Fight Inflation With Surplus, Not Scarcity

We have the opportunity to create surplus and manage away scarcity through government supply-side policy and smarter institutional design.

Jose Berrio for Noema Magazine

Nina Eichacker is an assistant professor of economics at the University of Rhode Island.

Jason Oakes is a research associate in the program in science, technology and society at UC Davis.

Earlier this year, the U.S. saw the greatest jump in year-on-year inflation rates since the 1980s. This generated hardship throughout the economy, especially for people living on low or fixed incomes. Some share of this recent inflation is related to global uncertainty about oil — but excluding even oil and food, inflation rates in April were at 6.2%.

Though some argue that this rapid inflation is a direct legacy of the U.S. government and the Federal Reserve’s expansive responses to the pandemic, it owes more to sustained pressures on the supply side of the economy. The reorganization of U.S. industries in response to globalization set the stage for the economy to be vulnerable to these pressures. The good news is that we can organize things differently now to make the economy more resilient.

Government intervention to address the pressure points and bottlenecks that have emerged during the pandemic can alleviate frictions caused on the supply side. Intervention in the realms of energy and transportation, in particular, can help relieve two major sources of the current inflationary pressure, while reducing demand for fossil fuel energy, lowering health costs and improving living conditions. The result would be a high-investment, dynamic economy characterized by a growing understanding of constraints and distributional trade-offs. In short, we would rebuild the capacity to plan “on the fly” by embracing “unbalanced growth” — that is, the economics of surplus. 

How We Got Here

From the 1980s onward, U.S. industries reduced their domestic capacity in response to globalization — a shift that would ultimately leave the economy more prone to being destabilized by sudden fluctuations in demand. The defining feature of this reduction of capacity was a change in which parts of the economic system bore excess uncertainty.

Across economic institutions, surplus capacity was engineered out, and systems were engineered to be as lean and efficient as possible. The emphasis was on increased efficiency of supply chains, utilizing just-in-time delivery of materials and relentless cost-cutting and productivity improvement. The complex network of contracts and firms doing business across international borders and supply chains placed the management of uncertainty onto the constituent firms, meaning a cessation of activity from any one of them would have ripple effects onto the others.

After the construction boom and bust of the global financial crisis, for example, construction of new housing declined precipitously, and domestic producers of lumber and other construction materials decreased their capacity in response. Union power diminished, and with it, workers’ power to demand wage increases commensurate with productivity gains. In some cases, local power brokers, such as NIMBYs in housing, blocked efforts to increase the supply of needed capacity. All of this created scarcity conditions that have persisted into the present — but this scarcity is a choice, not an inevitability.

The pandemic highlighted how vulnerable the U.S. economy now is to shortages, as American economic institutions could not ramp up production of vital medical supplies and technology fast enough to keep up with demand. There were suddenly not enough tests, life-saving drugs or hospital beds, and staffing levels at hospitals were not adequate to avoid overwork and burnout.

Additionally, when the government provided direct cash support and loans to households and business, patterns of consumption shifted toward goods and away from services, further stressing the lean and efficient supply chains and causing a shocking bout of inflation. Prices rose sharply in food, energy, used cars and especially housing.

“Government intervention to address pressure points that emerged during the pandemic can alleviate frictions caused on the supply side.”

But interestingly, housing prices had been high and rising for years before COVID, along with the price of health care, education and child care. The price inflation in these sectors points to a deeper problem: the intrinsic shortages created by the way the institutions that provide them have been organized. 

Three questions are helpful for addressing these problems: what resources are scarce, why are they scarce, and should they be scarce? Most economists avoid these questions because they assume a given distribution of resources; how those resources were created or distributed is irrelevant to their models. However, if we agree with the transformative ideas of John Maynard Keynes, we can begin to design an economy in which, to paraphrase, we can afford anything we can desire.

Some resources, like platinum, are scarce because they are geologically rare. Other resources, like housing at present, are rare due to production decisions, zoning policies or other human-level interventions. Still others may be rare because of unexpected vulnerabilities: consider, for example, unexpected decreases in agricultural yields that resulted from droughts, floods and wildfires in recent years.

When resources are scarce due to human decisions at the individual, firm or government level, direct action by the public sector can increase abundance. And if resources may become scarce due to predictable environmental outcomes created by climate change, policies to actively reduce carbon emissions or protect environments from likely weather patterns can likewise hedge against scarcity.

