Category: Macroeconomics

The U.S. Dollar in the World Economy

The U.S. dollar is the most important currency in the world economy. The funds that governments and central banks hold to carry out international transactions are called their official foreign exchange reserves. (See Macroeconomics, Chapter 18, Section 18.1 and Economics, Chapter 28, Section 28.1.) There are 180 national currencies in the world and foreign exchange reserves can be held in any of them. In practice, international transactions are conducted in only a few currencies. Because the U.S. dollar is used most frequently in international transactions, the majority of foreign exchange reserves are held in U.S. dollars. The following figure shows the composition of official foreign exchange reserves by currency as of mid-2021.

Over time, the percentage of foreign exchange reserves in U.S. dollars has been gradually declining, although the dollar seems likely to remain the dominant foreign reserve currency for a considerable period. Does the United States gain an advantage from being the most important foreign reserve currency? Economists and policymakers are divided in their views. At the most basic level, dollars are claims on U.S. goods and services and U.S. financial assets. When foreign governments, banks, corporations, and investors hold U.S. dollars rather than spending them, they are, in effect, providing the United States with interest-free loans. U.S. households and firms also benefit from often being able to use U.S. currency around the world when buying and selling goods and services and when borrowing, rather than first having to exchange dollars for other currencies.

But there are also disadvantages to the dollar being the dominant reserve currency. Because the dollar plays this role, the demand for the dollar is higher than it would otherwise be, which increases the exchange rate between the dollar and other currencies. If the dollar lost its status as the key foreign reserve currency, the exchange rate might decline by as much as 30 percent. A decline in the value of the dollar by that much would substantially increase exports of U.S. goods. Barry Eichengreen of the University of California, Berkeley, has noted that the result might be “a shift in the composition of what America exports from Treasury [bonds and other financial securities] … toward John Deere earthmoving equipment, Boeing Dreamliners, and—who knows—maybe even motor vehicles and parts.”

As shown in the following figure, the importance of the U.S. dollar in the world economy is also indicated by the sharp increase in the demand for dollars and, therefore, in the exchange rate during the financial crisis in the fall of 2008 and during the spread of Covid-19 in the spring of 2020. (The exchange rate in the figure is a weighted average of the exchange rates between the dollar and the currencies of the major trading partners of the United States.) As an article in the Economist put it: “Last March, when suddenly the priority was to have cash, the cash that people wanted was dollars.”

Sources: International Monetary Fund, “Currency Composition of Official Foreign Exchange Reserves,” data.imf.org; Alina Iancu, Neil Meads, Martin Mühleisen, and Yiqun Wu, “Glaciers of Global Finance: The Currency Composition of Central Banks’ Reserve Holdings,” blogs.imf.org, December 16, 2020; Barry Eichengreen, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System, New York: Oxford University Press, 2001, p. 173; “How America’s Blockbuster Stimulus Affects the Dollar,” economist.com, March 13, 2021; and Federal Reserve Bank of St. Louis. 

The Case of the Missing Highways

In November 2021, Congress passed and President Joe Biden signed the trillion dollar Infrastructure Investment and Jobs Act, often referred to as the Bipartisan Infrastructure Bill (BIF). The bill included funds for:

  • Highways and bridges
  • Buses, subways, and other mass transit systems
  • Amtrak, the federally sponsored corporation that provides most intercity railroad service in the United States, to modernize and expand its service
  • A network of charging stations for electric cars
  • Maintenance and modernization of ports and airports
  • Securing infrastructure against cyberattacks and climate change
  • Increasing access to clean drinking water
  • Expansion of broadband internet, particularly in rural areas
  • Treating soil and groundwater pollution

As with other infrastructure bills, although the federal government provides funding, much of the actual work—and some of the funding—is the responsibility of state and local governments. For instance, nearly all highway construction in the United States is carried out by state highway or transportation departments. These state government agencies design new highways and bridges and contract primarily with private construction firms to do the work.

Because state and local governments carry out most highway and bridge construction, Congress doesn’t always achieve the results they intended when providing the funding.  Bill Dupor, an economist at the Federal Reserve Bank of St. Louis, has discovered a striking example of this outcome. In 2009, in response to the Great Recession of 2007–2009, Congress passed and President Barack Obama signed the American Recovery and Reinvestment Act (ARRA). (We discuss the ARRA in Macroeconomics, Chapter 16, Section 16.5 and Economics, Chapter 26, Section 26.5.) Included in the act was $27.5 billion in new spending on highways. This amount represented a 76 percent increase on previous levels of  federal spending on highways. As Dupor puts it, Congress and the president had “great hopes for the potential of these new grants to create and save construction jobs as well as improve highways.”

Surprisingly, though, Dupor’s analysis of data on the condition of bridges, on miles of highways constructed, and on the number of workers employed in highway construction shows that the billions of dollars Congress directed to infrastructure spending under ARRA had little effect on the nation’s highways and bridges and did not increase employment on highway construction.

