The “Inflation Reduction Act” of 2022 was one of our more inappropriately named pieces of legislation. (And there’s plenty of competition—recall FDR’s National Industrial Recovery Act.)
The Financial Times has a new piece entitled:
Critics warn US Inflation Reduction Act could keep prices high
A scramble for workers might complicate the Federal Reserve’s efforts to cool the economy
In the article, critics complain that the legislation is boosting costs:
“You don’t hear the word globalisation anymore,” Fink told an energy conference at Columbia University this month. “We’re building new chip factories in the United States — at what cost?”Fink said the Biden administration’s efforts to reshore manufacturing would mean US inflation was unlikely to fall below 4 per cent “anytime soon”.While the IRA includes subsidies for clean energy worth $369bn, the credits are “uncapped”, meaning the final bill for taxpayers could eventually exceed $1tn, according to Credit Suisse, Goldman Sachs and the Brookings Institution.Analysts say the sheer scale of the handouts will put a wrench in markets.“You’re distorting free markets when you create these incentives and when you create rules that require you to buy from domestic firms,” said Ethan Harris, head of global economics at Bank of America. “If it was the most cost efficient way to do something, you wouldn’t need a subsidy for it.”
On the other hand, if the Fed is truly committed to bringing inflation down to 2%, then it should offset the impact of this legislation with tighter monetary policy. In that case, economic activity is non-subsidized sectors will suffer.
The government is not very good at allocating resources, and attempts to do so almost invariably reduce economic efficiency. Subsidies and trade barriers lead to a misallocation of resources. In most cases, when people complain that government policies will lead to higher inflation, the actual risk is lower real output. That’s also how much of the public thinks of inflation—something that reduces their living standards.
The final sentence in the FT article gets to the core of the problem:
[T]he Biden administration’s efforts to satisfy its decarbonisation, industrial and geopolitical ambitions at the same time — all while promising to drive down costs — are causing alarm among some analysts.“Once you go down the national security path and don’t narrowly constrain it, boy, it’s a killer to economic efficiency,” Hufbauer said.
That’s the real issue—economic efficiency, not inflation.
READER COMMENTS
nobody.really
Apr 25 2023 at 4:21am
That’s the real issue–according to whom?
Can we dig up old issues of the Financial Times from the 1930s, praising Poland for avoiding the mania then sweeping Europe for investing in the military? Surely the lower Polish taxes led to greater economic efficiency, and doubtless Poland reaped the benefits of its clear-eyed focus on economic efficiency. As everyone knows, there’s no need for a nation to subsidize a military; if it was the most cost efficient way to do something, you wouldn’t need a subsidy for it. And once you go down the national security path and don’t narrowly constrain it, boy, it’s a killer to economic efficiency….
I can’t read the Financial Times‘s gated article, but the quoted passages seem willfully myopic. Yup, the Inflation Reduction Act will cause all kinds of economic inefficiency–relative to a world with no market failures such as climate change and military rivalries. If you acknowledge that the real world has market failures, then you might also acknowledge the potential merit of adopting policies to address those failures, even if this results in less efficiency than in a make-believe world. You can agree or disagree with the specific policies proposed, but it does your argument no credit to ignore the purposes of the legislation.
(Ok, I’d acknowledge that much/most of the policies in the Inflation Reduction Act were not designed with the goal of reducing inflation. You win that one.)
Does anyone doubt that the Fed adjusts monetary policy in response to regulatory and fiscal policy (spending, tax cuts, etc.)? And sure, I expect that the combined effects of regulatory, fiscal, and monetary policies affect different economic sectors differently. Surely this was true before the passage of the Inflation Reduction Act, and is true today. What else is new?
In sum: I agree that if you ignore market imperfections, the Inflation Reduction Act seems counterproductive. But as the Spartans would respond, “If….”
Jon Murphy
Apr 25 2023 at 6:40am
For people in general. Inflation is a problem because it distorts economic calculation and reduces standards of living. If inflation didn’t distort economic calculation, it wouldn’t be a problem.*
Economic efficiency represents an improvement in one’s standards of living as judged by themselves. So, the real issue is how people’s standards of living changes rather than inflation per se. Inflation matters because it affects economic efficiency.
*As a thought experiment to show this to yourself: how would your life change if you woke up tomorrow and all prices, including all wages, doubled?
Andrew_FL
Apr 25 2023 at 8:48am
Jon, your hypothetical is not quite enough. If there was a sudden unexpected one time uniform jump in the price level, that halves the real value of all nominal debts. That would change a lot of debtors and creditors lives!
nobody.really
Apr 25 2023 at 10:04am
Having read this post, I am now persuaded that we should pursue economic (market) efficiency and low inflation, all else being equal. Thank you.
