March 22, 2022

Inflation Is Largely a Demand-Side Problem

Senate Committee on Banking, Housing, and Urban Affairs
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Chair Brown, Ranking Member Toomey, and members of the Senate Committee on Banking, Housing, and Urban Affairs:

Thank you for the opportunity to testify today. My name is Veronique de Rugy, and I hold the George Gibbs Chair at the Mercatus Center at George Mason University, where I study tax and fiscal policy, the federal budget process, and the implications of government spending for economic growth.

I would like to offer the following three main takeaways:

  1. The inflation Americans are experiencing today was to be expected. There were sufficient warnings that this inflation should not have been a surprise.
  2. The inflation Americans are experiencing is the result mostly of expansive monetary and fiscal policy, rather than the result of global supply chain problems or other supply shocks.
  3. Fiscal and monetary restraint are key to controlling inflation.


The Consumer Price Index in February 2022 showed its sharpest year-over-year spike in four decades, catching the Federal Reserve (Fed) by surprise. After being slow to recognize the inflation, the Fed claimed that the inflation is transitory, meaning that it will go away all on its own. When inflation persisted, the Fed said that prices are just catching up to prepandemic levels. When prices began to exceed prepandemic levels, the list of “causes” of inflation began to change with the circumstances, to the point that one could conclude that inflation can be caused by nearly everything (the restricted supplies of lumber, used cars, and other goods, as well as overall supply chain tangles).

Today, the argument that inflation is mostly the result of supply shocks such as the war in Ukraine or of global supply chain problems continues to be widespread.

None of these alleged causes, however, can explain the persistence of inflation or its scale compared with inflation in other countries. In particular, explanations about supply-shock-driven inflation seem to mistake inflation (i.e., an increase in the general price level—that is, of all prices and wages) with changes in relative prices (i.e., when only some prices rise, as when the price of cars rises relative to the price of other goods and to wages because of reductions in the supply of computer chips). In the end, excessive focus on the supply side of this issue causes people to fail to recognize the overwhelming role played by the demand side, in particular the role of deficit spending accommodated by the Fed’s expansionary monetary policies. This oversight is surprising, considering that many legislators, Fed officials, and many experts have treated the pandemic- and lockdown-induced downturn as if it were a demand-side shock and have responded with measures meant to raise aggregate demand. They should not be surprised that this inflation is demand pull rather than cost push.

Global Supply Chains Are Not the Primary Cause of Inflation

One of the most common talking points about the inflation is that it was caused by supply shocks in general and global supply chain weaknesses in particular. Fixing inflation therefore requires, among other things, pulling in supply chains behind national borders. This hypothesis is based on misconceptions about both supply chains and inflation.

According to the World Trade Organization, trade in intermediate goods continued to rise during the pandemic, albeit at a slower rate than before, in spite of port and shipping bottlenecks. In other words, although there were chokepoints, supply chains were far from “cut off,” as the president recently claimed on national television. In fact, as I will show later, most of the supply chain issues had to do with the tremendous increase in demand rather reductions in the economy’s ability to supply goods owing to supply-chain-specific issues. Economist Scott Lincicome has demonstrated repeatedly that “the nation’s overall productive capacity and its medical goods industries are generally healthy and that domestic industries and their supply chains have adapted during the pandemic to meet extraordinary demand.”

Furthermore, it is at best unlikely that moving supply chains to domestic producers will lower inflation by reducing the cost of production. Global supply chains are global because every other available mode of production and distribution is more costly. Were the government to forcibly constrain and alter these supply chains, it would increase costs further—and as costs go higher, so would prices. Also, undoing decades of globalization would take a commensurate number of decades.

Rachel Fefer, Andres Schwarzenberg, and Liana Wong, economists at the Congressional Research Service, write that

"the United States, in particular, was a driving force in breaking down trade and investment barriers across the globe and constructing the open and rules‐based global trading system that has enabled [global value chains] to proliferate. . . . For example, stronger linkages to the global economy force U.S. industries and firms to focus on areas in which they have a comparative advantage, provide them with export and import opportunities, enable them to realize economies of scale, and encourage knowledge sharing and innovation. In addition, households have been able to enjoy lower product prices and a broader variety of goods and services—some of which may not be produced domestically."

"Global supply chain constraints or port bottlenecks do exist, and Congress can address them in several ways, some of which I will mention later in this testimony. Indeed, the United States could get much more out of global supply chains by removing the many government-imposed barriers that have intentionally diminished US supply chain capacity, efficiency, and flexibility and thus made the supply chain crisis far worse than it ever needed to be."