What happened to the $27.5 billion Congress had appropriated? Dupor concludes that after receiving the federal funds most state governments:”cut their own contributions to highway capital spending which, in turn, … [freed] up those funds for other uses. Since states were facing budget stress from declining tax revenues resulting from the recession, it stands to reason that states had the incentive to do so.”

He finds that following passage of ARRA many states cut their spending on highway infrastructure while at the same time increasing their spending on other things. For instance, Maryland cut its spending on highways by $73 per person while increasing its spending on education by $129 per person. 

Can we conclude that that Congressional infrastructure spending under ARRA was a failure and the funds were wasted? To answer this question, first keep in mind that when it authorizes an increase in infrastructure spending, Congress often has two goals in mind:

  1. To maintain and expand the country’s infrastructure
  2. To engage in countercyclical fiscal policy

The first goal is obvious but the second can be important as well. Typically, Congress is most likely to authorize a large increase in infrastructure spending during a recession. When the ARRA was passed in the spring of 2009, Congress and President Obama were clear that they hoped that the increased spending authorized in the bill would reduce unemployment from the very high levels at that time.  (Economists and policymakers debated whether additional countercyclical fiscal policy was needed at the time Congress passed the BIF in late 2021. Although the Biden administration argued that the spending was needed to increase employment, some economists argued that the BIF did little to deal with the supply problems then plaguing the economy.)

We discuss in Macroeconomics, Chapter 16, Section 16.2 (Economics, Chapter 26, Section 26.2), how expansionary fiscal policy can increase real GDP and employment during a recession. If Dupor’s analysis is correct, Congress failed to achieve its first goal of improving the country’s infrastructure. But Dupor’s findings that states, in effect, used the federal infrastructure funds for other types of spending, such as on education, means that Congress did meet its second goal. That conclusion holds if in the absence of receiving the $27.5 billion in funds from ARRA, state governments would have had to cut their spending elsewhere, which would have reduced overall government expenditures and reduced aggregate demand. 

As this discussion indicates, the details of how fiscal policy affects the economy can be complex. 

Sources: Gabriel T. Rubin and Eliza Collins, “What’s in the Bipartisan Infrastructure Bill? From Amtrak to Roads to Water Systems,” wsj.com, November 6, 2021; Bill Dupor, “So Why Didn’t the 2009 Recovery Act Improve the Nation’s Highways and Bridges?” Federal Reserve Bank of St. Louis Review, Vol. 99, No. 2, Second Quarter 2017, pp. 169-182; Greg Ip, “President Biden’s Economic Agenda Wasn’t Designed for Shortages and Inflation,” wsj.com, November 10, 2021; and Executive Office of the President, “Updated Fact Sheet: Bipartisan Infrastructure Investment and Jobs Act,” whitehouse.gov, August 2, 2021. 

What’s Next for China?

Xi Jinping

When Deng Xiaoping assumed control of China following the death of Mao Zedong in 1976, he was in charge of one of the poorest countries in the world. The average person in China survived on the equivalent of $3 per day and the bulk of the population worked on government-run collective farms. Deng’s response to this dismal situation was a series of economic reforms that led China away from Mao’s socialist regime toward a free market economy. The results have been spectacular.

Since 1978, when Deng’s reforms began, real GDP per capita in China has increased from $381 (in 2010 prices) to $10,431 in 2020. Today, China is a solidly middle-income country on a par with Mexico or Indonesia. According to World Bank data, in 1981 more than 875 million people in China lived in extreme poverty. By 2019, fewer than 1 million did. The world has never seen such a high economic growth rate sustained over such a long period or as dramatic a reduction in poverty in such a short period. Deng brought about an increase in the material well-being of his people unrivaled in history.

But, as we discuss in the Apply the Concept in Section 11.5 of Chapter 11 in Macroeconomics (Section 21.5 in Chapter 21 of Economics), despite Deng’s success he failed to resolve a conflict at the heart of the Chinese system:  Deng and the other party leaders saw their economic reforms as strengthening socialism and not as replacing socialism with capitalism. They had no intention of undermining the role of the Communist Party in Chinese society or of introducing democracy. The result is the peculiar situation China now finds itself in under current leader Xi Jinping: A country that extensively relies on free markets ruled by an autocratic regime that justifies its dictatorship as necessary for the preservation of socialism.

In 2022, at the 20th Congress of the Chinese Communist Party, Xi seems likely to be elected to a third term as leader of the Communist Party, breaking with the tradition since Deng of leaders serving only two terms. Like Mao, Xi’s apparent intention is to retain his office indefinitely. Xi’s speeches indicate that he believes that China is following a path like the one that Karl Marx, writing in the 1800s, believed countries would follow, which would culminate in a socialist economy. He sees Mao as having reasserted China’s independence from Europe and the United States, although at his death China remained largely rural and agricultural with very little scope for market activity. Deng continued the evolution of the economy by establishing a market system that raised incomes and allowed for industrial development. Xi sees himself as finishing the process by leading China to become a “modern socialist nation” by 2035.

