We now seem to be living in post-modern economic times, when the fiscal and monetary verities of the latter twentieth century have turned into paradoxes. Two of those paradoxes are happy ones, but the economic program of Joe Biden’s administration will stress test both of them. The third is largely beyond his reach but will be critical to America’s economic future.
By Gregory F. Treverton
NOTE: The views expressed here are those of the author and do not necessarily represent or reflect the views of SMA, Inc.
The first paradox concerns the famous, now infamous, “Phillips curve,” one probably unknown to my students. It portrayed the trade-off between unemployment and inflation, the less of the former, the more of the latter; the nation could have price stability or low unemployment but not both. In the 1960s, low unemployment drove up wages and prices, and in the 1970s the sharp rise in oil prices led to expectations of inflation. It took a major recession, with unemployment over ten percent, to get inflation under control. I remember those days all too keenly, for when I bought an apartment in 1982 my mortgage interest rate was 17 percent!
The Philips curve is now consigned to the dustbin of economic history—or is it? Despite all the hand wringing, inflation has been low for thirty years. Exactly why remains something of a mystery. Before the 1990s, price inflation seemed sensitive to slack in the labor market—the less slack, the more inflation—but became less so in the 1990s, and the usual models did not work well. Explanations fall into several categories.
One is expectations, or what economists call “anchored expectations.” In that historical dustbin, when inflation spiked, businesses and consumer expected that some portion of the spike would continue. Now, though, after thirty years of low inflation, the expectation is that any increase will be temporary. Another explanation holds that the absence of a correlation between prices and employment is only an illusion, created by the fact that the Fed has succeeded in keeping inflation close to its target of 2 percent. In states and cities, which don’t have their own Fed, prices are as sensitive to employment as in the 1980s and 1990s: ask those who seek to buy houses in Silicon Valley.
Another part of this first paradox is that while unemployment has been going down, to record low levels by 2020, wages have been slow to rise. Here, one explanation is that unemployment is not a very good measure of slack in the labor markets, for there may have been many more people willing to work after the 2008 recession than the unemployment figures indicated: while politicians touted America’s low unemployment before Covid, those numbers disguised the fact that almost 20 percent of males in prime working age had dropped out of the labor force and thus were not counted as unemployed. Thus, if Wagner’s music is not as bad as it sounds, unemployment is not as good as it looks, thus less upward pressure on prices. So, too, structural change—especially the weakening of unions and increased competition from abroad—probably have suppressed wage growth. Moreover, growth in productivity has been low, and after accounting for that fact, the latest labor market expansion doesn’t look very different from previous ones. Thus, the traditional Philips curve may not be dead for unemployment and wages: if the former is higher, the latter will be lower. Yet even then the lack of upward pressure on consumer prices remains a puzzle.
The second paradox is deficits and debt. Certainly, the federal budget deficit is large and getting larger, nearly a trillion in 2019, up from $585 billion in 2016. Over the next decade, the total the U.S. government owes is expected to increase from 78 percent of gross domestic product (GDP) to 104 percent—an unprecedented level in a time of economic prosperity. The common perception is that deficits have bulged because government spending has become more lavish, especially for entitlement programs like Medicare and Social Security.
Yet that perception is dead wrong: deficits have increased because revenues have declined. The tax cuts enacted under Presidents George W. Bush and Donald Trump totaled three percent of GDP—much more than the growth of entitlement spending over the next thirty years. The Trump 2017 tax cut alone will cost $1.9 trillion over ten years, and it boosted growth only slightly; it did enrich the rich while depriving many poorer people of health insurance. It also meant that government revenue in 2018 came to only 16 percent of GDP, the lowest levels in a half century save for a few recession periods.
