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How Public Policy Can Fight Inflation and Lower Prices
The Biden administration’s proposed solutions vary in quality, and much more needs to be done
By Patrick Horan
Inflation has become a major problem in the United States. When prices first began to rise at higher-than-normal rates in spring 2021, higher inflation was not necessarily a big problem because prices had dropped the previous year. However, by the end of 2021, it became clear that excessive monetary and fiscal stimulus, along with supply chain disruptions, had caused inflation to rise to rates not seen since the 1980s. Now the United States faces the prospect of even higher prices as the U.S. and other countries have slapped major sanctions on Russia for its invasion of Ukraine. The prices of oil and other commodities have already begun to soar.
During his 2022 State of the Union address, President Joe Biden said his “top priority is getting prices under control” and laid out an array of proposals to quell the recent high inflation. Unfortunately, much of this inflation is beyond his control. To the extent that he can affect inflation, many of his suggested solutions would do little to alleviate the problem, and some would even be counterproductive.
Inflation is the increase in the general level of prices across the economy. While nonmonetary shocks such as the pandemic and the war in Ukraine can temporarily affect the price level, monetary policy is what ultimately determines inflation beyond the short run. The Nobel Prize-winning economist Milton Friedman compared the Federal Reserve, which sets monetary policy, to a thermostat and compared inflation to temperature. Just as a thermostat keeps a house’s temperature stable by offsetting changes in the weather outside, the Fed offsets changes in the economy to keep inflation at a certain target.
Despite this fact, Biden only briefly mentioned monetary policy, when he said, “Confirm my nominees to the Federal Reserve, which plays a critical role in fighting inflation.” This description of the Fed is an understatement: The Fed plays the most critical role in fighting inflation in the medium to long run. But since neither the White House nor Congress can do very much to affect the Fed’s decision-making, it makes sense, politically, that Biden would choose to mostly leave the Fed out of his speech.
Pros and Cons of Biden’s Plans
Non-monetary-policy changes that make the U.S. economy more productive can also help reduce some prices, even in the relatively short run, and this matters right now as Americans are confronted with much higher bills. They can also reduce the real (i.e., inflation-adjusted) prices of important goods and services in the long run and make us wealthier. The question is whether Biden’s ideas would achieve these goals.
One valid point Biden stressed was the importance of fighting any future variants of COVID-19. The government can play a legitimate role in making sure COVID-19 cases remain low by helping to provide vaccinations, tests and antiviral pills, particularly if a new, dangerous variant arises at some point in the future. However, as the Omicron variant recedes and the economy continues to reopen, these policies are not especially relevant for inflation right now.
One immediate action the president announced is the release of 30 million barrels of oil from the Strategic Petroleum Reserve. (The Reserve was also tapped last November.) This action may alleviate gas prices somewhat and is strategically justified because Russia’s war against Ukraine has caused oil and gas prices to soar. However, most experts argued that the benefits to consumers from the previous release were only modest. It is unlikely that the recent action will significantly dampen oil prices, especially since Biden has now announced a ban on the importation of Russian oil and gas into the U.S.
Another aspect of Biden’s plan is to produce many more goods domestically, including cars and semiconductors, and to invest heavily in infrastructure using American-made materials. He also called for a shift away from relying on foreign supply chains. While these ideas may sound attractive, they would lead to higher prices and lower production, leaving Americans worse off. As former Treasury Secretary Larry Summers pointed out, “buying American” frequently means not buying at the lowest cost. Similarly, Adam Posen, the president of the Peterson Institute for International Economics, criticized the president, stating that such protectionism would raise costs and harm Americans.
Biden also connected rising prices with monopoly power by stating, “When corporations don’t have to compete, their profits go up, your prices go up, and small businesses and family farmers and ranchers go under.” He went on to say, “Tonight, I’m announcing a crackdown on . . . companies overcharging American businesses and consumers.” While it is correct that increased monopoly power leads to higher prices, monopoly power has little to do with inflation. A monopolist, who faces no competition, reduces output and charges a higher price. However, since the second quarter of 2020, real output growth has largely been above its pre-pandemic trend. Policymakers should encourage greater competition across sectors, but it is unlikely that monopoly power is meaningfully contributing to inflation right now.
