Because of global events, we now face the possibility of a supply-induced recession, the likes of which we haven’t experienced since the oil shocks of the 1970s. The war in Ukraine and the spread of the Omicron variant of Covid-19 in China could hit supply chains and production capabilities in the U.S. and around the globe, leading to the return of stagflation: high inflation and low economic growth at the same time.
We need to adjust our economic toolkit to deal with stagflation. While stimulus payments from Congress and the Fed successfully sustained American demand in the face of the global pandemic and averted a much bigger recession, demand-side fiscal and monetary policies won’t be nearly as useful in a supply-shock recession. To minimize the severity of the next recession, we must address the supply-side of the economy directly.
The war in Ukraine, with its resulting loss of shipping insurance and other forms of self-sanctioning, reduced the volume of Russian oil reaching the global marketplace. The International Energy Agency estimates that Russia’s crude- and refined-oil product output could shrink by up to 2.5 million barrels per day by next month—and that’s without any official sanctions on Russia’s energy sector. Those sanctions may yet come as Vladimir Putin ramps up the brutality of his campaign in Ukraine. Oil prices rose from about $90 per barrel prior to the invasion to a high of $130 per barrel before falling on the prospect of a China-induced global recession.
It’s not just oil that’s getting scarcer. Industrially important metals like nickel, of which Russia is a major exporter, have doubled in price since the invasion. Interruption of Ukraine’s wheat production will raise food prices globally and cause hardship, if not famine, in countries that rely on Ukrainian imports, like Gambia, Lebanon, Moldova, Djibouti, Libya, Tunisia, and Pakistan.
China’s struggles to contain Omicron represent a distinct set of shocks. The “Zero Covid” policies the country used successfully to contain the virus thus far do not appear up to the job of fighting off the new variant. Yet with a population protected only by less effective vaccines and virtually no immunity from prior infection, abandoning these policies would unleash a massive wave of Covid cases that would overwhelm Chinese hospitals and increase the disease’s fatality rate.
China is stuck. The country is now locking down multiple cities and even entire provinces. Even if these lockdown measures work in the short term, they may need to be reimposed over and over again, absent a new strategy to contain one of the most contagious diseases in history. These repeated lockdowns will hamper China’s ability to contribute to the global economy and its supply chains.
Traditional monetary and fiscal policies have limited utility against a supply shock. At the aggregate level, supply and demand are more interdependent than typical charts let on, so demand-side policies do have a role to play in preventing the supply shock from depressing spending. But beyond limiting the contagion, these conventional macroeconomic policy tools cannot address the shocks we may soon experience.
The only solution is to offset the shock to aggregate supply with a boost in the economy’s productive capacity. Without such a compensatory supply-side action, the negative supply shock will increase inflation and hurt economic growth, producing stagflation.
To avoid stagflation, we can try to undo the specific shocks we are experiencing. For example, we can try to compensate for the reduction in Russian oil supplies with greater domestic oil production. But this kind of response can only go so far. We cannot quickly ramp up the production of wheat, nickel, or Chinese manufactured goods to make up for each individual shock. And with the complexity of modern production, even one missing part can bring a factory to a halt.
If we can’t counterbalance the supply shock in every granular manifestation, we can at least take action to boost productivity and aggregate supply. Macroeconomic textbooks don’t focus on this policy lever because they assume that the supply side of the economy is already optimized. Yet it is manifestly evident that American society is not maximizing its productivity. If we wanted to raise American productivity, for example, we could simplify geothermal permitting, deregulate advanced meltdown-proof nuclear reactors, make it easier to build transmission lines, figure out why high-speed rail is so expensive, fix permitting generally, abolish the Jones Act, automate our ports, allow drones to operate autonomously, legalize supersonic flight over land, reduce occupational-licensing requirements, train more medical workers, build more hospitals, revamp our pandemic-response institutions, simplify drug approvals, deregulate land use to allow denser housing and mixed-use neighborhoods, allow more immigration, cancel inefficient programs, restrict cost-plus procurement contracts in favor of more effective methods, end appropriations based on job creation, avoid political direction of scientific research, and instill urgency in grantmaking.
In other words, there is much we could do to boost supply. No, not all these actions will offer relief from the specific supply shocks we could soon face; nor will they all have an immediate effect. Still, doing as much as possible now to remove barriers to productivity and efficiency is our best hope to avoid prolonged stagflation.