As we discuss in the Apply the Concept, there are a number of obstacles to China’s continued economic growth, obstacles that appear to have increased during 2021 as Xi’s plans have become clearer.

  1. As part of his plan to transition China to being a socialist nation, Xi has increased government regulation of China’s economy. He has imposed large fines on technology firms such as Alibaba and Tencent and on the ride-hailing firm Didi. A government proclamation effectively ended the for-profit school tutoring industry, which seven of ten Chinese students had been using. This government action raised concern among the owners of some small and medium-sized businesses that their investments in their firms could be wiped out arbitrarily without notice. Wealthy Chinese entrepreneurs were also being pressured to devote more funds to charity. Whether increased government regulation will result in entrepreneurs pulling back from the investment needed to sustain economic growth remains to be seen. 
  2. Over the decades since market reforms began, the Chinese economy had been cutting reliance on production by state-owned enterprises (SOEs) in favor of production by private firms. Recently, some observers have concluded that Xi plans to increase the share of the economy controlled by SOEs, although his public statements have emphasized the need for SOEs to become more efficient and for the government to reduce its subsidies to these firms. Many of China’s trading partners, including the United States, have objected to these subsidies. If the importance of SOEs in the Chinese economy should increase, it would likely further slow economic growth and increase the frictions between China and its trading partners. 
  3. Economic growth has been slowing down. Between 1978 and 2011, per capita real GDP grew at an annual average rate of 8.9 percent. Between 2012 and 2020 that growth rate slowed to 6.0 percent. Although compared with most other countries, a 6 percent growth rate is quite high, some economists believe that the Chinese government has been overstating the true growth rate. As an article in the Wall Street Journal put it, “real growth has long been one of the ways officials are evaluated in China, and so there is a strong incentive to inflate it—and substantial evidence that has happened.”
  4. China’s population is rapidly aging. Its birthrate of 1.3 children born per woman during her lifetime is well below the rate of 2.1 needed to maintain the population. The working age population has been declining since 2011, as the fraction of the population over 65 has been increasing. Although the populations of Europe, the United States, and other high-income countries have also been aging, those countries have more resources than does China to provide support to retired people, as with the Social Security and Medicare programs in the United States. Because China’s average retirement age is only 54, while its average life expectancy is 77 years, an increasing number of retirees is being supported by a decreasing number of workers. The Chinese government has announced plans to raise the official retirement age but the government has abandoned past attempts to do so in the face of public protests.
  5. The economy’s excessive reliance on investment in real estate. Particularly during the past five years, real estate investment has been an important contributor to the growth of the Chinese economy, accounting for as much as 25 percent of GDP (as opposed to only about 7 percent in the United States). But the difficulties that the Evergrande real estate development firm encountered during 2021 seemed to be an indication that what has been the largest real estate boom in history may be ending. In some cities as many as 40 percent of apartments are empty, making it difficult for Evergrande and other developers to make the interest payments on their loans and bonds. The Chinese government has issued regulations that limit borrowing by real estate developers in an attempt to reduce what the government sees as speculative building of apartments. Whether the government can reduce the importance of real investment in the economy without causing a significant reduction in the economy’s growth rate is uncertain. 
  6. Increasing political problems with other countries. The Chinese government has drawn sharp international criticism for a number of actions: Its repression of the more than one million members of a Muslim minority in western China; its ending the political independence of Hong Kong; the expansion of its military and its threatening actions towards Taiwan (which the Chinese government believes is part of China); and its failure to be forthcoming with information about the origins of the Covid-19 virus. An additional source of disagreements with other governments has been disputes over international trade. Both the Trump and Biden administrations, as well as governments in Europe, have been critical of the Chinese government forcing foreign firms that operate in China to transfer intellectual property to Chinese firms, an action that is in violation of the World Trade Organization’s (WTO) rules. The growth of Chinese exports has been greatly helped by China’s membership in the WTO, which may be threatened by what other governments see as China’s violations of WTO rules.

The actions that Xi Jinping takes in the coming years are likely to have a large effect on not just the Chinese economy, but on the world economy. 

Sources: Stella Yifan Xie, “China’s Economy Faces Risk of Yearslong Real-Estate Hangover,” wsj.com, November 8, 2021; “Xi Jinping Is Rewriting History to Justify His Rule for Years to Come,” economist.com, November 6, 2021; Sofia Horta e Costa, “Chinese Developer Controlled by Government Is Latest to Plunge,” bloomberg.com, November 8, 2021; Kevin Rudd, “What Explains Xi’s Pivot to the State?” wsj.com, September 19, 2021; “At 54, China’s Average Retirement Age Is Too Low,” economist.com, June 26, 2021; Nathaniel Taplin, “China’s Economic Data: A Guide for the Dazed and Confused,” wsj.com, January 4, 2021; Stella Yifan Xie and Mike Bird, “The $52 Trillion Bubble: China Grapples With Epic Property Boom,” wsj.com, July 16, 2020; the World Bank; and the Federal Reserve Bank of St. Louis.

