By Arnold Kling
“Dormant inflation” will spring to life, at some point quite rapidly, and the Fed will choose to tighten. Five to six percent inflation for a while would be OK but we will be faced with the prospect of more than that.
I think of the recession as a massive adjustment problem. Economic activity consists of people dividing labor and purchasing goods and services from the market, rather than doing things for themselves. If you build your own deck or mow your own lawn, that is contractionary. The challenge is to arrive at a division of labor that has everyone creating useful output, as opposed to excess output in housing construction, automobiles, and financial services.
Whether households lean toward more consumption or more saving is not the big issue that everyone thinks it is. The key issue is new enterprises that profitably employ young people entering the labor force.
I agree with Tyler that the outlook for inflation is bad. That in turn will cause a lot of distortions in people’s behavior and slow the recovery. The “stimulus” will turn out to be a permanent increase in government spending. It will have its maximum effect on reducing unemployment in 2011.
The big upside surprise would be a snap-back in housing and autos, due to pent-up demand. The biggest downside risks are: (a) that other countries will have even worse adjustment problems, and their adjustment problems will feed back on ours; (b) that there is a sudden collapse of confidence in the solvency of the U.S. government, forcing us to sharply raise taxes or reduce spending.