'No easing up on action to cut inflation' - Larry Summers at Davos 2023

Central banks must resist political and public pressure to ease up on their action to reduce inflation, a leading US economist has warned.

Inflationary pressures are hitting economies across the world amid high energy prices, pent-up consumer demand post-pandemic, and the ongoing impact of war in Ukraine – not to mention the ensuing cost of living crisis.

“I think it would be a grave error for central banks to revise their 2% inflation targets upwards at this point,” said Larry Summers, Charles W Eliot University Professor at the Harvard Kennedy School of Government and former US secretary to the Treasury.

“It seems to me that having failed to attain the 2% inflation target, having re-emphasized repeatedly the absolute commitment to the 2% inflation target, to then abandon the 2% inflation target would do very substantial damage to credibility. If you can adjust once, you can adjust again.”

Speaking during the What Next For Monetary Policy? session at Davos, Summers explained that much of the rhetoric surrounding the argument that it’s not worth having a recession to reduce inflation misunderstands the counterfactual.

“The counterfactual is not: can we have more inflation and not have a recession? The counterfactual is: if we fail to deal with inflation, we’re likely to have a larger and more serious recession at some subsequent point,” he said.

Summers added that even if the main goal was maximizing the average level of employment over the next decade, and not focusing on the rate of inflation per se, that maintaining a commitment to price stability, as it had been defined, would be appropriate.

“Ultimately what happens in the real economy is not determined by monetary policy and you can’t make it happen better by hitting some kind of monetary policy accelerator permanently,” he stressed.

Summers acknowledged that the world was falling far short on what it should be doing to cushion blows and to cushion necessary adjustments, particularly in regards to the developing world.

“But I think to suppose that some kind of relenting on an inflation target will be a salvation, would be a costly error. It would ultimately have adverse effects as it did in a spectacular way during the 1970s for real economies and working people everywhere,” he added.

Speaking during a later session, Global Economic Outlook: Is this the End of an Era?, Summers warned against complacency despite the global economy being in better shape than many had forecast previously.

“We’re experiencing some exhilaration of relief in Davos. Hyperpopulists lost elections and accepted their defeat. Europe has not frozen. Recession has not come. China has adjusted its policies towards the world and inflation has decelerated. Those are all positive things and reasons why we should feel better than we felt a few months ago,” he observed.

“But relief must not become complacency. Inflation is down but just as transitory factors elevated inflation earlier, transitory factors have contributed to the declines that we have seen in inflation,” Summers said.

Summers warned that if inflation was allowed to surge back, it would put at risk not just price stability and the standards of living for those on the lowest incomes, but also pose substantial risks to cyclical stability.

“As in many journeys, the last part of the journey is often the hardest. And that’s true with respect to a return to the inflation target,” he observed. “The greatest tragedy in this moment would be if central banks were to lurch away from a focus on assuring price stability prematurely, and we were to have to fight this battle twice.”

Leaders also need to remember the importance of those who have been left behind – both at home and around the world – and bear the greatest burden of economic disruption when making necessary economic adjustments in the years ahead.

“Global integration must never be the primary cause of local disintegration if that integration is going to continue with all of the benefits that it can bring,” said Summers. And that implicates every policy issue – from the treatment of debts of countries with substantial debt overhangs to the challenges in less-populated areas of industrial countries – if people are to feel part of a successful community.

Appropriately at Davos, Summers said there is great potential in this moment to address some of the world’s greatest challenges due to the potential of technology. Whether it is green technology, biotechnology, artificial intelligence or information technology, he believes it has the potential to make things better for everyone.

Asked about the potential global ramifications of the US Inflation Reduction Act, which directs federal spending towards reducing emissions and boosting R&D and commercialization of green technologies, he said it was a historically positive measure as it could boost innovation worldwide.

“A subsidy war [opposed to a trade war] about very good things, is basically a good thing. Walling off each other’s innovation is basically much more problematic. So I would like to keep markets open and I think that’s mutually important,” he observed.

“If we’re all competing over who can accelerate a transition towards renewables more rapidly, who can be the biggest leader in storage and transmission technologies – that’s a very healthy kind of competition,” Summers added.

“So, yes, let’s compete on that. But let’s compete by how hard we try and how much we subsidize, and not by how we wall-off others or try to take down others. We need to win in a positive-sum way, by building ourselves up rather than by seeking to tear others down. And if we can do that, I think there’s enormous potential in this moment.”