The Congressional Budget Office’s Changing Forecasts of U.S. Economic Growth

There are many macroeconomic forecasts. Some forecasts are made by private economists, including those who work for Wall Street Investment firms. Other forecasts are made by economists who work for the government. Perhaps the most widely used macroeconomic forecasts are those published by economists who work for the Congressional Budget Office (CBO). The CBO is a nonpartisan agency within the federal government that provides estimates of the economic effects of government policies as part of the process by which Congress prepares the federal budget. One important aspect of the CBO’s work is to estimate future federal government budget deficits.

To forecast the size of future deficits, the CBO needs to forecast growth in key macroeconomic variables, including GDP. Faster growth in the U.S. economy should result in faster growth in federal tax revenues and slower growth in federal government transfer payments, including payments the federal government makes under the unemployment insurance system, the Temporary Assistance for Needy Families program, and the Supplemental Nutrition Assistance Program. When revenues grow faster than expenditures, the federal budget deficit shrinks.

The CBO’s forecasts of potential GDP provide perhaps the most best known projections of the future economic growth of the U.S. economy. The CBO calculates its forecasts of potential GDP by forecasting the variables that potential GDP depends on. As we’ve seen in Macroeconomics, Chapters 10 (Economics, Chapters 20), the two key variables in determining the growth in real GDP are the growth in labor productivity—the ratio of real GDP to the quantity of labor—and the growth of the labor force.

How well has the CBO forecast future U.S. economic growth? Or, equivalently, how well has the CBO forecast potential GDP. Each year the CBO publishes forecasts of potential GDP for the following 10 years and for longer periods—typically 40 or 50 years. Claudia Sahm, an economic consultant and opinion writer and formerly an economist at the Federal Reserve and the White House, has noted that the CBO’s 10-year forecasts of potential GDP have not been good forecasts of the actual growth of real GDP. Over the past 15 years, the CBO has also carried out surprisingly large downward revisions of its forecasts of potential GDP.

The figure below is similar to one prepared by Sahm and shows the forecasts of potential GDP the CBO published in 2005, 2010, 2015, and 2020 for the following 10 years. (For Sahm’s Twitter thread discussing her figure, click HERE.) That is, in 2005, the CBO issued a forecast of potential GDP for the years 2005–2015. In 2010, the CBO issued a forecast of potential GDP for the years 2010–2020, and so on. Note that for ease of comparison, all GDP values in the figure are set equal to a value of 100 in 2005.

Each straight line on the chart represents the CBO’s forecast of potential GDP over the 10 years following the year in which the forecast was published. For example, the top blue line represents the forecasts the CBO made in 2005 of the values of potential GDP for the years 2005 to 2015. The bottom blue line shows the actual values of real GDP for the years from 2005 to 2020. Note how at each five year interval, the CBO’s forecasts of potential GDP shifted down.

We can look at a few examples of how far off the CBO’s projections were. For instance, if the economy had grown as rapidly between 2005 and 2015 as the CBO forecast it would in 2005, real GDP would have been about 15 percent higher than it actually was. In other words, the U.S. economy would have produced about $2.5 trillion more in goods and services than it actually did. Similarly, if the economy had grown as rapidly between 2010 and 2019 as the CBO forecast it would in 2010, real GDP in 2019 would have been about 7.5 percent (or about $1.5 trillion) higher than it actually was. 

Why has the CBO persistently overestimated the future growth rate of the U.S. economy? The main source of error has been the CBO’s overestimation of the growth in labor force productivity. They have also slightly overestimated the growth of the labor force. Claudia Sahm has a more basic criticism of the CBO’s approach to estimating potential GDP. She argues that if real GDP grows slowly during a period, perhaps because monetary and fiscal policies are insufficiently expansionary, the CBO will incorporate the lower actual real GDP values when it updates its forecasts of potential GDP. This approach can raise questions as to whether the CBO is actually measuring potential GDP as most economist’s define it (and as we define it in the textbook): The level real GDP attains when all firms are producing at capacity. Other economists share these concerns. For instance, Daan Struyven, Jan Hatzius, and Sid Bhushan of the Goldman Sachs investment bank, argue that the CBO’s estimate of potential GDP understates the true capacity of the U.S. economy by 3 to 4 percent.

The CBO’s substantial adjustments to its forecasts of potential GDP are another indication of how volatile the U.S. economy has been since the beginning of the 2007–2009 recession.

Sources:  Tyler Powell, Louise Sheiner, and David Wessel, “What Is Potential GDP, and Why Is It So Controversial Right Now,” brookings.edu, February 22, 2021; and Congressional Budget Office, “Budget and Economic Data,” various years. 

