It’s fair to say that Wall Street usually takes little interest in debates between economists, even ones as distinguished as Larry Summers and Paul Krugman.
But the debate between the two Keynesians over the merits of Joe Biden’s stimulus package matters at a time when global stock markets are on their hottest run for 17 years. The mood has changed completely since fearful investors were piling into cash a year ago. The way the markets look at it, successful Covid vaccines plus low interest rates plus higher US government spending equals rapid growth and higher corporate profits.
Summers says it might also equal higher inflation. He has two main quibbles with Biden’s $1.8tn (£1.3tn) plan: it will lead to overheating that will prompt higher interest rates and the possibility of recession; and there is too much focus on measures to boost consumer spending rather than investment.
At root, Summers is concerned that Biden is blowing his political capital, making it harder to lift the US out of what he calls secular stagnation – where the economy suffers a chronic lack of demand even when interest rates are at ultra-low levels. What the US needs, according to Summers, is higher spending on America’s decrepit public infrastructure, but the chances of getting that will be damaged if inflation takes off this year.
Krugman however, reckons the US is effectively at war with the pandemic, and the question is not whether the stimulus plan will lead to higher inflation but whether it will help win the war. He doesn’t believe that the White House plan will be inflationary but says even if it is the Federal Reserve can respond with higher interest rates without causing a recession.
The real political risk for Biden, according to Krugman, is that he is too timid, and waters down his measures in the face of criticism from the Republicans and some of the more conservative Democrats. That would reduce the chances of the package working and make it easier for the president’s opponents to say government intervention doesn’t work. Krugman says that is what happened to Obama after the financial crisis: he wasted his political capital by doing too little rather than too much.
Inflation was notable by its absence in the US even during the pre-crisis period, and if price rises were kept in check when unemployment was at a 50-year low it is hard to imagine a permanent surge in the cost of living when the labour market is still weak. But in a sense, what matters is not what is going to happen but what the financial markets think is going to happen, and how the Federal Reserve responds.
The US central bank sides with Krugman and his view that inflation poses little threat, which is one reason share prices continue to scale fresh heights daily. But US bond yields are rising and even the hint of a Fed change of heart would puncture the bullish mood.