Finally, this is not to say that global supply chain constraints cannot and have not led to an increase in the price level. However, one needs to differentiate between supply constraints, which increase the price of some or even many goods relative to other prices, and inflation, which occurs when the prices of everything, including labor, eventually rise. Americans are now seeing the price of everything go up. Wages are also rising, albeit at a lower rate for now. Supply shocks and constraints do not cause that broad-based pattern. Indeed, individual price increases show up in measurements of inflation, but these increases in relative individual prices should not be confused with inflation. In addition, price-level hikes caused by supply-side shocks (such as supply-chain chokepoints) are generally not ongoing, month-after-month price hikes. They are usually a one-time price-level jump, which eventually dissipates when the supply shock is over and which usually reverses, resulting in a period of measured deflation. All prices are rising, the inflation is persistent, and there is no sign of a reversal.

Similarly, a shift in demand from services (e.g., restaurant meals) to goods (e.g., TVs) can cause goods prices to rise, but it causes services prices to decline, with no effect on the overall price level. That is not what Americans are seeing.

By contrast, inflation, or a general increase in all prices including wages, and the associated fall in the dollar’s purchasing power has a single source: the creation of too many dollars and the promise to print more dollars in the future.

The Main Cause of Inflation

Government-induced demand is a key player in this burst in inflation. The US Department of the Treasury first issued $3 trillion of new debt, which the Fed quickly bought in exchange for $3 trillion of new reserves that the Treasury sent out as checks and other forms of payments to Americans. The Treasury then borrowed another $2 trillion or so to send out another round of checks and payments to Americans. Overall federal debt rose by almost 30 percent of GDP.

This action was the product of a misdiagnosis of economic problems on the basis of the belief that the pandemic-induced recession was mostly an aggregate demand shock, not one of aggregate supply. That means that sending money to people would have very little impact on output, especially because a large share of the economy was closed. It would, however, affect demand for durable goods.

The size of fiscal stimulus was also an issue. Even by Keynesian economics standards, the $5 trillion injected into the economy was larger than any plausible output gap, at any level of multiplier. The same can be said of the $1.9 trillion American Rescue Plan, which was passed in March 2021. Around early 2021, the Congressional Budget Office projected that the output gap would be $700 billion through 2023, the period when most of the $1.9 trillion in spending would take place. $1.9 trillion was two or three times more than needed to fill the gap.

Whereas everyone from monetary experts to the Fed chairman to President Joseph R. Biden Jr.’s Council of Economic Advisers spent most of 2021 explaining this burst of inflation without any mention of the role played by fiscal and monetary policies, economists such as Larry Summers and Jason Furman, who had advised earlier Democratic administrations, and Olivier Blanchard of the International Monetary Fund were sounding the alarm. As some of the best Keynesian economists out there, they recognized that the $1.9 trillion American Rescue Plan was excessive and would cause an excessive increase in aggregate demand, followed by inflation.

A series of new studies confirm the demand-side effects on inflation. The World Trade Organization’s chief economist Robert Koopman also estimates that increased demand for goods was a major factor behind supply chain issues, accounting for anywhere between two-thirds to three-quarters of supply shortages. In other words, there wouldn’t be “supply chain” problems without the massive increase in demand for durable goods fueled by government spending.

The government has been borrowing money for decades and the Fed has been buying Treasury securities and turning the debt into reserves for a decade without causing inflation. What was different this time around? First, Americans have seen for a decade or so prices rise in assets from housing to land to the stock market, but the increase didn’t spread to broader prices until now.

Second, as economist John Cochrane explains, the large money printing and deficit spending alongside the absence of discussion about paying down the debt once this crisis is over is what produced this inflation:

"Inflation comes when government debt increases, relative to people’s expectations of what the government will repay. If the Treasury borrows, but everyone understands it will later raise tax revenues or cut spending to repay the debt, that debt does not cause inflation. It is a good investment, and people are happy to hold on to it. If the Fed prints up a lot of money, buys Treasury debt, and the Treasury hands out the money, as happened, but everyone understands the Treasury will pay back the debt with future surpluses, the extra money causes no inflation. The Fed can always soak up the money by selling its Treasury securities, and the Treasury repays those securities with surpluses (i.e., taxes less spending)."

"The 2020–2021 borrowing and money episode was distinctive because, evidently, it came without a corresponding increase in expectations that the government would, someday, raise surpluses by $5 trillion in present value to repay the debt."