How We Can Organize Our Institutions Away From Scarcity

Economists typically consider government spending on goods and services to be a form of aggregate demand because it is public consumption. But government spending policies have the potential to stimulate production, depending on their design.

By reducing reliance on international supply chains for components that are effectively catalysts for producing high-demand durable goods, the federal government can reduce delays in producing output that households want to purchase now. Measures that reduce the cost of producing and repairing cars and housing could, together, drive down aggregate price levels from the current unprecedentedly high levels.

Government production of housing, for example, would moderate housing prices over time. New residential construction has shrunk as a share of the U.S. population, from an average of 0.8% in the early 1970s to an average of 0.6% in the 1990s, then to an average of 0.3% in the aftermath of the sub-prime mortgage crisis in 2007. The broad decrease in home construction has led to a chronic shortage of housing for a growing population. The shortage is even more acute in high-growth areas like cities, where families and workers face the tradeoff of paying more for housing near where they work or moving to more affordable areas with lower employment prospects. The combination of low or fixed supply and high demand is a perfect storm for rising prices, which have resulted from bidding wars between high-income households and asset management corporations that have purchased increasing shares of housing.

These prices spill over for renters in these areas, as landlords raise prices for captive tenants. Concerted public home construction projects, matched with zoning reforms to allow new construction of high-density and multi-use buildings, would relieve pressure in these communities and bring down the overall price of housing. Increasing home permitting rates for multi-unit construction would likewise address these supply problems, while more active construction of homes specifically designated for low-income households would increase accessibility for populations routinely priced out of cities.

National production of energy resources and technology would likewise push down key drivers of domestic inflation. The recent hike in oil prices owes much to recent developments: in April 2020, President Trump negotiated a reduction in oil production to raise prices and profits for global and domestic fuel producers. This stabilized prices in oil markets during a time when the global economy was largely locked down, but supply of oil has remained low, even as households have resumed travel and workplaces have opened back up.

Though price hikes on gas directly affect households’ budgeting decisions, creditors for oil producers have continued to mandate low production in order to drive up profits. The Biden administration’s decision to increase production was an example of public intervention to increase the supply of oil, which has shown some downward pressure on gas prices — though prices remain above $4 per gallon in almost every state. Some part of this reflects typical gas price movements — gas prices rise in the summer when people drive more — but also reflects both the willingness of smaller oil producers to restrain output to benefit shareholders.  

Federal investment to repair transit infrastructure and build new rail and other mass transit, meanwhile, would decrease maintenance and transportation costs for households looking to decrease their reliance on cars while benefiting the environment. These construction projects would employ workers and benefit producers selling necessary inputs. The government can also expand programs that train workers whose current occupations are becoming obsolete, provide grants to states tagged to infrastructure projects, clean up environmental hazard sites near predominantly nonwhite communities and build more green housing to alleviate pent up demand.

“When resources are scarce due to human decisions at the individual, firm or government level, direct action by the public sector can increase abundance.”

And industry-specific policies may have deflationary effects in sector-specific locations. For example, policies designed to reduce the costs of health care — including deals to lower the prices of prescription drugs like insulin — adjustment of Medicare reimbursement rates and shifts away from fee-for-service medical business models can together lower the prices that households pay for necessary goods and services.

As the very contagious Omicron variant spread in late 2021, there was a shortage of rapid antigen tests. This happened because manufacturers decided to stop producing and destroy inventory after COVID rates had begun to decline earlier in the year. If the government had purchased and subsidized production of tests despite declining private sector demand, it would have fostered redundancy that could have relieved these pressures.

Improving the government’s capacity to produce key goods and services can also increase the flexibility of the national economy, as the government may have a greater willingness and ability to wind down production of goods and services no longer in such great need or demand than firms that spend a lot on high start-up costs. If there is a widespread move away from some resource like coal in favor of cleaner energy sources, governments could better smooth the transition process by compensating private producers in the coal industry for their exit, while further subsidizing cleaner technology substitutes to increase their scope of production. These transitions would reduce risk for financial institutions that have historically lent to older industries being replaced by new ones, while providing resources for employees of older industries to find new employment elsewhere.

Increasing government employment would also increase the economy’s productive capacity. Rushes to austerity after the 2008 Global Financial Crisis led to widespread termination of government jobs across the country. These jobs were engines for upward mobility for predominantly nonwhite and non-male workers. The early months of the pandemic revealed the material consequences of antiquated unemployment infrastructure; many households applied for enhanced unemployment insurance, only to meet long backlogs because of the overloaded system. Some households gave up applying, according to an EPI survey, due to their frustrations with the system.