The president also rebranded his “Build Back Better” agenda, which failed in the Senate last year, as “building a better America.” While the speech was short on specifics for how the agenda would be accomplished, Biden argued that his plan would reduce the costs of many goods and services, including housing, child care, pre-K and long-term care. Assuming Biden’s new plan is like the previous “Build Back Better” bill, the federal government would subsidize these sectors. However, as Samuel Hammond, Daniel Takash and Steven Teles explained in a paper for the Niskanen Center and an article in The New York Times, when you subsidize demand but don’t increase supply, you get higher prices instead of lower ones. Taking the child care example, they wrote in the Times:
Consider that the current proposal would also dramatically shift the cost structure of child care upward with regulations mandating higher salaries, greater credentials, and compliance with federal “quality standards.” Having made child care more expensive, it then proposes socializing over 90 percent of the cost for a subset of middle- and lower-income households. This won’t reduce rising prices so much as mask them. And with informal child care providers, including religious organizations, at risk of being crowded out, the true availability of low-cost child care could even contract.
This is an example of what the authors call “cost disease socialism,” a problem where the government creates higher prices by subsidizing demand while also constraining supply through onerous regulations.
What Can Biden Actually Do?
Again, inflation, the growth of the price level, is largely determined by the Fed over the long run. Jerome Powell and the other members of the Federal Open Market Committee have more control over inflation than Biden, Nancy Pelosi or any other congressional leader.
Unfortunately, some of the current inflation is due to temporary but painful negative supply shocks brought on by the pandemic and the Ukraine war. Although some tightening of monetary policy is warranted, it would be inappropriate for the Fed to fully offset the current inflation because doing so would likely hurt employment, the other part of the Fed’s mandate.
Even though inflation is ultimately a monetary policy problem, the administration and other policymakers can help control inflation by making the economy more productive and by boosting aggregate supply or real output in the economy. A more productive economy will help put some downward pressure on prices. How? Mostly by getting out of the way.
Rather than insisting that everyone “buy American,” the government should remove tariffs and other trade barriers and allow businesses and consumers to buy products at lower prices. Similarly, the government could repeal or at least suspend the Jones Act, a 1920 law that allows only U.S. ships to travel from one U.S. port to another, driving up the cost of shipping. The Cato Institute’s Colin Grabow has recently pointed out that the Jones Act has caused America, the world’s largest oil producer, to import oil from Russia because it has been cheaper to buy Russian oil than American. Since free trade forces U.S. firms to compete with firms across the globe, President Biden should be especially enthusiastic about scrapping the Jones Act if he is concerned about monopoly power.
To reduce energy prices, the administration can work to expand supply by encouraging more production. Although the Biden administration has generally favored a transition to renewable, “green” energies, most of America’s energy comes from fossil fuels, and this won’t change soon. Consequently, the administration needs to expand domestic production of oil and natural gas by permitting more drilling and by relaxing regulation. Even if the administration allows greater oil and gas production, U.S. residents may not see lower oil and gas prices immediately. Nevertheless, this action will be worth it if America wishes to permanently reduce its reliance on oil produced by Russia and other unfriendly countries.
Policymakers should also consider reducing or simplifying regulations to bring down the long-run costs of important goods and services such as green energy and housing. For example, the government could streamline lengthy environmental review processes, which delay energy production, including the production of green sources of energy. Ironically, these environmental rules make green energy technologies more expensive and hinder their development. Nuclear power, the most efficient energy source, is also greatly hampered by government regulation.
At the local level, single-family zoning rules and other housing regulations limit housing supply, making housing more expensive. By preventing housing from become denser, these housing regulations also harm the environment because people must drive cars to work or to run errands. While these regulations are set by local policymakers, as my Mercatus colleagues have argued, federal policymakers can play a role by providing grant money to encourage local zoning reform.
The same principles of boosting supply by removing poorly designed regulations apply to the other goods and services Biden discussed in his speech—healthcare, child care, etc. Before seeking to subsidize demand, policymakers should determine whether existing regulations can be removed and whether proposed regulations would do more harm than good.
The Biden administration is correctly worried about rising prices. Although the administration is not the most important player in fighting the current inflation, the president and other policymakers can still help reduce prices to make life easier for all Americans.