This is no ordinary economic recovery, but policymakers are using the same old playbook. The differences are apparent in the May jobs report: while the pace of hiring has slowed and people are leaving the labor force, wages rose at an annual rate of 7.4 percent. Normally, wages go up in a tighter labor market. The jobs data just add to the evidence that we are facing a supply shock.
Recessions come in two general types. The first is a demand shock, where some event—say, a financial crisis—causes people to lose confidence and no longer hire workers or spend money. The second is a supply shock, in which the amount of goods and services suddenly falls or firms can’t find qualified labor.
Most recessions in recent memory were demand shocks. People lost money as markets fell, their homes lost value, and their jobs became endangered, so they didn’t want to spend money. Policymakers could follow a standard playbook in response: low interest rates to spur investment and consumption and expansionary fiscal policy to add extra demand. Reasonable people disagree over how well these policies actually work, but they are valid approaches to deficient demand.
This time is different. Household balance sheets are the healthiest they’ve been in a long while after a year of government checks going out to people who had nowhere to spend the money. Restaurant traffic is coming back, people are buying houses and planning trips, and prices are rising on many different goods. In short, demand is healthy. But jobs remain unfilled and many goods are in short supply.
Unfortunately, the government’s response has been to pretend that it is dealing with a demand shock. The Federal Reserve is committed to low rates and will consider ending its purchasing only of long-term and private-sector debt. Many states are still paying enhanced unemployment benefits. And if President Biden’s budget proposal is any indication, demand stimulus will continue long after the recovery has taken hold.
These policies are wrong for the moment. During conditions of weak demand, high unemployment benefits can be useful: putting money in people’s pockets causes them to spend more, which makes companies more willing to hire. But during a supply shock in which people are already reluctant to work, such benefits increase the wage at which workers will accept a job. Telling businesses to increase wages may sound politically appealing, but such a policy risks devastating small businesses that barely survived the last year. They exist on tight margins and can’t raise prices. Some may have to close or automate away more jobs. People looking for work after the benefits expire may find that fewer jobs remain to be found.
Meantime, keeping rates artificially low for too long affects the risk investors will take by lowering the returns on low-risk assets. The price of low-risk assets also determines how all other assets are valued, so expansionary monetary policy can distort financial market prices. This, in turn, can affect the allocation of capital, which harms long-term growth.
The best thing that policymakers can do during a supply shock is get out of the way. Lifting restrictions on economic activity and clearing unnecessary obstacles in the way of businesses will allow the economy to recover on its own as supply returns and people get back to work. Prices may rise because of shortages, but firms will have an incentive to find a way to produce more goods.
Supply shocks pose hard challenges. A changing labor market—in which employers need, but can’t find, workers with certain skills—often causes longer-term problems. This problem may flare up once the initial boom wears off, especially if more firms automate in response to artificially high wages.
Policymakers should support a dynamic labor market in which people can change jobs or start businesses when they want or need to. Some aspects of the Biden budget address job training and education, which may help. But policymakers are generally treating this recovery like all others, which could undermine it.
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