Turns the aff – increased inflation hamstrings otherwise certain SME recovery.

Inflation was not the result of a policy mistake–it was the inevitable result of mammoth global shocks and their long-lived–but dampening-ripples

In early 2021, debate raged about the potential economic effects of the American Rescue Plan (ARP). The ARP, passed in early 2021, was explicitly designed as fiscal stimulus, with large and front-loaded transfers to households as its centerpiece, along with substantial aid to state and local governments.3

It is worth remembering the macroeconomic situation at the time of this debate. Of the 22 million jobs lost due to the COVID-19 shock, barely half had been recovered by December 2020, leaving the economy more than ten million jobs below pre-recession levels. This was a larger jobs gap than we had at the trough of the Great Recession and financial crisis of 2008-2009.

Further, the recovery that had begun in May 2020 was flagging. Monthly job gains had been getting smaller and smaller since September of that year, and December 2020—the last month’s data informing the meat of the debate over the ARP—saw outright job losses again.

Hence, the decision to go for a large fiscal stimulus was very well founded in the evidence.

Some critics of the ARP worried about its potential effect on inflation, as it was argued that the ARP would push gross domestic product (GDP) well over the economy’s long-run potential to deliver, hence causing inflation. In this story, a positive “output gap” with actual GDP far exceeding the economy’s long-run potential should have appeared in the data. Yet both real GDP and estimates of potential GDP today sit almost exactly where pre-pandemic forecasts predicted they would be in 2023 – and these forecasts included no indication of inflation. If the economy is not trying to produce more than it is capable of relative to pre-pandemic forecasts, it is hard to see where the heat that is generating inflation is coming from.

Reasonable estimates of potential GDP that account for the damage done by the pandemic were also slightly below pre-pandemic trends, but the size of the resulting output gap was utterly unremarkable—totally in line with recent past episodes that saw larger and more sustained gaps without generating any inflation at all.

Another piece of evidence against this simple overheating view comes from international data. Inflation—even outside of food and energy prices—has clearly been global. Every single advanced economy has seen inflation accelerate relative to pre-COVID trends, and most of these countries have seen a large acceleration, whether or not they used large stimulus programs. Some have argued that this just means that every single other advanced country replicated the U.S. “mistake” of overheating their economies. But this would suggest that the extent of inflationary acceleration should be correlated with reductions in unemployment—for overheating to take hold, it must run through labor market tightening. Yet across countries, there is no correlation at all between the reduction in unemployment and the acceleration of inflation in recent years.

Finally, key aspects of the labor market show little conventional signs of heat. One of the most reliable empirical relationships in modern business cycles is that low and falling unemployment (i.e., an economy that is “heating up”) pushes up the share of corporate-sector income claimed by workers (rather than capital owners). Yet the labor share fell sharply and has remained depressed all through the recent inflationary surge.4

Shocks and ripples

If inflation was not driven by macroeconomic overheating, what’s the alternative account? Extreme sectoral shocks kicked off large—but steadily diminishing—ripple effects. In this “shocks and ripples” account, if shocks relent, then inflation will normalize—even if it will take some time.

The shocks are fairly obvious: The pandemic led to a historically sharp reallocation of spending away from face-to-face services and toward goods consumption and residential investment. Simultaneously, the pandemic introduced huge snarls in global supply chains that need to function smoothly to meet demand for goods and materials used in residential investment. These extreme shocks to both sectoral demand and supply was the spark to inflation in 2021. In 2022, the Russian invasion of Ukraine added another, more familiar shock to energy and food prices.

Proponents of the macroeconomic overheating view often refuse to acknowledge that sectoral shocks that lead to large changes in relative prices (i.e., prices for specific goods and services) can cause overall inflation. Their reasoning is that if, say, gas prices rise by 50 percent in a short period, then this should lead to a near-immediate reduction in demand for other goods and services that forces down their prices, leaving overall inflation unaffected. There’s some logic to this, but the time span in which this kind of countervailing demand reduction happens following sectoral price shocks is far longer than they think—measured in years, not months. In short, thinking that sectoral shocks can have profound implications for inflation is not a simple failure to understand macroeconomics. James Tobin, perhaps the greatest macroeconomist of his generation, wrote in 1972 that:

“dispersion is inflationary … the rate of wage inflation will depend not only on the overall dispersion of excess demands and supplies across markets but also on the particular markets where the excess supplies and demands happen to fall. An unlucky random drawing might put the excess demands in highly responsive markets and the excess supplies in especially unresponsive ones.”