At the same time, conventional wisdom about deficits has been upended by newer economic conditions – perhaps some combination of lower investment demand, increased savings and widening inequality. Traditional economics held that big deficits would drive up interest rates, and thus inflation, and would crowd out private investment by making it more expensive. Indeed, the deficit “scolds” have been predicting inflation that didn’t happen for almost a generation. Instead, interest rates have been falling just as the debt-to-GDP ratio was increasing. Interest rates on the ten-year government bond fell from 4.3 percent in 2000 to 0.8 percent in 2018. Meanwhile, for the private sector, interest rates are low, the stock market is high and major companies are flush with cash. The cost of capital is hardly holding back investment. Moreover, the lower interest rates mean that while the deficit has increased as a share of GDP, the cost of interest, adjusted for inflation, is in line with historical averages since World War II.
The Biden administration’s policies will stress test both of these paradoxes—both economic growth and growing deficits without serious, let alone runaway, inflation. Some economists, like my former colleague and Treasury secretary, Larry Summers, worry that Biden’s $1.9 trillion dollar stimulus plan is too large. The reckon it at four times what is needed to close the “output gap” between what the economy would have produced absent Covid and what it actually produced. They worry that the package will fail the stress test, and that this time the inflation scolds will be right.
Moreover, the administration intends to follow the stimulus with upwards of two trillion in infrastructure spending. And while the administration has proposed tax increases to finance the infrastructure, it doesn’t take a seasoned congressional hand to imagine that Congress will end up voting for the goodies but skipping the taxes. There surely will be a spike of inflation as suppressed demand chases limited supply: think of all of us yearning to have a meal in our favorite restaurant, which, however, still must operate well below capacity. But I’m betting the spike will be a blip, not a trend.
The third paradox is productivity. The Nobel Prize-winning economist, Robert Solow, famously said in 1987 that the computer age was everywhere except for the productivity statistics. That paradox was resolved in the 1990s when the computer age did come of age, and the enormous advances in information technology (IT) led to visible increases in U.S. productivity. But not since: hence the paradox. Again, one suspect is the statistics we collect. For instance, the convenience of, say, our cell phones and pads, isn’t captured by the usual accounting of GDP. In that accounting, if something doesn’t cost money, it doesn’t count, and so much of what we value in today’s information world comes for free or nearly free. We know it isn’t really free, for we are paying by providing data on ourselves, usually without being aware of it. But since we do that freely, it too doesn’t count in the usual economic numbers.
Again, Summers has been eloquent on this issue. What GDP counts for Google is advertising revenue. Yet that number is a far cry from what economists would call the “consumer surplus” from using Google; it may be five or ten times greater that the “production cost” derived from, say, advertising revenues. One careful study of Facebook surveyed users, asking how much they would have to be paid to drop the service. It found that the median consumer surplus was around $500 per year in both the United States and Europe, or roughly four and ten times, respectively, the advertising revenues. It Is tempting but not entirely correct to conclude that the apparent absence of productivity increases in IT would disappear if the accounting were better. Yet earlier innovations, like antibiotics or television, also were free or nearly free, and so also produced much more consumer surplus than their production costs. What is fair to conclude is that current GDP accounting is a poor measure of values, especially in the digital sector.
Quite apart from IT, productivity growth is about a tenth what it was four decades ago in richer economies, and even emerging economies are struggling to continue past growth. The reason why is a broader version of the IT productivity puzzle. Because productivity drives growth, less means less of everything—fewer jobs, more inequality and lower living standards. On this score, Biden faces no stress test in the short run, but in the long run, the U.S. economy does.
 See Sage Belz and David Wessel, Explaining the Inflation Puzzle, Brookings, available at https://www.brookings.edu/product/explaining-the-inflation-puzzle.
 Numbers in this and subsequent paragraphs are from Jason Furman and Lawrence H. Summers, “How Washington Should End its Debt Obsession,” Foreign Affairs, 98, 2 (March/April 2019).
 See Tim Worthal, “Larry Summers and the Productivity Puzzle,” Forbes, February 21, 2015, available at https://www.forbes.com/sites/timworstall/2015/02/21/larry-summers-and-the-productivity-puzzle.
 Erik Brynjolfsson and Avinash Collis, “How Should We Measure the Digital Economy?” Harvard Business Review, November-December 2019, available at https://hbr.org/2019/11/how-should-we-measure-the-digital-economy.