But the question I posed was, is all else equal? I hypothesize that the Inflation Reduction Act helps manage issues that markets do not–such as enhancing our military (by creating a domestic source of microchips, which are used in all kinds of equipment, including military equipment) and managing climate change (by reducing the emissions of greenhouse gasses). Under this hypothesis, we face a trade-off between desirable outcomes. Merely exhorting the merits of this or that desirable outcome does not aid in finding the optimal balance.
Sumner states (below) that the parts of the Inflation Reduction Act under discussion do nothing to enhance the military or mange climate change (and, as a gimmie, do nothing to reduce inflation). If so, then my objections may not bear on the issue(s) discussed in the article. I can’t make that judgment based only on the quoted texts.
Jose Pablo
Apr 25 2023 at 8:45pm
Under this hypothesis, we face a trade-off between desirable outcomes.
That looks like a very interesting framing that allows some conclusions:
1.- The “selling” to the public of the “Inflation Reduction Act” is a fraud. Since it has not been sold to voters as a “trade-off” but as a “you can get all”: more consumption and a better climate and enhanced national security.
2.- Is the Act the best way of enhancing national security? Chips are glamorous but armies keep running on petrol (the US army ranks pretty high in the list of CO2 emitters). Since the Act discourage investments in the oil industry that does not look like “national security enhancing” to me
Stopping the billions wasted every year on the Congress-driven military pork barrel will do wonders to national security AND reduce its price tag (and so taxes)
https://www.nytimes.com/1985/04/01/us/military-pork-barrel-wastes-billions-a-year-official-says.html
[Not placing your warships together in a poorly defended base in the middle of the Pacific, will also help]
3.- Is the Act the best way to reduce CO2 emissions?
Since chip production has a huge carbon footprint, onshoring this industry will increase the US based CO2 emissions defeating the purpose of the Act. Granted, they will be reduced elsewhere … or maybe not since the “cold war” mindset will put us in a scenario where more chips will be required.
To this goal, would not be better to phase out the subsidies to local coal and oil in the US? at 24.2 billion $ per year, the US is among the top-5 fossil fuel subsidizing countries in the world
I don’t know. Again, an interesting framing but letting the government manage a trade-off is a self-defeating proposition.
Dylan
Apr 25 2023 at 12:10pm
This would have a negative impact on my life, because we (or at least I) think in nominal terms even when we know we shouldn’t. So, I would simultaneously feel all of a sudden really wealthy and complain about how expensive everything has gotten. Speaking from a little real recent experience, my total consumption would likely fall, as I’d get a little psychic pain every time I bought a six pack that should cost $10 but now costs $20.
BS
Apr 25 2023 at 2:00pm
A person retired and living off savings, though, would unambiguously be screwed and would probably feel that way.
Scott Sumner
Apr 25 2023 at 8:31am
The provisions they object to neither improve the climate nor make our military stronger.
Stephen M Holly
Apr 25 2023 at 4:27pm
Could you explain why “the provisions they object to neither improve the climate…” It would seem if the IRA includes more subsidies for clean energy, then more clean energy could be built, and some claim that will improve the climate.
Scott Sumner
Apr 26 2023 at 6:31pm
They object to provisions that require companies to meet those objectives in a less cost efficient manner, say using domestic inputs, or union labor.
nobody.really
Apr 26 2023 at 8:36pm
Well … foo. Those objections seem reasonable and appropriate, as these policies would seem to inflate costs and reduce efficiency in achieving the legislation’s putative goals. Which is pretty much what … Sumner … said ….
(Killjoy.)
Stephen M Holly
Apr 26 2023 at 9:40pm
The article sounded like they were also objecting to the “sheer scale of the handouts (that) will put a wrench in markets.”
MarkW
Apr 25 2023 at 7:01am
On the other hand, if the Fed is truly committed to bringing inflation down to 2%, then it should offset the impact of this legislation with tighter monetary policy. In that case, economic activity is non-subsidized sectors will suffer.
Won’t the non-subsidized sectors suffer regardless of whether or not the Fed manages to tame inflation? It doesn’t seem like there’s any way around the huge subsidies meaning a shift into spending money and devoting resources to these things rather than to the myriad of alternatives.
[T]he Biden administration’s efforts to satisfy its decarbonisation, industrial and geopolitical ambitions at the same time…
Yes, and that’s forgetting things the initiatives to promote ‘environmental justice’ and create ‘equity action plans’ across all federal agencies. The warped priorities and economic distortions seem endless. Trump kicked got us going on bad economic policies justified by ‘national security’ and the Biden administration has doubled and tripled down.
