“We know now that inflation results from all that deficit spending. Government has only two ways of getting money other than raising taxes. It can go into the money market and borrow, competing with its own citizens and driving up interest rates, which it has done, or it can print money, and it’s done that. Both methods are inflationary.” — Ronald Reagan
Approaching the intersection, when the light turns yellow, should you step on the gas or step on the brake? Well, we all know how you are supposed to answer that question if you want to pass the written test for your driver’s license.
In the United Kingdom, to address that nation’s economic problems, its leaders are not going to pass the written economics exam. They are stepping on the gas.
Unorthodox, certainly, and irresponsible, probably. The tax policies first floated this summer by the now-newly elected British Prime Minister Liz Truss are the opposite of what textbooks and most commentators recommend for taming inflation.
Chancellor of the Exchequer Kwasi Kwarteng’s September 23 presentation to Parliament let the world know the proposals weren’t just campaign promises to secure the vote of Thatcher-nostalgic Tories.
The inflation rate in the United Kingdom, the world’s fifth largest economy, is 9.9 percent now and forecast to rise even further. Truss and Kwarteng will cut taxes and argue that it will increase aggregate supply, which it could, thereby reducing inflation . . . in a few years.
But it will also increase aggregate demand in the short run and push up the overall price level, and — by the way — reduce the value of the pound and raise interest rates. The markets are not pleased. See Figure 1.
The Truss roll of the macroeconomic dice is headline news worldwide in the financial press. But this made-in-London turmoil is a small squall of economic eccentricity compared with the Category 5 policies authored by President Recep Tayyip Erdoğan in Turkey, the world’s 20th largest economy.
Again, the policies are the exact opposite of conventional wisdom. Based loosely on his experience in business and his Islamic faith, Erdoğan believes the way to reduce inflation is to cut interest rates. There is no independent monetary authority in Ankara. Erdogan controls the Turkish central bank with an iron fist.
Too bad. Underneath all the misguided financial machinations of the government, Turkey has the potential to be an economic powerhouse. But out-of-control inflation, which had been tamed by post-crisis reforms in the early 2000s, is back with a vengeance. The Turkish inflation rate is now 80 percent, and the Turkish lira, which would cost you 50 cents in 2014, can now be bought for a nickel.
Seeing how terribly out-of-whack policies can be, we here in the United States might start feeling a little smug. Sure, Fed Chair Jerome Powell and his 300 economists didn’t see high inflation coming and were slow to put on the monetary brakes.
But they have corrected their mistakes, and monetary policy is now briskly moving in the right direction: less money injected into the economy (through purchases of government debt), a higher discount rate, and a lot of pronouncements to stay the course until U.S. inflation, now at 8.2 percent, returns to something like 3 percent.
No So Fast
While far better than the United Kingdom or Turkey when it comes to fighting inflation, the United States has its own considerable shortcomings. The problem is that we rely almost exclusively on the Federal Reserve to maintain aggregate price stability.
When it comes to the effect of fiscal policy on inflation, we’re at best a little confused and more often blissfully ignorant. We wholeheartedly agree with the September 29 column from The Wall Street Journal economics commentator Greg Ip: “Elected leaders are still stuck in prepandemic times. They acknowledge inflation is a problem but continue to borrow as if limits don’t exist.”
We’re about to take a short walk down memory lane to explain how the obsession with the Fed and disinterest in fiscal matters became so prevalent in policy discussions about inflation. But first, let’s skip right into the implication of this mindset: By neglecting to recognize the potential effects of fiscal policy on inflation, we’re not only leaving idle an important tool in our toolkit, we’re also potentially making matters worse by opening the door to politically expedient inflationary fiscal policies — like tax cuts and new spending programs — that today’s conventional wisdom condones.
Here’s an analogy. Suppose it is true that caloric intake (diet) and caloric burn (exercise) are the keys to managing body weight, and suppose weight control is our number one health goal. If a fad diet (Paleo, Mediterranean, and so forth) becomes so trendy that folks discount the role of exercise, we would be neglecting a tool that would complement our laudable dietary habits and that would allow us to achieve our weight goals more quickly. That’s not optimal, but not so bad either.
Now suppose that instead of just neglecting to complement diet with exercise, we use diet as a substitute for exercise. Depending on the actual impact of diet and exercise regimens, it’s possible that caloric intake reduction is less than caloric burn increase — that is, we gain weight because of a net increase in calories. What is certainly true is that relying on one method of weight loss (diet) while neglecting the other (exercise) means that the first must be conducted more rigorously if we want to reach our goal.
Back to macroeconomics. On May 10 President Biden said, “I’m taking inflation very seriously, and it’s my top domestic priority.” That is good.
In today’s circumstances, giving priority to fighting inflation over other important causes (for example, reducing poverty) makes sense because we don’t want inflationary expectations to take hold and create a wage-price spiral that will only become more painful to unravel over time.
And we must consider that ignoring the inflationary effect of tax and other expansionary fiscal policies means the Fed must raise interest rates even more than it otherwise would.
