The End of Magic Money

Two years ago, I predicted in Foreign Affairs that the COVID-19 recession, coming on top of the financial crisis of 2008, would lead rich democracies to redefine the outer limits of their monetary and fiscal power, ushering in an “age of magic money.” Because central banks had a long record of containing inflation, the penalty for profligacy would likely not materialize; supersized stimuli could coexist with stable prices. Of course, the success of this experiment would depend on the continued inflation-fighting credibility of central banks, the Federal Reserve foremost among them. “If the Fed loses its independence, the age of magic money could end in catastrophe,” I noted.

Since then, the idea of magic money has been discredited. Although the Federal Reserve has yet to lose its independence, it has fumbled the inflation challenge in ways that I failed to take sufficiently seriously. For the first time in about two decades, the imperative of price stability will complicate central banks’ ability to achieve other objectives, from financial stability (it will be hard to cut interest rates to help weak borrowers) to employment stability (as it plays catch-up against inflation, the Fed will probably cause a recession). A few years ago, cartoonists regularly portrayed central bankers in Superman outfits. Now that inflation has returned, the monetary superheroes have lost their powers.

How long this fall to earth will endure depends on two questions. First, was the whole idea of magic money doomed from the get-go, or could it have succeeded if managed differently? Second, if some other approach could have worked, can the Fed learn lessons from its experience?

The Road Taken

Start with the first question, which is the more straightforward. Under the right conditions, magic money can undoubtedly be deployed successfully.

Both theory and experience teach that large economic stimuli—delivered by central bankers or budget authorities or both—need not destabilize prices. If a financial crash or a pandemic causes private spending to collapse, governments can print money and run budget deficits to push spending up again. If this intervention is well calibrated, demand will remain in balance with supply, causing no change in inflation. To be sure, the calibration is difficult, not least because government largess puts money into the hands of private companies and households, whose eagerness to spend is uncertain. But stimulus at least has a shot at balancing supply and demand. In contrast, not stimulating guarantees that demand will be too low, ushering in deflation and recession.

The idea of magic money has been discredited.

The government’s response to the 2008 financial crisis provides an illustration of this process. Central banks printed trillions of dollars, leading their critics to predict terrible inflation. But in the 36 quarters from 2009 to 2017, core inflation never exceeded the Fed’s two percent target, averaging only 1.5 percent. Far from being reckless, this first experiment with magic money was actually too timid: given the inflation undershoot, an even larger stimulus would have been appropriate. Even so, the stimulus was a success. It saved the U.S. economy from a repeat of the Great Depression of the 1930s.

At first, the response to COVID-19 was even more impressive. The pandemic caused U.S. GDP to collapse in the second quarter of 2020: output shrank at an annualized rate of 32 percent. This fall was four times deeper than the hit from the financial crisis in the fourth quarter of 2008; indeed, it was the sharpest ever contraction in the post–World War II period. The Fed responded aggressively, creating twice as much money as it had from 2008 to 2009. Likewise, the president and Congress delivered a budget stimulus that was twice as big as the 2009 version. By acting so vigorously, authorities demonstrated that they had learned the lesson of the last recession, when they undershot with their spending. They were also emboldened by the fact that inflation expectations were low, reducing the risk that a stimulus would set off an upward price spiral.

In the second half of 2020 and the first quarter of 2021, this mega-stimulus worked perfectly. The U.S. economy bounced back, almost recovering its pre-pandemic level of output. And despite the lavish money-printing, there was no sign of inflation. In the first quarter of 2021, the Fed’s preferred index of “core” prices was up just 1.7 percent from the previous year. As of March, the broader consumer price index remained well within the comfort zone.

If the authorities had been able to stop there, they would have pulled off a textbook example of macroeconomic stabilization. But from the spring of 2021 the experiment started to go wrong. How it failed provides lessons for policymakers attempting to navigate the current macroeconomic moment.

