As a physician, I have spent decades diagnosing diseases and then prescribing treatments. For many diseases, there is more than one single cause and there are more than one possible treatment. Sometimes the treatment is easy but sometimes the treatment is worse than the disease. Inflation is no different. Here is how to fix inflation from a physician’s vantage point, when we look at inflation the way we look at a disease.
What causes inflation?
In 1976, my college macroeconomics professor said that understanding inflation at its basic level is simple – it is too many dollars chasing too few goods and services. 46 years later, that central tenet is still true: inflation occurs when demand exceeds supply. In this sense, inflation is similar to a medical condition like respiratory failure. In respiratory failure, the patient gets short of breath when the body’s demand for oxygen exceeds the supply of oxygen that the lungs can deliver. The treatment of respiratory failure is to either increase the supply of oxygen being delivered to the body’s tissues or reduce the demand for oxygen by the body’s tissues. Preferably, you do both.
Like respiratory failure, there is usually not just one simple cause of inflation but instead there are several alterations in the things that cause demand for goods and services as well as the things that affect the supply of goods and services. Although demand can be affected by changes in what consumers want to purchase, it is more often caused by the amount of money consumers have in their hands to make purchases. In our nation’s current bout of inflation, there are contributions from both the supply side and the demand side. In addition, there is an effect of the national psychology attendant to inflation expectations.
Alterations in demand for goods and services:
- Increased disposable income from COVID relief programs. When COVID surged, the U.S. unemployment rate spiked and the government response was to inject money into the economy in the form of COVID relief checks. This resulted in many Americans having cash on hand and no place to spend it during the COVID isolation period. In 2021 and 2022, when isolation restrictions eased up, many Americans started to spend these built up cash reserves and we all started to buy stuff.
- Exceptionally low interest rates to borrow money since 2010. Borrowing money has never been less expensive in the U.S. as it has been for the past 12 years. Low interest rates result in more people buying houses and cars. Low interest also result in companies borrowing more money to expand their business operations. As more people borrow money, there is more money circulating in the economy and that results in more money available to spend on goods and services.
- Historically low federal income tax rates enacted by the 2018 income tax cuts. The current U.S. income tax rates are among the lowest Americans have had in generations. This graph shows the effective income tax rates for all incomes in 2016 (before the 2018 tax cuts) and in 2020 (after the 2018 tax cuts). As a result of these tax cuts, all Americans had more money to spend on goods and services over the past year.
- Federal student loan forgiveness programs. In August 2022, President Biden authorized $10,000 per person federal student loan forgiveness ($20,000 for those with Pell grants). This week, former students can start to apply for those funds. The economic effect of this will not be felt until individuals get their forgiveness applications approved but many affected Americans have already changed their spending habits based on the expectation that they will have $10,000 or $20,000 more to spend on goods and services than they had budgeted for earlier this year.
- Increasing federal deficit spending since 2002. The U.S. government has a long habit of spending more money than it takes in each year. In fact, the only years that the government ran an annual surplus in recent memory were in 1998 – 2001 due to combined efforts by Democratic president Bill Clinton and Republican House Budgetary Chairman John Kasich. When the government spends money, it primarily goes to purchasing goods and services and puts more money in the hands of Americans that produce those goods and services.
Alterations in supply of goods and services:
- COVID brought supply chain disruptions. These disruptions made it difficult to get foreign-produced products into the United States. These supply chain disruptions also made it difficult to get raw materials and production components into the U.S. resulting in decreased domestic production. As a result, products such as appliances made abroad and U.S.-manufactured cars that depend on foreign-made computer chips became suddenly scarce.
- Changes in consumer buying patterns during COVID. As a result of the pandemic, Americans wanted computers in order to work from home and wanted new suburban homes to work and live in. This resulted in heightened demand for houses and computers. There were also transient demand spikes for toilet paper and subscription video streaming services, like Netflix. During the pandemic, consumers could not spend money on services (like travel, restaurants, and concerts) and shifted their spending patterns to goods, like appliances, TVs, and furniture. Quite rapidly, the demand for these goods exceeded the supply of these goods.