We Will Never See Anything Like It Again: Movements in Real GDP during the Covid-19 Recession

There are a number of ways in which the Covid-19 pandemic was unlike anything the United States has experienced since the 1918 influenza pandemic. Most striking from an economic perspective were the extraordinary swings in real GDP. The following figure shows quarterly changes in real GDP seasonally adjusted and calculated at an annual rate. There were three recessions during this period (shown by the shaded areas).

The first of these recessions occurred during 2001 and was similar to most recessions in the United States since 1950 in being short and relatively mild. Real GDP declined by 1.5 percent during the third quarter of 2001. The recession of 2007–2009 was the most severe to that point since the Great Depression of the 1930s. The worst periods of the 2007–2009 were the fourth quarter of 2008, when real GDP declined by 8.5 percent—the largest decline to that point during any quarter since 1960—and the first quarter of 2009, when real GDP declined by 4.6 percent. 

Turning to the 2020 recession, during the first quarter of 2020, only at the end of which did Covid-19 begin to seriously affect the U.S. economy, real GDP declined by 5.1 percent. Then in the second quarter a collapse in production occurred unlike anything previously experienced in the United States over such a short period: Real GDP declined by 31.2 percent. But that collapse was followed in the next quarter by an extraordinary recovery in production when real GDP increased by 33.8 percent—by far the largest increase in a single quarter in U.S. history.

The following figure shows the changes in the components of real GDP during the second and third quarters of 2020. In the second quarter of 2020, consumption spending declined by about the same percentage as GDP, but investment spending declined by more, as many residential and commercial construction projects were closed. Exports declined by nearly 60 percent and imports declined by nearly as much as many ports were temporarily closed. In the third quarter of 2020, many state and local governments relaxed their restrictions on business operations and the components of spending bounced back, although they remained below their levels of late 2019 until mid-2021. 

Even when compared with the Great Depression of the 1930s, the movements in real GDP during the Covid-19 pandemic stand out for the size of the fluctuations. The official U.S. Bureau of Economic Analysis data on real GDP are available only annually for the 1930s. The following figure shows the changes in these annual data for the years 1929 to 1939. As severe as the Great Depression was, in 1932, the worst year of the downturn, real GDP declined by less than 13 percent—or only about a third as much as real GDP declined during the worst of the 2020 recession.

We have to hope that we will never again experience a pandemic as severe as the Covid-19 pandemic or fluctuations in the economy as severe as those of 2020.

Source: U.S. Bureau of Economic Analysis. Note: Because the BEA doesn’t provide an estimate of real GDP in 1928, our value for the change in real GDP during 1929 is the percentage change in real GDP per capita from 1928 to 1929 using the data on real GDP per capita compiled by Robert J. Barro and José F. Ursúa. LINK

Is the U.S. Economy Heading “Back to the ‘60s”?

A recent publication by economists Regis Barnichon, Luiz E. Oliveira, and Adam H. Shapiro at the Federal Reserve Bank of San Francisco asks that provocative question. “The ‘60s” is a reference to the events that led to the U.S. economy experiencing more than 10 years of high inflation rates. Below is a graph similar to Chapter 15, Figure 15.1 in Macroeconomics (Economics, Chapter 25, Figure 25.1) that shows the inflation rate in the United States as measured by the percentage change in the Consumer Price Index (CPI) for each year since 1952. Economists call the years from 1968 though 1982 the “Great Inflation” because inflation was greater during that period than during any other period in the history of the United States.

As we discuss in Macroeconomics, Chapter 17, Section 17.2 (Economics, Chapter 27, Section 27.2), many economists believe that the Great Inflation began as a result of the Federal Reserve attempting to keep the unemployment rate below the natural rate of unemployment for a period of several years. As predicted by the Phillips Curve, the inflation rate increased and, as Milton Friedman and Edmund Phelps had argued would likely happen, the expected inflation rate eventually increased. The inflation was made worse during the 1970s by two supply shocks resulting from sharp increases in oil prices.

Is the United States on the edge of repeating the experience of the Great Inflation? Earlier this year, Olivier Blanchard of the Peterson Institute for International Economics wrote a paper arguing that the U.S. economy was at significant risk of experiencing a significant acceleration in inflation. His paper included a figure similar to the one below showing the combinations of inflation and unemployment during each year of the 1960s. The figure shows a substantial acceleration in inflation over the course of the decade.

Blanchard notes that: 

“The history of the Phillips curve is one of shifts, largely due to the adjustment of expectations of inflation to actual inflation. True, expectations have [currently] been extremely sticky for a long time, apparently not reacting to movements in actual inflation. But, with such overheating, expectations might well deanchor. If they do, the increase in inflation could be much stronger.” 

….

“If inflation were to take off, there would be two scenarios: one in which the Fed would let inflation increase, perhaps substantially, and another—more likely—in which the Fed would tighten monetary policy, perhaps again substantially. Neither of these two scenarios is ideal. In the first, inflation expectations would likely become deanchored, cancelling one of the major accomplishments of monetary policy in the last 20 years and making monetary policy more difficult to use in the future. In the second, the increase in interest rates might have to be very large, leading to problems in financial markets.”

