Why Inflation Fears Are Overstated: The Real Impact of Post-COVID Stimulus and Why We Performed Them

In response to the economic downturn caused by the COVID-19 pandemic, the U.S. government, under two different administrations, enacted significant spending packages. Despite public concerns, these measures were rooted in an economic philosophy dating back to the 1930s: Keynesian Economics. Some feared that these spending packages would lead to runaway inflation and economic collapse. While inflation is indeed a valid concern, the idea of an economy-crashing inflationary spiral is not grounded in reality.

Keynesian Economics, developed by British economist John Maynard Keynes, emerged during the Great Depression. Keynes argued that, in times of severe economic downturns, the government must intervene to stabilize the economy. His analysis, published in The General Theory of Employment, Interest, and Money, revealed two key points: aggregate demand (the total demand for goods and services) plays a critical role in the economy, and government intervention is essential to smooth out natural economic cycles.

During the Great Depression, a collapse in consumer spending and business investment caused a downward spiral of falling production and rising unemployment. Keynes argued that only government action could reverse this cycle by injecting money into the economy to stimulate demand, create jobs, and restore confidence. The COVID-era spending packages reflect this same approach, combining direct aid to individuals with lowered interest rates by the Federal Reserve to encourage borrowing and spending.

However, critics like Austrian economist Friedrich A. Hayek warned that such government intervention would lead to unchecked inflation by increasing the money supply without a corresponding increase in goods and services. Inflation, which occurs when prices rise and the value of money declines, is often feared because it reduces consumers’ purchasing power. Hayek’s concerns about inflation are valid, especially in extreme cases like Venezuela or Argentina, where hyperinflation followed government mismanagement.

Keynes, however, had an answer to these fears. He referred to the work of American economist Irving Fisher and the Phillips Curve, which shows an inverse relationship between inflation and unemployment.

The inverse relationship forces decision-makers to weigh their choices and choose the lesser of the two evils. Keynes argued that, in the short run, avoiding mass unemployment should take precedence over the fear of inflation. For every 1% rise in unemployment, the U.S. could see an estimated 37,000 additional deaths due to increased stress and economic insecurity. Keynes believed that government involvement should continue after a recession to maintain economic stability and prevent severe inflation.

American’s fear of inflation comes entirely from the loss of their purchasing power. As inflation rises, the value of the money in their pockets decreases, and buy fewer of the basic necessities and services than before. However, to that point, inflation is a normal part of a growing economy. Although the COVID inflation rate hit its highest rate at 9.1% in June 2022, the Federal Reserve does aim for a 2% year-on-year inflation rate. The concerns of inflation are offset when looking at the labor market dynamics. In other words, if inflation rises, labor market participants will ask for more through wages to offset the increased prices thus negating the inflation. This phenomenon is called the wage-price spiral since one is connected to the other.

To illustrate this, consider the relationship between inflation and real wage growth, which adjusts wages for inflation. By using the real wage matric, we can show the relationship of the wage-price spiral. In a “perfect world”, the real wage growth would be 0% since this would provide the maximum benefit to both buyers and sellers. Between 2020 and 2024, real wage growth fluctuated, rising in 2020, declining in 2021, and recovering in 2022 and 2023. This indicates that while inflation had an effect, wage growth helped offset the loss of purchasing power for most workers.

There is some truth in these concerns about the loss of purchasing power with inflation. Normally, as inflation rises, there is a degree of expectation in the relationship between employers and employees that the wages will rise too. If, however, this relationship becomes less mutual and more one-sided, then you are likely to see companies raise prices, while keeping wages stagnant.

Following 2008, the demand for airplanes decreased, which forced Boeing to resort to cost-cutting measures such as layoffs, hiring freezes, and even wage freezes. During this time, Boeing kept pay increases below inflation for many employees, particularly in its production and engineering divisions. While some workers received small raises or bonuses, the cost of living was increasing at a faster rate due to inflation, effectively reducing workers’ real wages. While these austerity measures were in place, the CEO, Jim McNerney, was earning nearly $20 million a year and continued to rise. This one-sided relationship led to mass unrest among Boeing employees who were losing their purchasing power.

However, such examples are exceptions rather than the rule. Labor market dynamics cannot be ignored as a source of “correction” in wages. In a well-functioning labor market, companies that fail to adjust wages risk losing employees to competitors. On a macro level, the average wages will tend to rise in response to inflation, providing a natural corrective mechanism.

Hayek also raised significant concerns about the capacity and trustworthiness of governments in managing economies. He feared that excessive government intervention could lead to overreach, with power concentrated in the hands of a few, opening the door to corruption and oppression. Hayek argued that allowing governments to actively steer the economy could ultimately lead to its downfall. His skepticism was not without merit, as evidenced by the economic mismanagement seen in countries like Venezuela and Argentina.

In Venezuela, government overspending — much of it funded by oil revenue — persisted even as oil prices plummeted. This, combined with the excessive printing of money, resulted in hyperinflation that peaked at a staggering 65,000%. Similarly, Argentina has faced repeated currency crises, largely driven by fiscal mismanagement and large budget deficits. These issues led to inflation rates approaching 100%, eroding purchasing power and destabilizing the economy.

However, there is one simple fact that makes these examples different from the United States which is that Argentina and Venezuela are not the United States. The US Federal Reserve is not mired by problems that the Central Banks of Argentina and Venezuela have like corruption and political interference. Jerome Powell and the rest of the board of the Federal Reserve are very qualified and competent at their jobs. Janet Yellen, the secretary of the Treasury, received her PhD in economics from Yale University and has previously been the chair of the Fed herself. Although there may be disagreements with their approaches or economic philosophies, they are more than qualified to help guide our country in making the correct financial decisions.

In summary, while fears of inflation following government intervention during the COVID-19 pandemic are not unfounded, the idea of an economy spiraling into uncontrollable inflation is exaggerated. Keynesian economics, which advocates for government action in times of economic crisis, has proven time and again to be a stabilizing force, especially in moments of severe downturn. Although critics like Hayek raised valid concerns about inflation, the U.S.’s strong institutional safeguards, such as the Federal Reserve, help manage these risks effectively. History has shown that targeted government spending can mitigate the worst effects of recessions while providing a cushion for recovery, without leading to runaway inflation. As the economy continues to recover, it is essential to acknowledge both the risks and the strengths of Keynesian principles, recognizing that balanced intervention, guided by sound economic policy, remains a valuable tool for navigating future challenges.