built up, we'll probably continue to have inflationary pressures.
David D. Stewart: Now, you jokingly mentioned a tax solution to this problem, but are there policy measures that can be implemented that would reduce these inflationary pressures? Maybe not confiscating $8,000 out of everybody's bank account in order to get us back to the original number, but what sort of policy measures can be taken to get us out of this inflationary cycle?
Martin A. Sullivan: Of course, you just turn on your business news station, you will immediately hear about the Fed going to increase interest rates, and that will almost certainly happen throughout the remainder of this year. That will somewhat reduce demand because for folks who are buying on credit, the interest rate will be lower. Folks who are buying houses, the interest rate will be lower. Also, the stock market wealth will go down and people will have less money to spend.
But the other way, and I think the more important but politically impossible way, is to actually increase taxes that would reduce consumption, or absorb that savings.
So, as you say, again, massively oversimplifying in the aggregate, but if we confiscated that $8,000 in everybody's bank account, then that would probably eliminate the inflationary pressure that we're now experiencing. But again, that's just not going to happen.
David D. Stewart: Right. What are you expecting out of the next few years for inflation? I know at the beginning we were told this is transient. This is not going to last very long. Are we looking at a period of 7-percent-plus inflation for a few years, or is this something that will come back to normal levels?
Martin A. Sullivan: Let's break it into two parts. The first thing I would say is that over time, that mythical $11,000 I'm talking about will get spent. When I can buy my oven, as the supply chains loosen up and meet people's demand, as restaurants open up again, as people start taking vacations again, that will reduce that inflationary pressure.
I played with some ballpark calculations. In a year or two that will sort of work its way out of the economy. It all depends on how fast the economy can fix the supply side problems. The good news is we don't need any government policies to do that because business wants to figure out how to fix these problems. The free market will fix these problems. As soon as that happens, inflation should settle down.
What we haven't mentioned so far is this problem from the 1970s, my era, when we had what was called a "wage price spiral." Let's say all the inflationary pressure goes away that I was talking about, but people just start getting so used to inflation that when I'm setting my prices at my local store, I'm just always increasing them by 5 percent or 10 percent because I expect that to happen. When I'm negotiating my wages, I'm always negotiating 5 percent or 10 percent more because I just expect that to happen.
What we don't want is inflation to last so long that people have this sort of built into their expectations. That would be a very bad development. There's no reason necessarily to expect that, but that could happen.
David D. Stewart: Well, Marty, this has been fascinating. Thank you for joining me.
Martin A. Sullivan: Hey, thank you for having me.