The authors of the San Francisco Fed publication are more optimistic. They begin their discussion by observing that because of the pandemic, the state of the labor market is more difficult to assess than in most years. They note that the unemployment rate of 4.8 percent in September 2021 was only slightly below the average unemployment rate over the past 30 years and well above the low unemployment rates of 2019 and early 2021. So, on the basis of the unemployment rate, policymakers at the Fed and in Congress might conclude that the inflation the U.S. economy is experiencing is not the result of overly tight labor markets such as those of the late 1960s. But the job openings rate(sometimes called the vacancy rate) is telling a different story. Job openings are positions that are both available to be filled within the next 30 days and for which firms are actively recruiting applicants from outside the firm. (According to the BLS: “The job openings rate is computed by dividing the number of job openings by the sum of employment and job openings and multiplying that quotient by 100.”)

The authors of the San Francisco Fed study note that “the vacancy rate is well above its 30-year average … and has surpassed its historic highs from the late 1960s … indicating that employers are having a difficult time filling positions. Confirming this high vacancy rate, the fraction of small businesses reporting that job openings are hard to fill is at historic highs ….” The figures below show the vacancy rate and the unemployment rate since January 2016.

The authors combine the unemployment rate and the vacancy rate into a statistic—the vacancy-to-unemployment ratio—that they demonstrate has historically done a better job of explaining movements in inflation than has the unemployment rate.  They expect that expansionary fiscal policy will result in an increase in vacancy-to-unemployment ratio and, therefore, an increase in the inflation rate. But they share the view of Blanchard and many other economists that a key issue is “the stability of longer-run inflation expectations.” 

We know that in the 1960s, several years of rising inflation made long-run inflation expectations unstable—in terms of the discussion in Chapter 17, the short-run Phillips curve shifted up. We don’t yet know what will happen to inflation expectations in late 2021 and in 2022, so we can’t yet tell how persistent current rates of inflation will be. 

Sources: Regis Barnichon, Luiz E. Oliveira, and Adam H. Shapiro, “Is the American Rescue Plan Taking Us Back to the ’60s?,” FRBSF Economic Letter, No. 2021-27, October 18, 2021; Olivier Blanchard, “In Defense of Concerns over the $1.9 Trillion relief Plan,” piie.com, February 18, 2021; and Federal Reserve Bank of St. Louis.

Elkhart County, Indiana Rides the Surge in Spending on Consumer Durables

More than 80 percent of the recreational vehicles (RV) sold in the United States are manufactured in Elkhart County, Indiana. As we discuss in the opener to Chapter 22 in Economics (Chapter 12 in Macroeconomics), being dependent on sales of expensive durable goods like RVs means that the county is particularly vulnerable to the business cycle, with local firms experiencing rising sales during economic expansions and sharply falling sales during economic recessions. Accordingly, the unemployment rate in the county fluctuates much more during the business cycle than is typical—as shown in the above graph.

For example, during the Great Recession of 2007-2009, the unemployment rate in the country rose from a low of 3.9 percent in May 2007 to a high of 20 percent in March 2009, before declining during the following economic recovery.  Just before the start of the Covid-19 recession of 2020, the unemployment rate in Elkhart was 2.8 percent. It then soared to 30.8 percent in April. 

But, as we discuss in the chapter, the recovery from the 2020 recession was unusually rapid, although uneven. Many services industries, such as restaurants, gyms, and movie theaters continued to struggle well into 2021 as firms had difficulty attracting workers and as some consumers remained reluctant to spend time inside in close contact with other people. In contrast, consumer spending on durable goods was far above its pre-pandemic level, as well as being above the rate at which it had been growing during the years before the pandemic. The two graphs below show real consumer spending on durables and on services up through August 2021.

During 2021, sales of RVs through August were 50 percent higher than in the same period in 2020 and were on a pace to reach record annual sales. The success of the RV industry has led to rising incomes in Elkhart County, which, in turn, has allowed the area to attract other industries, including a logistics center that when completed will be the largest industrial building in Indiana and an Amazon warehouse that when completed will provide 1,000 new jobs. Rising incomes have also supported other businesses, such as community theaters, art galleries, and a recently reopened 1920s-era hotel.

In October 2021, the Wall Street Journal ranked Elkhart County first in its rating of metropolitan areas as measured by the index it compiles with realtor.com. The index “identifies the top metro areas for home buyers seeking an appreciating housing market and appealing lifestyle amenities.” If consumers continue to buy more goods and fewer services, it could be bad news for restaurants and other service industries, but good news for places like Elkhart that depend on goods-producing industries. 