Adam Posen of the Peterson Institute for International Economics made this same point in recent commentary on the United Kingdom: “The Bank of England should make it clear immediately that the government’s reckless budget plan will surely require higher interest rates.”
If you think our strategy is so superior to the new British approach to inflation, think again. As Ip’s recent column tells us, noting excessive spending by the Biden administration: “The country that resembles the U.K. most closely is the U.S. While the reserve status of the dollar and Treasury debt insulates the U.S. from some of the pressures buffeting Britain, its fiscal policy is just as miscalibrated.”
Now here’s your oversimplified and irreverent decade-by-decade overview of how we ended up with policymakers who are comfortable with the Federal Reserve taking responsibility for controlling inflation and leaving them out of the picture.
In the 1950s President Eisenhower believed in a balanced federal budget, so when the 1958 recession struck, he allowed taxes to rise, deepening the recession even further. In the 1960s, reacting to Eisenhower’s lack of activism, the Kennedy and Johnson administrations embraced Keynesian doctrine and used fiscal policy to fine-tune a proper balance between inflation and employment.
In the 1970s, reacting to the near complete collapse of faith in Keynesian economics (caused by, for example, the inability to control either unemployment or inflation), monetary policy became the focus of attention among macroeconomists — first in academia (led by Nobel Laureate Milton Friedman) and then in Washington (led by Fed Chair Paul Volcker).
It seemed that Volcker single-handedly tamed inflation. (See Figure 2.) But his action also resulted in what was then the largest recession since the 1930s. And, although little noticed, monetarism in academia was being knocked off its pedestal because empirical studies were showing that monetary policy wasn’t all-important.
With the message from traditional macroeconomists so muddled, the confidence exuded by the new supply-side economists got a warm welcome and became what we now know as Reaganomics. Fiscal policy flourished. But like the Keynesian and monetarist macroeconomic doctrines that preceded it, the supply-side economics overpromised.
In the 1990s, because supply-side tax cuts didn’t pay for themselves, and the level of the federal debt rose to what was then considered terrifying levels, the use of fiscal policy to tamp down inflation and business cycles was dropped entirely. Deficit reduction was the be-all and end-all of fiscal policy.
This brings us to the turn of the century. How did the great debates about the macroeconomics of inflation evolve?
They didn’t. Inflation faded away. (Again, see Figure 2.) And with the disease under control, economic doctors lost almost all interest in understanding its causes and finding a cure.
A New Era
Then the pandemic gobsmacked the U.S. economy in early 2020, throwing 25 million people out of work in two months. Slowly but surely, concern about inflation reemerged as a major political and economic issue.
Raising the public’s and the political establishment’s awareness of fiscal policy’s potential contribution to rising inflation will be an uphill battle. There are so many strands of thought woven into our policy consciousness that keep inflation off the radar:
- Friedman’s declaration that inflation “is always and everywhere a monetary phenomenon” remains the guiding principle of macroeconomics for many, so fiscal policy isn’t considered an important determinant of inflation.
- The justifiable rise of popular interest in supply-side economics that began in the late 1970s has caused many to unjustifiably ignore or discount the role of demand-side effects of fiscal policy.
- Many considered the $787 billion American Recovery and Reinvestment Act of 2009 (the “Obama stimulus”) enacted in the wake of the Great Recession too small and the reason for the absence of a strong post-recession rebound. Democrats didn’t want the Biden administration’s stimulus to similarly fall short, so significant emphasis was put on growth, drowning out any concern about inflation.
In addition to those notions, two fundamental facts kept concerns about the effects of fiscal stimulus on inflation subdued. First, individuals under the age of 50 never experienced double-digit inflation in their adult lifetimes. (Inflation, what’s that?)
Second, elected officials are more than willing to continue providing benefits (even if they do fully understand the inflationary effects) if it’s widely accepted that it’s the Federal Reserve’s job to do the dirty work of administering the bitter economic medicine necessary to control inflation. (Inflation, not my job.)
But two and a half years later, with the benefit of hindsight, all these excuses are less compelling. We have a high rate of inflation that we didn’t see coming. Overgenerous pandemic-related fiscal stimulus was undoubtedly a major underlying cause.
A bunch of smaller but still significant reliefs followed in 2022. Those include the grants and tax credits to support semiconductor manufacturing in the CHIPS
And shortly after, on August 24, Biden issued an executive order providing massive student loan forgiveness. Preliminary estimates from the administration put the average annual cash flow effect at about $24 billion. Just released Congressional Budget Office estimates put the total cost at about $400 billion.
Both political parties, anxious to please voters in upcoming elections, are considering more deficit-financed tax cuts and spending programs. Their inflationary policies include the much-hoped-for extension of the “usual” expiring tax breaks and maintaining the phasing-out and expiring tax breaks provided in the Tax Cuts and Jobs Act. We can no longer allow them to wave away concerns about inflation — the stakes are too high.