- COVID rebound spending. As isolation practices eased, Americans started to act on their pent-up consumption appetite. We started eating out at restaurants again. We began planning vacations involving air travel and car rental. We started buying new clothes to wear as we returned to the office. But restaurants had just recently laid off staff, airlines had stopped replacing retired pilots, and car rental companies had sold off their rental car stocks. As a result, these industries were unable to meet the rebounded demand for their goods and services.
- War in Ukraine. The global disruption in gas and oil supply resulting from global sanctions on Russia after its invasion of Ukraine has been felt in most Western nations, including the United States. As a result, the worldwide supply of gasoline exceeded the supply and the price per gallon spiked.
- Foreign import tariffs. A tariff is a tax on imported goods. By making these goods more expensive, the demand for those goods drops and is replaced by demand for more expensive domestically-produced goods. In addition, tariffs can cause foreign manufacturers to redirect their sales to other countries that do not have tariffs in order to maximize their profits. As a result, the amount of foreign-produced goods falls and U.S. consumers pay more for a given item. Tariffs introduced by President Donald Trump resulted in a drop in supply of many foreign-produced goods.
- Low unemployment rates. The supply of services is often reflected in the unemployment rate. When the unemployment rate rises, there are too many workers competing for too few jobs and when the unemployment rate falls, there are too many jobs for too few workers causing employers to increase wages to attract workers. The pandemic resulted in many workers retiring early and also restricted the flow of immigrants and seasonal foreign workers into the United States thus shrinking the labor pool. Consequently, we now have too many job openings for too few workers, particularly for low wage jobs and farm workers.
Alterations in the expectation of inflation:
- Worker expectations. When workers think inflation is getting worse, they proactively demand increased wages. This was evidenced recently but the increase in unionization over the past year with the assumption that by unionizing, they could use collective bargaining to get pay raises.
- Manufacturer and employer expectations. Forecasts of inflation also affects the costs of goods and services – when companies forecast inflation in the near future, they increase the price of their goods and services in anticipation of increased costs to produce those goods and services in the future.
- Consumer expectations. The psychology of inflation is often discussed in terms of worker and employer expectations but consumer psychology is just as important. When consumers hear that inflation is going up, they come to believe that they should be paying more for goods and services. This can result in a mentality of: “Well, normally I’d never pay $25 for a pizza but inflation is happening so I guess it is OK to spend that much”.
How do we cure inflation?
With disease, we often focus too often on treating the symptoms rather than treating the underlying cause. Symptom-based treatments can provide transient relief but do not cure the underlying disease. You can give a patient with sepsis Tylenol and make his fever go away but he’ll still die of sepsis. Similarly, a disease with multiple causes requires treating all of the underlying causes and not just one. When a trauma patient is bleeding from 5 different gunshot wounds and you only suture one of them up, the patient will still bleed to death. Treating inflation is no different – you have to treat the underlying causes. Some of these treatments are relatively easy but others can be too politically painful to realistically implement.
Treating alterations in demand for goods and services:
- Eliminate COVID relief spending. Much of this has already occurred but many state and local governments still have unspent federal COVID relief funds and they are looking for things to spend that money on. Unspent funds should be returned to the Federal government to prevent further cash injection into the economy.
- Increase interest rates. The Federal Reserve is already addressing this by progressively increasing the federal fund rate. The downstream effect is rising mortgage rates and car loan rates that in turn reduce demand for new house construction and automobiles.
- Raise income taxes. This is probably the single most effective way for the federal government to cool off inflation. It takes money out of worker’s pockets and thus reduces their demand for goods and services. However, increased taxes is viewed as a politically nuclear option and no elected official wants to go on record for voting for higher taxes. Even politicians who lean to the left usually only want to increase taxes on the wealthy. However, selectively increasing taxes on the wealthy can increase federal government revenues but has less effect on inflation. The wealthy tend to spend their extra income on investments and luxury goods but to really cool off inflation, one must decrease the demand for everyday goods. For that reason, for tax increases to be effective in reducing inflation, everyone would have to pay higher taxes, not just the wealthy.