Ripples that were surprising—but likely to decline without high interest rates

These sectoral shocks led to more persistent effects on inflation than many anticipated in part because of a key ripple effect—nominal wage growth accelerated noticeably in late 2021 and early 2022. This nominal wage acceleration did not provide the initial impetus to inflation—the pandemic and war shocks did that. Further, while nominal wage growth accelerated relative to pre-pandemic levels, it remained slower than overall inflation and so actually muffled rather than amplified the inflationary shock.

Essentially, the pandemic and war shocks to prices sent economic actors—firms, workers, and consumers—scrambling to protect their own real incomes from higher costs. As nonlabor costs rose due to pandemic and war shocks and pushed up prices, workers tried to protect their real (inflation-adjusted) incomes by demanding higher nominal wages. Firms in turn tried to keep their own profit margins intact or even to opportunistically raise them. This cascade of higher nominal wage demands and profit margin hikes intensified the inflationary effect of the initial shocks and made them more persistent.

Nominal wage acceleration did keep inflation higher than it would have been had wage growth not budged from its pre-pandemic pace. But even if nominal wage growth had not quickened at all, we still would have had a burst of inflation over the past two years. The reduced inflation that could have been “bought” by keeping unemployment higher and nominal wage growth lower in 2021 and 2022 would have been relatively small—and the price of this slightly slower inflation would have been even larger declines in real wages for working families than we have seen. In short, given the incredibly binding constraints put on the range of economic choices by the pandemic distortions and the Russian invasion of Ukraine, choosing to tolerate some inflation as the price of engineering a remarkably fast recovery was the right thing to do.

Inflation has been mostly a distributional challenge–sellers have done well

There are times when inflation really can be driven by most incomes in society rising at mostly the same pace. In this case, inflation is distributionally neutral, but there’s also no “real” cost. For example, if inflation accelerates from 0% to 4%, but nominal wage growth accelerates from 2% to 6%, real wages haven’t been harmed (they grow at 2% in either case). The inflation we have seen since 2021 has not been distributionally neutral. Prices and incomes for low-wage workers, middle-wage workers, high-wage workers, and profits have not moved in lockstep but have seen very different rates of growth.

Most striking is the role of corporate profits in starting and sustaining inflation since 2021. Figure A below shows one measure of profit “mark-ups” in the non-financial corporate (NFC) sector of the U.S. economy. We look at this sector because it has rich and timely data coverage. Mark-ups are essentially profits earned per unit of output divided by labor and non-labor costs.

When these profit markups rise, the result is increasing prices for consumers (inflation). The very large spike in the beginning quarters of the COVID-19 recovery is clear. Since then, mark-ups have come down a little, but remain extremely elevated relative to historic norms. Many (including me) had hoped these high mark-ups would relent sooner and provide more relief from too-high inflation by now, but it has not yet happened in a serious way.

Figure B shows the contribution of profits, labor costs, and nonlabor costs to growth in NFC prices between the beginning of the COVID-19 recovery (the second quarter of 2020) and the end of 2022. Measuring since the last business cycle peak (the fourth quarter of 2019) does not change this story radically.

In normal times, corporate profits contribute about 13% to prices. Between the second quarter of 2020 and the end of 2022, they have instead contributed more than a third of price growth, or more than twice as much as they normally do. This contribution was larger in previous quarters, which means the slight decline in mark-ups shown in Figure A has put a small bit of welcome downward pressure on inflation in recent quarters. But there remains a long way to go before profits are back to normal, and this profit normalization drive even more disinflation.

Have small businesses also been able to increase their profit margins due to pandemic and war distortions?

Much of the income earned by small businesses is classified as “proprietors’ income” in by the National Income and Product Accounts (NIPAs)–the statistical backbone of the U.S. economy. Before looking at aggregate trends in this measure, it is vital to note that many firms that get classified as small businesses or included in proprietors’ income are actually extraordinarily privileged and rich enterprises.