Most economists believe that the Fed has the tools to control inflation today by raising interest rates. However, one needs to face the fact that the amount of America’s debt may make fighting inflation harder than in the past. A few fiscal facts are important to bear in mind. Federal debt held by the public is now $23 trillion, or 100 percent of GDP, and a large share of that debt is short term (30 percent has a maturity of a year and over 60 percent a maturity of four years). Therefore, any increase in interest rates sufficient to fight inflation would quickly lead to large increase in interest payments.

In addition to being politically unpopular, if the additional interest payments are paid for with borrowed money rather than higher taxes, the borrowing may add fuel to the inflation fire. Cochrane explains:

"This consideration is especially relevant if the underlying cause of the inflation is fiscal policy. If we are having inflation because people don’t believe that the government can pay off the deficits it is running to send people checks, and it will not reform the looming larger entitlement promises, then people will not believe that the government can pay off an additional $1 trillion deficit to pay interest costs on the debt. In a fiscally driven inflation, it can happen that the central bank raises rates to fight inflation, which raises the deficit via interest costs, and thereby only makes inflation worse.”

Reform Ideas

First, the Fed needs to fully step back from its expansionary policy. It needs to raise interest rates significantly to tame inflation. With inflation at 7 percent, even the Fed’s promise to raise interest rates to about 2 percent leaves the real, after-inflation cost of borrowing at a stunning −5 percent. The rule of thumb is that to tame inflation, the Fed must raise nominal interest rates by more than the inflation rate, so that real interest rates rise. Current Fed policy will only achieve that goal if almost all of today’s inflation miraculously melts away on its own.

But Congress needs to do its part too. Without fiscal consolidation, the government’s interest costs on the debt will rise. Unless fiscal policy tightens to pay those interest costs, raising interest rates just makes deficit-induced inflation worse. As economist Eric Leeper states, “fiscal responses are fundamental, even indispensable to monetary policy impacts on inflation.” They are “the difference between a Brazilian-style interest rate and inflation spiral and a successful reigning [sic] in of inflation,” he adds.

Empirical work confirms that fiscal contraction is a key element to reducing persistent inflation. For instance, legislators implemented fiscal consolidation (by raising revenue—through progrowth tax and regulatory reforms that increased the tax base—decreasing spending, or both) during each of the four latest victories over inflation: in the late 1940s, after the 1980–1982 Recession, in the late 1980s, and in mid-1990s. Unfortunately, this link between fiscal and monetary expectations is too often overlooked in conventional inflation debates, with fiscal authorities acting as though inflation outcomes are independent of fiscal policy.

Also, higher real interest rates would increase household wealth through lower inflation (increasing the real value of wealth) and higher interest receipts (raising household income flows). Thus, although the central bank is aiming to lower inflation, its efforts could backfire by boosting demand for goods and services. Higher levels of debt work to amplify these (demand-driven) inflationary pressures if there are no plans for fiscal consolidation (e.g., tax hikes to offset the wealth effect).

Second, Congress needs to get its fiscal house in order above and beyond the need to tame inflation. Perpetual deficits and a looming entitlement crisis will increase the national debt and increase political pressure to finance this growing debt with inflation. The good news is everyone knows what types of fiscal adjustments are effective at reducing the US debt-to-GDP ratio. Alberto Alesina and others have shown that fiscal adjustment packages based on spending cuts—preferably reforms to programs that are the drivers of future debt: Social Security and Medicare—rather tax increases are the most effective way to reduce the debt. Such packages are also less likely to cause short-term recessions and, if they do cause short-term recessions, those recessions are mild and short, unlike those caused by adjustments based on tax increases.

Third, many of the long-term structural problems with the global supply chain are legislative, and Congress should fix them. Here are a few:

  • Eliminate the Jones Act (Merchant Marine Act of 1920).
  • Reform the Foreign Dredge Act, which requires that dredging barges comply with the Jones Act.
  • End punitive tariffs, duties, and quotas, which inflate costs and reduce the supply of goods that are essential for alleviating supply constraints.
  • Ease immigration restrictions.
  • End the ban on Mexican trucking companies’ operation on US roads.

These are some of the things that Congress can do specifically to alleviate some of the restrictions imposed on global supply chains.

Finally, there is a temptation to offset inflation with subsidies, to have the government borrow more money to help Americans pay for gas, housing, childcare, and more. Given that fiscal largesse is the source of the problem, and given that these efforts make the markets for these goods and services more inefficient, this approach threatens a greater stagnation spiral.