Sources: Nicole Friedman, “RV Capital of America Tops WSJ/Realtor.com Housing Index in Third Quarter,” wsj.com, October 19, 2021; Business Wire, “Amazon Announces New Robotics Fulfillment Center and Delivery Station in Elkhart County, Creating More Than 1,000 New, Full-Time Jobs,” businesswire.com, October 7, 2021; Construction Review Online, “Hotel Elkhart Grand Opening Celebrated in Elkhart, Indiana,” constructionreviewonline.com, October 4, 2021; Construction Review Online, “Elkhart County Logistics Facility to Bring about 1,000 jobs in Indiana,” constructionreviewonline.com, August 16, 2021; Federal Reserve Bank of St. Louis; and RV Industry Association.

WeWork Gets SPAC’d

In 2021, SPACs were the hottest trend on the stock market and had become the leading way for companies to go public. A public company is one with shares that trade on the stock market. Private firms make up more than 95 percent of all firms in the United States. Most will never become public firms because they will never grow large enough for investors to have sufficient information on the firms’ financial health to be willing to buy the firms’ stocks and bonds.

But some firms, particularly technology firms, grow rapidly enough that they are able to become public firms. Apple, Microsoft, Google, Uber, Facebook, Snap, and other firms have followed this path. When these firms went public, they did so using an initial public offering (IPO). (We briefly discuss IPOs in Economics and Microeconomics, Chapter 8, Section 8.2 and in Macroeconomics, Chapter 6, Section 6.2.) With an IPO, a firm uses one or more investment banks to underwrite the firm’s sales of new stocks or bonds to the public. In underwriting,investment banks typically guarantee a price for stocks or bonds to the issuing firm, sell the stocks or bonds in financial markets or directly to investors at a higher price, and keep the difference, known as the spread.

Beginning in 2020 and continuing through 2021, an increasing number of firms have used a different means of going public—merging with a SPAC. SPAC stands for special-purpose acquisition company and is a firm that holds only cash—it doesn’t sell a good or service—and only has the purpose of merging with another firm that wants to go public. Once a merger takes place, the acquired firm takes the place of the SPAC in the stock market. For instance, a SPAC named Diamond Eagle Acquisition merged with online sports betting site DraftKings in April 2020. Once the merger had been completed, DraftKings took Diamond Eagle’s place on the stock market, trading under the stock symbol DKNG. By 2021, the value of SPAC mergers had risen to being three times as much as the value of IPOs.

Some firms intending to go public prefer SPACs to traditional IPOs because they can bargain directly with the managers of the SPAC in determining the value of the firm. In addition, IPOs are closely regulated by the federal government’s Securities and Exchange Commission (SEC). In particular, the SEC monitors whether an investment bank is accurately stating the financial prospects of a firm whose IPO the bank is underwriting. The claims that SPACs make when attracting investors are less closely monitored. SPAC mergers can also be finalized more quickly than can traditional IPOs.

The experience of WeWork illustrates how some firms that have struggled to go public through an IPO have been able to do so by merging with a SPAC. Adam Neumann and Miguel McLevey founded WeWork in 2010 as a firm that would rent office space in cities, renovate the space, and then sub-lease it to other firms. In 2019, the firm prepared for an IPO that would have given the firm a total value of more than $40 billion. But doubts about the firm’s business model led to an indefinite postponement of the IPO and Neumann was forced out as CEO.

WeWork was reorganized under new CEO Sandeep Mathrani and went public in October 2021 by merging with BowX Acquisition Corporation, a SPAC. Although WeWork’s stock began trading (under stock symbol WE) at a price that put the firm’s value at about $9 billion—far below the value it expected at the time of its postponed IPO two years before—investors seemed optimistic about the firm’s future because its stock price rose sharply during the first two days it traded on the stock market. 

Some policymakers are concerned that individual investors may not have sufficient information on firms that go public through a merger with a SPAC. Under one proposal being considered by Congress, financial advisers would only be allowed to recommend investing in SPACs to wealthy investors. The SEC is also considering whether new regulations governing SPACS were needed. Testifying before Congress, SEC Chair Gary Gensler sated: “There’s real questions about who’s benefiting [from firms going public using SPACs] and [about] investor protection.” 

It remains to be seen whether SPACs will retain their current position as being the leading way for firms to go public.

Sources: Dave Sebastian, “WeWork Shares Rise on First Day of Trading, Two Years After Failed IPO,” wsj.com, October 21, 2021; Peter Santilli and Amrith Ramkumar, “SPACs Are the Stock Market’s Hottest Trend. Here’s How They Work,” wsj.com, March 29, 2021; Benjamin Bain, “SPAC Marketing Heavily Curtailed in House Democrats’ Draft Bill,” bloomberg.com, October 4, 2021; and Dave Michaels, “SEC Weighs New Investor Protections for SPACs,” wsj.com, May 26, 2021.

New 10/17/21 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss economic impact of infrastructure spending & the supply-chain challenges.

Authors Glenn Hubbard and Tony O’Brien discuss the economic impact of the recent infrastructure bill and what role fiscal policy plays in determining shovel-ready projects. Also, they explore the vast impact of the economy-wide supply-chain issues and the challenges companies face. Until the pandemic, we had a very efficient supply chain but now we’re seeing companies employ the “just-in-case” inventory method vs. “just-in-time”!