For example, as Smith, Yagan, Zidar and Zwick (2020) note–“More than 69 percent of the top 1 percent of income earners – and more than 84 percent of the top 0.1 percent of income earners accrued some pass-through business income in 2014, the most recent year for which complete data are available.”5 Pass-through income is essentially all business income earned by entities that are not traditional C-corporations (ie, corporations that pay federal taxes at the enterprise level). Further, these same authors estimate that half of the post-1979 doubling of the share of total national income claimed by the top 1 percent can be accounted for by rising pass-through business income. In short, small businesses are an even more-varied and unequal set of economic actors than any other in the U.S. economy.

In the aggregate, proprietors’ income has lagged overall domestic income growth since the last business cycle peak in the last quarter of 2019 – growing at a 4.6% annualized rate in nominal terms compared to over 5.6% for overall domestic income. But, proprietors’ income growth lagged even worse in the last 2 years before pandemic – growing at just an annualized rate of 3.2% between 2017 and 2019, compared to 4.5% growth in overall domestic income. In short, there is little evidence that any economic development – inflation or anything else – has severely affected the relative performance of the sector that small business incomes appear in since 2020.

Many genuine small businesses surely find themselves facing rising input cost pressures. The huge increases in corporate prices, however, should have given many of these smaller businesses some elbow room to raise their own prices to deal with some of these more expensive input costs. In cases where small businesses work as suppliers for larger corporations, and these corporations have held the line on what they will pay their suppliers, this is obviously a huge source of pressure for the smaller businesses – but its root cause is the asymmetry in market power, not inflation per se. This asymmetry in market power that allows “lead firms” to pressure their own suppliers and starve them of opportunities is a real problem in the U.S. economy in recent decades.6 It should be met primarily with enhanced anti-trust efforts that put market power in labor markets and supplier markets on the same footing as power in product markets. The Biden administration’s Federal Trade Commission (FTC) and the Anti-Trust division of the Department of Justice have made admirable steps in this regard.

There is no labor shortage

There has been a consistent complaint by business over the course of the recovery over labor shortages. For short periods in some sectors since the recovery from the COVID-19 recession began, there did indeed seem to be some labor shortages which were relatively quickly alleviated by raising wages. But by now, there is no evidence at all of any economy-wide labor shortage relative to pre-pandemic trends. The level of employment and the labor force participation rate are higher than what the CBO projected in February 2021, before the American Rescue Plan took effect. Further, these are both higher than what the CBO projected in early 2020, before the Covid pandemic.

The number of prime-age adults (those between 25 and 54) working is not only higher than 2019 levels, it is the highest it has been since 2001. Black workers, in particular, have had historically high levels of employment in the recovery, a testament to the broad nature of this recovery. In recent months, for the first time in recorded history, the overall employment to population ratio for the Black population exceeded that of the white population. Much of this crossover was driven by differential aging trends (the white population is getting older faster and relatively more of them are crossing over retirement), but much of it is the natural tightening of racial gaps in employment that occur when the labor market is in good health.7

There is work that we could certainly to do to expand labor supply even further and beat past trends by supporting workers and by extension small businesses. The most obvious plank of a progressive labor supply policy that would yield big results would be a robust public investment in child care. By making high-quality childcare more affordable, we would reliably boost the labor supply of young parents–particularly women.8

Risks to robust recovery–and small businesses–from attacking inflation with the wrong policy tools

If one sees inflation as ipso facto evidence that the economy has a macroeconomic excess of demand over productive capacity, and one sees this productive capacity as relatively fixed in the short-run, the obvious policy corollary is to tamp down demand–either through contractionary fiscal or monetary policy. But if one instead sees the inflation over the past 2 years as a set of long-lived ripples stemming large pandemic and war shocks, then one would expect inflation to normalize even without sharply contractionary policy.

In recent months there has been a sharp decline in the pace of nominal wage growth even as unemployment has remained low. Further, home price declines from early and mid-2022 are just now showing up in official inflation data. In short, there is substantial reason to expect a normalization of inflation in the coming months even if we manage to keep the unemployment rate very low.

This scenario where inflation normalizes without a recession–the “soft landing”–is by far the best one for small businesses and nearly every other actor in the U.S. economy. The necessary condition for success in business–whether small or large–is a steady stream of customers. These customers will dry up if contractionary policy takes hold.

Inflation has been key challenge to the U.S. economy and its small businesses in recent years, but it remains the case that many proposed cures for this inflation would do more harm than the malady itself. Further, given the many promising signs on disinflation coming down the pike, risking a recession now by calling for ever more-contractionary monetary and fiscal policy would be akin to snatching defeat from the jaws of victory.