- Eliminate loan forgiveness programs. Unfortunately, once you promise people money, it is exceptionally difficult to then take it away – it would be political suicide. Nevertheless, even lowering the income threshold for loan forgiveness eligibility would effectively take cash out of the economy.
- Decrease federal spending. Much of the huge spike in federal spending from 2020 – 2022 was on COVID programs such as vaccines, medications, and testing. The public health advocate in me wants to continue free access to vaccines and tests but to reduce inflation, it is better to start asking Americans to pay for these goods and services themselves. Belt-tightening inside the Washington Beltway is never popular but to fight inflation, federal spending should be limited to only those programs and federal departments that are vital to keep the country running safely.
Treating alterations in supply of goods and services:
- Improve supply chain disruptions. Many of the COVID supply chain issues have been resolving over the past year as the country has gotten back to work. However, transportation bottlenecks still exist in some areas and union strikes could cause additional transportation disruptions in the near future.
- Re-set consumer buying patterns. The free market is already doing this to an extent. Computer sales are falling as people return to the office after working from home. Netflix subscriptions are falling. Home sales are decreasing due to a combination of people no longer fleeing to the safety of the suburbs to avoid COVID, no longer needing more space to work from home, and no longer being able to buy houses with rock-bottom mortgage rates.
- Temper COVID rebound spending. The government can’t just tell people to stop buying stuff. But fortunately, the combination of a year of high inflation plus a year of spending down COVID-related household cash reserves has already tempered America’s recent buying spree.
- End the war in Ukraine. This one is not under the United States’ control but until the war ends, normalization of trade relations with Russia as well as resumption of Ukrainian agricultural and manufactured goods exports will continue to cause international inflationary pressure. In addition, Western countries, including the U.S., are spending much cash on military items with the downstream effect of that cash going into military production worker wages.
- Lift foreign import tariffs. There are compelling political reasons to continue some tariffs but from an economic standpoint, the more inexpensive goods we get into the country, the better from an inflation standpoint. First, increased imports reduce the cash supply by getting U.S. cash out of the country and thus out of circulation in the U.S. economy. Second, increased imports keep the cost of American-made goods lower by increasing competition.
- Increase the unemployment rate. It would be politically poisonous to simply eliminate jobs but if the unemployment rate increases, circulating cash is taken out of the economy as the supply of workers drops. In addition, employers would no longer have to keep increasing wages to attract workers. However, an alternative strategy could be more palatable, namely, increase the number of workers by increasing foreign immigration. We currently have too many foreigners trying to get into our country illegally in order to find employment and escape unsafe living conditions. By legalizing the presence of many of these undocumented foreigners, we can increase our workforce, particularly for lower wage jobs and farm work jobs. Our immigration problem and our low unemployment problem are the solutions to each other.
Treating alterations in inflation expectation:
- Politicians as psychologists. Changing the psychology of an entire country is hard, but not impossible. This is where the charisma of individual leaders can have an impact. Another ways by having agreement between the political parties. Getting Republicans and Democrats to come together on anything is hard anytime but even more so in an election year. During election years, it is far too easy for both parties to point the blame for inflation on each other. It is far to easy for a political party to say “Elect us because the other guys are going to make inflation worse”. Nevertheless, consensus on legislation portrayed as being inflation-reducing can send a powerful psychological signal that can help Americans of both parties.
- Just do something. In medicine, doctors often prescribe antibiotics for bronchitis and sinusitis even though they know that the infection is most likely viral and the antibiotics won’t do anything. But it is the patients’ expectation that something is being done to cure their disease. If Americans see no-one doing anything to reduce inflation, their expectation will be that it is just going to keep on going until someone does something. Thus far, the public face on inflation control has been the Federal Reserve and to give the Fed credit, they have made aggressive interest rate increases. But ideally, there should also be executive branch action and legislative branch action to fight inflation so that our country’s perception is that war is being fought and will soon be won.
It really is like a disease
Admittedly, I am neither an economist nor a politician. But as a doctor, I see so many similarities between inflation and disease. In fact, inflation can be seen as a disease of the country’s economy. And just like most diseases, you can’t just treat the symptoms and hope that it goes away on its own, you have to treat the causes of the disease, preferably all of the causes.
October 19, 2022