While households that succeeded in applying for enhanced benefits might have received a lump sum to account for accumulated earnings, their material stress and delayed payments on obligations like food, housing, utilities and more were unnecessary.

Improvements in the government’s welfare infrastructure would also increase its capacity to nimbly respond to crises. Sustained consumption expenditure and declining poverty rates early in the crisis showed the potential systemic benefits of these policies. These supply-side interventions, taken as a whole, would have the effect of buffering the volatility of the existing system by reallocating uncertainty away from individual firms and towards the organization best able to bear it: the public sector.

Why This Approach Will Combat, Not Worsen, Inflation

Typical arguments against government spending say that it will generate inflation and “crowd out,” or take the place of, private sector spending. This logic requires several assumptions. First, that firms are already producing at full capacity. If they are, then they will not be able to produce more output to meet current demand without increasing their average costs of production. Second, it assumes that firms will pass all costs onto consumers, presumably to maintain profit margins. Cost increases are more likely to translate into price increases in some industries than others; while some producers currently appear to be passing rising costs on to consumers, not all are doing so. Third, it assumes that the public sector will purchase goods and services that the private sector might have ordinarily purchased or that any spending by the government is implicitly zero-sum relative to the private sector. Since many opponents of government intervention in the economy assume that private sector actors make more efficient choices than the public sector, they assume it will likely reduce the output available for households and firms and reduce overall productive capacity.

Why might we be skeptical that these interventions will encourage long-term inflation? First, we might note that before the second half of 2020, inflation had systematically undershot targeted rates of 2%. The inflationary pressures we have observed since May 2020 have been concentrated in particular areas defined by diminished productive capacity following the Great Recession: durable goods prices increased much faster than the core inflation rate during the pandemic, due to supply bottlenecks and lack of domestic capacity to satisfy increased demand. As producers adjusted to skyrocketing demand for wood in 2021 and increased their productive capacity, commodity prices in lumber gradually fell.

“If we agree with the transformative ideas of John Maynard Keynes, we can begin to design an economy in which we can afford anything we can desire.”

Spikes in lumber prices in December and January of 2022 are a result of diminished supply due to wildfires in British Columbia and the Pacific Northwest this past summer. This supply problem was compounded by mudslides and flooding after record November rainfall which delayed shipments from the Port of Vancouver. As climate change increases the volatility of commodity prices, the stabilizing effects of a green transition on supply costs seem clear. In realms like housing, active construction of supply will bring down prices gradually. Where the U.S. depends on foreign markets, there will always be a vulnerability to supply chain shocks and logistical SNAFUs that can delay deliveries of crucial components. In these arenas, industrial policy that deliberately builds redundancy and capacity can accommodate rising demand.

Recent history is also full of examples of government policy successfully shaping productive capacity. The CARES Act provided low-cost credit to firms at risk of bankruptcy in the early months of the pandemic; the Paycheck Protection Program was designed to ensure that firms could maintain their workforces while closed for lockdowns.

The government has a history going back to the Civil War of contracting with large firms to foster industrial development. Through a combination of investment and regulation, the government fostered American industrial production of munitions and military materiel used in the Second World War. Similarly, the U.S. military has helped develop technologies adopted at low cost by companies like Apple in their innovation of market-making projects. The development of the COVID vaccine was a contemporary example of these practices: grants to pharmaceutical firms in pursuit of a cure for COVID followed decades of federally funded scientific research in the development of vaccines.

Why Climate Change Makes All Of This Even More Important 

The government’s ability to steer production toward under-provided goods and services by direct intervention has the potential to address short-term price hikes as well as longer-term sustainability challenges.

Weather events linked with climate change, whether they are droughts, floods, fires or insect swarms, have wreaked havoc on production of agricultural products like grapes for wine or cultivated cacao beans for chocolate. Global prices for peas — a central component of many alternative meat products and high-protein energy bars — spiked in 2021 after droughts in Canada and floods and France reduced yields. Changes in their price could likely translate into higher prices for all manner of consumer goods. Government investments that facilitate the transition away from fossil fuels and mitigate the effects of climate change can minimize these damages.

