Biden sleepwalks into a stagflation nightmare

The Biden administration’s US$1.9 stimulus package, adding to last year’s $2 trillion in Covid-19 related handouts, has the effect of feeding sugar to a diabetic. The patient is on a sugar high, but at risk of collapse.

The US doesn’t have the productive capacity to meet the demand created by the federal government and the Federal Reserve. The result is stagflation—a combination of inflation and economic weakness that we last saw during the Jimmy Carter administration in the 1970s.

There are two big differences between now and the 1970s, though. The first is the explosion of US government debt. The second is China.

Instead of throwing money out of helicopters, the US should invest trillions of dollars in infrastructure, R&D, selective production subsidies (for example semiconductors) and science education. As it is, the Biden administration is putting the credit and future borrowing capacity of the US at risk in return for a temporary boost to output.

Last week, the Philadelphia Federal Reserve Bank published the highest reading for its manufacturing diffusion index since 1972, right after the Federal Reserve reported a 3.1% fall in manufacturing output during February.

There’s a simple explanation for these wildly divergent readings: Higher input prices drove the jump in the Philadelphia Fed index. What’s worse, the difference between prices paid by manufacturers for inputs and prices received for finished products rose to the highest level since the Great Recession of 2009, as shown in the following chart:

The chart shows the difference between the proportion of manufacturers reporting higher output prices and the proportion reporting input costs. By a margin of 40% of all manufacturers, the preponderance of firms surveyed reports faster growth in input costs. That hasn’t happened since the aftermath of the Great Financial Crisis of 2008.

This is what recessions are made of. When a scissors opens between input costs and prices paid, manufacturers restrict operations rather than lose money.

But there is a critical difference between the deflationary recession of 2009 and the stagflation of 2021. In 2009, prices of inputs as well of finished goods both fell sharply. In 2021, they rose as the graphic below shows:

Faced with a widening gap between input costs and final prices, many manufacturers will choose to shut down production lines rather than lose money. That, as well as the disastrous Texas electricity blackout, explains why production fell: Consumers push back against higher prices while input costs push up the cost of production.

The US Consumer Price Index is rising at less than 2%, a number that the Federal Reserve seems to think charmed. But that’s an artifact of measurement.

The Bureau of Labor Statistics’ gauge of consumer inflation remains subdued in large part because the cost of renting homes has risen more slowly (about 2% a year) in recent months than previously, thanks to high unemployment. Shelter is nearly two-fifths of the CPI, and that keeps the index down.

The 2009 crisis came from the demand side. When the housing bubble collapsed, trillions of dollars of derivative securities backed by home loans collapsed with it, wiping out the equity of homeowners and the capital base of the banking system.

The 2021 stagflation—the unhappy combination of rising prices and falling output—is a supply-side phenomenon. That’s what happens when governments throw trillions of dollars of money out of a helicopter, while infrastructure and plant capacity deteriorate.

Chronic underinvestment in US plant and equipment as well as infrastructure has left American supply chains and transport networks strained.