Rajat
Apr 25 2023 at 7:47am
Yep, there is a great deal of ruin in a nation. I don’t mind so much when the younger generation votes for this nonsense, but they just shouldn’t expect to be better off than their parents. They will have more counselling, sensitivity and attention paid to their preteen sons, but fewer goods and other services to enjoy.
Spencer
Apr 25 2023 at 12:30pm
“Rising prices and falling output” That’s called stagflation, business stagnation accompanied by inflation. Money is not neutral.
Lending/investing by the banks is inflationary (expands both the volume and turnover of new money). (where S “≠” I ). Lending/investing by the nonbanks is noninflationary (other things equal). (where S = I ),
With nonbank lending/investing, there is an increase in the supply of loan-funds, but no change in the money stock, a velocity factor, where pooled savings are matched with loans and investments.
Monetary policy is only efficient to the extent that it activates monetary savings, where it completes the circuit income and transaction’s velocity of funds.
Spencer
Apr 25 2023 at 12:46pm
Interest is the price of credit, or loan funds. The price of money is the reciprocal of the price level.
The FED pays interest on interbank demand deposits, so banks won’t lend. The FED pays interest on O/N RRPs so bank deposits won’t circulate. O/N RRPs (outside money) absorb bank deposits (inside money). There is a huge surfeit of loanable funds (an excess of savings over real investment outlets).
That is incontrovertibly, a misallocation of resources.
Stephen M Holly
Apr 25 2023 at 3:25pm
The Inflation Reduction Act was poor public policy because it picked winners and losers. First, the energy subsidies favor expensive wind, solar, long-distance transmission, batteries and electric vehicles that will get even more expensive as manufacturing is moved to the U.S. Moreover, these subsidies are targeted for continued control by utility monopolies, the big banks and large corporations, especially tech firms. Second, the microchip subsidies favor firms locating in the U.S., which will result in mostly low-quality chips. It is doubtful the Taiwan Semiconductor Manufacturing Corporation will locate their best technology in the U.S., because they want the U.S. to defend their country against aggression from China. So yes, the result will be supply-driven inflationary pressures, even if the act does not increase deficit spending as promised. Meanwhile, the Fed will be trying to control inflation by tightening monetary policy. Increased inflationary pressures will result in a strangling of the economy.
Jose Pablo
Apr 25 2023 at 7:51pm
The government is not very good at allocating resources, and attempts to do so almost invariably reduce economic efficiency
Coase will say that this “almost invariably” is an understatement.
When I was editor of The Journal of Law and Economics, we published a whole series of studies of regulation and its effects. Almost all the studies–perhaps all the studies–suggested that the results of regulation had been bad, that the prices were higher, that the product was worse adapted to the needs of consumers, than it otherwise would have been.
Thomas Hutcheson
Apr 25 2023 at 10:31pm
Yes, but that was not what the headline claimed. It reflected the old chestnut of changing federal deficits driving inflation. Sorry, the Fed controls inflation.
Spencer
Apr 26 2023 at 8:03am
It seems incredulous to me that the pundits are clamoring about a deceleration in the money stock. No money stock figure standing alone is an adequate signpost for monetary policy. And Barnett’s Divisia aggregates and Rothbard-Salerno’s TMS figures show poor correlations for N-gDp. Hunt’s ODL is not a superior metric. M2 is mud pie.
Banks don’t lend deposits. Only deposit holders/owners can spend or invest their funds. The banks can’t use these deposits. Banks create deposits when they lend/invest. And the volume of money (stock) is irrelevant unless it is turning over (flow). Thus, one should use means-of-payment money in their analysis.
Link: George Garvey:
Deposit Velocity and Its Significance (stlouisfed.org)
“Obviously, velocity of total deposits, including time deposits, is considerably lower than that computed for demand deposits alone. The precise difference between the two sets of ratios would depend on the relative share of time deposits in the total as well as on the respective turnover rates of the two types of deposits.”
The rate-of-change in short-term money flows, the proxy for real output increased in March.
Michael Sandifer
Apr 26 2023 at 8:13am
Jeremy Siegel has been saying that, if you disregard lagged components, current inflation is already back down to around 2%. And the 5 year breakeven is at roughly 2% in core PCE terms.
https://www.youtube.com/watch?v=9TDjMlzoFjw
Stephen M Holly
Apr 26 2023 at 10:06am
That wouldn’t be a surprise with the economy slowing into a recession after the Fed raised interest rates by about 5%.
Spencer
Apr 27 2023 at 8:13am
What’s interesting is that Shadow stats reports that “Basic M1” (Currency plus Checking) jumped to a new 53-year high of 35.0% of the aggregate Money Supply M2.”That implies that the velocity of money is steadily increasing.
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