Developing certain kinds of infrastructure, for example, can ameliorate the consequences of exponentially increased carbon emissions, while bolstering physical capital against the consequences of warming, rising sea levels and more volatile weather. Existing firm-level investment in these technologies will necessarily be insufficient, as entrepreneurs have a perverse incentive to wait and see how things will turn out. Uncertainty again inhibits innovation and investment in needed areas.

Private trends in funding these transitions are promising. Some banks are pledging less support to fossil fuel producers and selling off assets linked with carbon emissions. These pledges are not universal; large banks are still investing in carbon-intensive agriculture projects, and American banks’ commitment to cutting carbon lags their European bank peers. At the same time, the spike in oil prices has, ironically, encouraged many Democratic politicians to promote oil production through public means. This temporary assistance should be matched with more robust support for alternative energy and public infrastructure.

None of these programs in isolation may generate the rapid and large-scale change necessary to combat the already visible consequences of climate change. Furthermore, regulations and private sector activity that make fossil fuels more expensive are insufficient to push societies past depending on carbon-intensive technologies and may alienate voters from re-electing governments willing to respond to these monumental challenges.  Local populations will resist measures that could mitigate carbon emissions if they lack affordable alternatives, which themselves require funding to develop and implement.

Governments and central banks can spur this kind of innovation in several ways. They can provide indirect incentives for firms to pursue certain courses of action, like subsidies, tax rebates, grants and preferred lending terms. The government can directly purchase output and provide a ready customer base for firms producing particular goods and services. Finally, the government can produce goods and services to sell or distribute to the broader public.

In the U.S., the Department of Energy has lent to firms including Tesla that have promoted renewable energy production and transmission. The federal government has also created public banks to promote different economic aims, like the Export-Import Bank, which assists firms entering global markets, and the North American Development Bank, funded by both the U.S. and Mexican governments, which lends to green development projects in border areas of Mexico, California, Arizona, New Mexico and Texas. State-level publicly funded green banks now operate in 15 states and Washington, D.C., and they have collectively lent nearly 2 billion dollars between 2011 and 2020. Creation of a federal-level public infrastructure bank would expand the scope of funding and further propel investment potentially by hundreds of billions of dollars over the next 10 years.

“Private investment alone can enable some of these changes, but it is insufficient to the scope of transformation necessary for present challenges.”

The Federal Reserve could follow the recommendation some European analysts have given the the European Central Bank: to create green long-term refinancing operations (LTROs), monetary policy instruments designed to promote lending to firms producing renewable energies in Europe. While some argue that guiding industrial policy is beyond the Fed’s remit, the potential negative effects of climate change on economic output and financial volatility may recommend such actions.

The government can also spend directly on climate initiatives. The U.S. government’s commitment to work with unions to purchase more electric vehicles encourages their production and provides disincentives to union bust in the process. Infrastructure projects that build more energy-efficient housing and climate change-resilient architecture generate employment, increase the supply of tight resources driving inflation and lower households’ and communities’ repair costs when coping with the ongoing damage from climate change.

Governments can also contribute directly as producers. The federal government accounts for roughly 15% of physical capital expenditure in U.S. GDP. Increasing the government’s contribution to utility services like energy production, both to increase domestic supplies of fossil fuels where needed and to transition away from those products as capacity grows, would address shortfalls in fuel availability boosting inflation rates at present. These programs would present employment opportunities for workers in volatile industries, and they would also increase domestic capacity for transitioning away from more environmentally degrading practices in the short and medium term.

Private investment alone can enable some of these changes, but it is insufficient to the scope of transformation necessary for present challenges. Indeed, the past two years have shown that many individual firms will cut back on their own activities when confronted with shortages or supply bottlenecks rather than bear the uncertainty of overproduction.

Rather than pulling back, governments should double down on their interventions, and particularly focus on the supply side in order to sustain these gains for the long run. Dynamic economic activity responding to an exogenous shock such as COVID-19 will inevitably produce lags and whiplash effects. These friction points produce distributional trade-offs in purchasing power, which we have seen in price inflation in consumables and durable goods.

While some degree of “reshoring” is possible, the U.S. economy will remain highly globalized. This means that exogenous shocks from various causes — including but not limited to pandemic disease, geopolitical conflict and climate change — will continue. Hence, it is reasonable to buffer the inherent uncertainties of such an economic system through government attention to and intervention in key points of friction, bottlenecks, lags and trade-offs. Greater government involvement in guiding industrial policy has the potential to improve people’s quality of life and promote equity. It could dramatically increase economic capacity in the U.S. and the world at large.