Don’t Blame the Bully Pulpit

When I proposed the idea of magic money back in 2020, the likeliest source of economic misjudgment appeared to reside in the White House. U.S. President Donald Trump had scant respect for the independence of the central bank, tweeting about it on more than 100 occasions. “My only question is, who is our bigger enemy, Jay Powell or Chairman Xi?” he fulminated in the summer of 2019, at a time when Fed Chair Jerome Powell was hiking interest rates more than Trump found congenial. The closest historical precedent for this bullying illustrated how serious the consequences could be. In the 1970s, President Richard Nixon slandered Fed Chair Arthur Burns. The browbeating contributed to the chronically timid monetary policy of that decade, and hence to stagflation.

Given this experience, Trump’s intemperate Fed commentary seemed to present the chief risk of magic money. It was easy to imagine a situation in which, because of the difficulty of calibrating the stimulus, there might be an initial spurt of inflation. Once that happened, the Fed might flinch from clamping down, allowing inflation to persist out of fear of pressure from the White House.

Presidential bullying is not the only reason central banks lose their grip on inflation.

The 2020 election changed this calculus. Unlike his predecessor, President Joe Biden showed no inclination to browbeat the Fed, on Twitter or elsewhere. His Treasury secretary, Janet Yellen, was herself a former Fed chair, and would therefore be the last person to attack the institution. In May 2022, with the inflation threat intensifying, Biden went out of his way to emphasize the independence of the central bank. “My predecessor demeaned the Fed, and past presidents have sought to influence its decisions inappropriately during periods of elevated inflation,” he wrote in The Wall Street Journal. “I won’t do this,” he added.

But it turns out that presidential bullying is not the only reason why central banks lose their grip on inflation. Starting in the spring and summer of 2021, the Fed committed three mistakes, opening the door to today’s price surge. Regrettably, very few observers, and certainly not this one, anticipated all three. But the good news is that two of these errors point to ways in which the Fed can reform its approach in the future, perhaps allowing an eventual return to the use of magic money.

Not a Passing Phase

The Fed’s first error has received by far the most attention, but it is also the hardest to learn from. It consisted in miscalibrating the balance between supply and demand, a challenge that, as noted already, is necessarily hard, given the unpredictable spending decisions of private citizens and companies.

The miscalibration began with the passage of the American Rescue Plan in March 2021. This was the third budgetary stimulus delivered by the U.S. Congress, and it crossed the line from appropriate support to dubious overreach. In March and April 2020, Washington had enacted a fiscal stimulus worth $2.4 trillion; in December it had followed up with a further $900 billion. With this extra spending in the pipeline, the U.S. economy was expected to grow by four percent between the fourth quarter of 2020 and the fourth quarter of 2021, a respectable performance. The March 2021 stimulus sloshed an extra $1.9 trillion of fuel onto the fire. Commenting on the likely upshot before the passage of the bill, the Brookings Institution forecast  that by the end of 2021 the economy would be “operating above its maximum sustainable level.”

Confronted with this risk of inflationary overshoot, the Fed declined to raise interest rates or dial back its quantitative easing—the bond-buying program by which it affects longer-term interest rates. To some Fed critics, this was a clear error. If the central bankers had listened to forecasters such as the Brookings team, they would have headed off today’s inflation. But the truth is that forecasting in the midst of the pandemic was more art than science, and the Fed’s wait-and-see attitude was arguably understandable. Although the $1.9 trillion stimulus presented an obvious risk of overreach, it remained possible that other forces would conspire to dampen demand. To cite just one wild card, the contagious Delta variant of COVID-19 spread rapidly in the summer of 2021, leading to a surge in the total infection rate in August and September.

As the Fed sat on the sidelines, core inflation drifted up, reaching an annual rate of 3.4 percent by the second quarter of 2021 and 3.6 percent in the third quarter. Again, with the benefit of hindsight, the Fed should have hiked interest rates, snuffing out the inflation before it became serious. But the Fed justified procrastination by arguing that the inflation was merely “transitory.” COVID-19-related supply-chain snafus seemed to explain the upward pressure on prices; as workers returned to jobs and ports reopened, these bottlenecks would surely correct themselves. And to be fair to…