Some links referenced in the podcast:

Here’s Alan Cole’s blog: https://fullstackeconomics.com/how-i-reluctantly-became-an-inflation-crank/

Neil Irwin wrote a column referencing Cole here:  https://www.nytimes.com/2021/10/10/upshot/shadow-inflation-analysis.html

Here’s a Times article on the inefficiency of subway construction in NYC:  https://www.nytimes.com/2017/12/28/nyregion/new-york-subway-construction-costs.html

A recent article on the state of CA’s bullet train:  https://www.kcra.com/article/california-bullet-trains-latest-woe-high-speed/37954851

A WSJ column on goods v. services: https://www.wsj.com/articles/at-times-like-these-inflation-isnt-all-bad-11634290202

The Pandemic and Hidden Inflation

If the price of your meal is the same, but the service is slow and the menu is limited you have experienced hidden inflation.

Each month, hundreds of employees of the Bureau of Labor Statistics gather data on prices of goods and services from stores in 87 cities and from websites. The BLS constructs the consumer price index (CPI) by giving each price a weight equal to the fraction of a typical family’s budget spent on that good or service. (We discuss the construction of the CPI in Chapter 9, Section 9.4 of Macroeconomics and Chapter 19, Section 19.4 of Economics.) Ideally, the BLS tracks prices of the same product over time. But sometimes a particular brand and style of shirt, for example, is discontinued. In that case, the BLS will use instead the price of a shirt that is a very close substitute.

A more difficult problem arises when the price of a good increases at the same time that the quality of the good improves. For instance, a new model iPhone may have both a higher price and a better battery than the model it replaces, so the higher price partly reflects the improvement in the quality of the phone.  The BLS has long been aware of this problem and has developed statistical techniques that attempt to identify that part of price increases that are due to increases in quality. Economists differ in their views on how successfully the BLS has dealt with this quality bias to the measured inflation rate. Because of this bias in constructing the CPI, it’s possible that the published values of inflation may overstate the actual annual rate of inflation by 0.5 percentage point. So, for instance, the BLS might report an inflation rate of 3.5 percent when the actual inflation rate—if the BLS could determine it—was 4.0 percent.

During 2021, a number of observers pointed to a hidden type of inflation occurring, particularly in some service industries. For example, because many restaurants were having difficulty hiring servers, it was often taking longer for customers to have their orders taken and to have their food brought to the table.  Because restaurants were also having difficulty hiring enough cooks, they also limited the items available on their menus. In other words, the service these restaurants were offering was not as good as it had been prior to the pandemic. So even if the restaurants kept their prices unchanged, their customers were paying the same price but receiving less. 

Alan Cole, who was formerly a senior economist with the Congressional Joint Economic Committee, noted on his blog that “goods and services are getting worse faster than the official statistics acknowledge, suggesting that our inflation problem has actually been bigger than the official statistics suggest.” As examples, he noted that “hotels clean rooms less frequently on multi-night stays,” “shipping delays are longer, and phone hold times at airlines are worse.” In a column in the New York Times, economics writer Neil Irwin made similar points: “Complaints have been frequent about the cleanliness of [restaurant] tables, floors and bathrooms.”  And: “People trying to buy appliances and other retail goods are waiting longer.”

A column in the Wall Street Journal on business travel by Scott McCartney was headlined “The Incredible Disappearing Hotel Breakfast.” McCartney noted that many hotels continue to advertise free hot breakfasts on their websites and apps but have stopped providing them. He also noted that hotels “have suffered from labor shortages that have made it difficult to supply services such as daily housekeeping or loyalty-group lounges,” in addition to hot breakfasts.

The BLS makes no attempt to adjust the CPI for these types of deterioration in the quality of services because doing so would be very difficult. As Irwin notes: “Customer service preferences—particularly how much good service is worth—varies highly among individuals and is hard to quantify. How much extra would you pay for a fast-food hamburger from a restaurant that cleans its restroom more frequently than the place across the street?”

As we noted earlier, most economists believe that the failure of the BLS to fully account for improvements in the quality of goods results in changes in the CPI overstating the true inflation rate.  This bias may have been more than offset since the beginning of the pandemic by deterioration in the quality of services resulting in the CPI understating the true inflation rate. As the dislocations caused by the pandemic gradually resolve themselves, it seems likely that the deterioration in services will be reversed. But it’s possible that the deterioration in the provision of some services may persist. Fortunately, unless the deterioration increases over time, it would not continue to distort the measurement of the inflation rate because the same lower level of service would be included in every period’s prices.

Sources: Alan Cole, “How I Reluctantly Became an Inflation Crank,” fullstackeconomics.com, September 8, 2021; Scott McCartney, “The Incredible Disappearing Hotel Breakfast—and Other Amenities Travelers Miss,” wsj.com, October 20, 2021; and Neil Irwin, “There Is Shadow Inflation Taking Place All Around Us,” nytimes.com, October 14, 2021.