James Carville, Bill Clinton’s political adviser, famously said that when it comes to elections, “It’s the economy, stupid.” In the run-up to November’s midterms, President Joe Biden must hope that Carville’s adage is not always true since his Democratic Party will go to the polls with the economy in shambles.
Whether or not Biden is fully to blame for the economy’s sorry state, his party will face the electorate with the country’s highest inflation rate in 40 years. It seems increasingly likely that we will have an economy on the cusp of a recession and a stock market on the back foot. This does not bode well for Democrats retaining control of either house of Congress. This is especially the case considering that polls show that voters consider inflation or the high cost of living to be the most important issue facing the country.
Biden is not the first president to drag inflation woes into a midterm election, so there’s precedence for what likely lies ahead. Three other presidents have watched their parties take it in the chops in the midterms as Americans faced rapid price increases: Gerald Ford, Jimmy Carter and Ronald Reagan. Here’s what the past can teach us about what lies ahead — and what Biden got wrong.
A tale of three presidents
There were a lot of reasons that in 1974 Republicans took the worst midterm beating of either party in nearly two decades. One, of course, was Ford’s September pardon of Richard Nixon. While the pardon was certainly no boost to the GOP’s short-term prospects, the party’s real problem was an average annual inflation rate of more than 11%. The price shocks, which began with OPEC’s oil embargo the year earlier, long outlasted the oil crisis itself. Democrats gained 49 seats in the House and 4 in the Senate, numbers that would not be surpassed for 20 years.
As inflation persisted, so did the political misery for the party in power. In 1978, with average annual inflation at 7.62%, just below current rates, Carter watched Democrats give back 15 of the House seats they had won during Republicans’ inflationary pains.
Then, in 1982, with inflation clocking in at 6.16%, Reagan oversaw the punishing loss of 26 House seats for his party, including many that had flipped from blue to red as part of his smashing victory just two years earlier.
Reagan and his team, though, knew that such losses were likely, and probably necessary if their plan to break inflation’s hold on the economy was to work. The president had made inflation a major part of his campaign against Carter as Americans were getting crushed under rates that hit 15% in 1980.
After taking office the next year, Reagan backed Federal Reserve Chairman Paul Volker’s audacious bid to use massive interest rate hikes to finally burst the inflation bubble. Volker rode interest rates to their all-time high of 22.36% in July 1981. The strategy whipped inflation, but also devastated much of the economy as businesses were starved of capital and home buyers fled the market. Reagan used the last of the mandate from his 1980 landslide to push through the most significant tax cut in generations, including new inducements to capital investment.
As the economy slipped into an even deeper recession, Reagan could at least hope that the steps he’d taken would pay off later, despite the political pain that the 1982 midterms would bring. He was right. The recovery that followed propelled Reagan two years later to a re-election victory in which he carried 49 states. But there is nothing at all to suggest that Biden is following a similar approach or that he will obtain similar results. After belatedly acknowledging the issue at all, Biden’s priorities on inflation seem to be first, to shift blame to others, and second, to offer mostly symbolic balms while still pursuing deficit spending that exacerbates the underlying problem.
A string of bad luck
To be sure, Biden has had more than his share of bad economic luck, including the rise of the omicron variant of COVID-19 just as delta began to fade. Then there was another external economic shock in Russia’s invasion of Ukraine, which led to an international oil price of over $100 a barrel, which contributed to record high gas prices in the U.S. At the same time, the Russian invasion has sent grain prices through the roof and substantially increased the price of key industrial metals like aluminum, nickel and palladium.
Closer to home, Biden has the misfortune of having a Federal Reserve that has been asleep at the wheel. Throughout 2021, as inflation kept accelerating, the Fed managed to convince itself that the surge was but a transitory phenomenon that would soon be reversed once the pandemic abated. That caused the Fed to keep its policy interest rate at its zero lower bound and to fall well behind the inflation curve. It also caused the Fed to turn a blind eye to the money supply’s acceleration to its fastest pace of growth in the past 50 years.
The Fed also seems to have done Biden no favors by creating an equity, housing and credit market bubble through its aggressive buying of Treasury bonds and mortgage-backed securities. Throughout most of last year, even at a time when the equity and housing markets were on fire, the Fed kept on buying $120 billion of bonds a month, including $40 billion a month in mortgage-backed securities.
In effect, the Fed kept spiking the punch bowl while the party was in full swing. As a result, equity valuations rose to nosebleed levels experienced only once in the past century. Meanwhile, even in inflation-adjusted terms, housing prices exceeded those in 2006 on the eve of the housing-market bust, and highly leveraged companies were able to borrow readily at low interest rates.
Finally, while Biden can point to external factors that have contributed to inflation, his claims that he should bear no responsibility ring hollow, given that in March 2021, Larry Summers, treasury secretary under Barack Obama, warned Biden that his signature piece of economic legislation, the American Rescue Plan, would overheat the economy.
That $1.9 trillion package came on top of the previous year’s $3 trillion bipartisan budget response to the COVID-19-induced recession. It also came at a time when the economy was recovering strongly from that recession and inflation was beginning to pick up.
The moral of the story
After having been overly complacent about the risk of inflation, the Fed now seems to be attacking inflation with the zeal of a convert. In addition to signaling that it will raise interest rates in 50 basis points rather than 25, the Fed is now committed to rapidly reduce its balance sheet by not rolling over its bond holdings when they fall due. This means that instead of supplying $120 billion a month in liquidity to the market as it did last year, the Fed will now be withdrawing $95 billion a month in liquidity.
This could spell even more trouble for American families. In the past, there have been very few occasions when the Fed has succeeded in squeezing inflation out of the economy without precipitating an economic recession. And this time, the Fed’s tightening will be occurring against the backdrop of an equity, housing and credit market bubble that the Fed itself created by its prolonged period of ultra-easy monetary policy.
Today, equity valuations remain at stratospheric levels, housing prices exceed their 2006 peak even in inflation-adjusted terms, and credit spreads on highly leveraged loans remain low.
By raising interest rates and committing to rapidly run down the size of its balance sheet, the Fed could very well trigger the bursting of those bubbles. As occurred in 2008, this could precipitate a deep economic recession. And all of this could be happening as Americans go to the polls in November.
If there is a lesson for future politicians to learn from the Democrat Party’s likely shellacking, it’s the importance of taking the political cycle into account when making major economic policy initiatives. The key mistake that Biden made was to engage in excess budget stimulus too soon without consideration of the political cycle.
To be sure, his American Rescue Plan did produce a strong economic boom last year. However, it also contributed to the surge in inflation and set up the conditions for an economic bust on the eve of the midterms. Unlike Reagan’s calculated decision long ago to suffer short-term political pain to defeat inflation and spur long-term growth, Biden may have set himself for suffering both now and later.
Desmond Lachman is a senior fellow at the American Enterprise Institute and former deputy director at the International Monetary Fund’s Policy Development and Review Department. Chris Stirewalt is a senior fellow at the American Enterprise Institute and a contributing editor for The Dispatch.