Fighting inflation: Challenging conventional wisdom

Many of today’s inflation hawks attribute the current high levels of inflation to excessively loose economic policies — both fiscal and monetary. They point to the policies implemented at the onset of the pandemic when public health considerations precipitative forced shutdowns across many sectors of the economy. At that time, Congress passed a massive covid relief bill that directly defrayed business losses and supported consumer spending; and the Fed sharply ramped up its purchases of financial assets, keeping interest rates near zero and assuring ample liquidity to allow the recovery to gain traction.

Would it really have been a better choice to have pursued policies that would have deferred these achievements until some more distant date? I tend to think not. I accept the current level of inflation as somewhat of the price that had to be paid to get America back to work. In any case, if you want to blame policy makers for being responsible for our current inflation, it’s only fair to credit those same people and institutions for precipitating the rapid pace of economic expansion that we’ve enjoyed for the last 6 quarters and counting, culminating with the recovery of virtually all the job losses from the pandemic and the lowest unemployment rate since immediately before the pandemic.

Econ 101 teaches that contractionary fiscal and monetary policy can be used to tamp down inflation. In both policy venues, the conventional anti-inflationary remedy requires suppressing aggregate demand. Fiscal policy does so by reducing spending by the government sector and/or raising taxes to decrease discretionary incomes, fostering a lower pace of spending by both households and businesses. Tight monetary policy requires reducing the rate of monetary expansion, which precipitates higher interest rates; and those higher interest rates make borrowing more expensive, causing a cutback in spending activity.

Those who blame current inflation rates on previously employed economic policies generally favor using both fiscal and monetary policy levers to address our current inflation difficulties. I’m on board with this orientation in connection with monetary policy, but I’m less enthusiastic about the shift of fiscal policy. I fear that the broad-brush fiscal policy designed to dampen aggregate demand may be unnecessary and even shortsighted.

Monetary policy is a blunt tool that inherently chooses between directing its efforts to either (a) encourage faster economic growth and lower unemployment or (b) fight inflation. Fiscal policy, on the other hand, isn’t so binary. While fiscal policy can certainly be used to counter inflation, it must be used in connection with other policy goals, as well, like insuring health, safety, and general welfare. Sometimes — like now — these various objectives may be somewhat in conflict; in which case objectives unrelated to inflation shouldn’t be entirely ignored.

It’s also important to realize that while government spending is certainly a component of aggregate demand, over time, that same spending can also influence aggregate supply. Specifically, any spending that improves market efficiencies or encourages greater labor force participation stimulates aggregate supply along with aggregate demand. Categorically seeing such expenditures as inflationary is an overly simplistic assessment.

Whether spending is inflationary or not may depend on the nature of the expenditures and the time horizon under consideration. Over time, the supply side effect could very well dominate relative to demand side effects in many types of government spending. The traditional economic policy remedy on the fiscal side fails to give appropriate weight to this consideration.

Consider, for example, the various kinds of spending initiatives that had been suggested under the Build Back Better program, including funding to (a) maintain and improve traditional infrastructure, (b) expand broadband access, (c) lower health care costs, (d) encourage the transition to clean energy, and (e) offer support to families with pre-school age children. Categorizing all of these initiatives as inflationary is disingenuous. That’s hardly the case. Much of that spending would have directly lowered costs for American households or stimulated higher labor force participation in a host of newly created jobs. In any case, as originally conceived, all the expenditures under the Build Back Better bill were to be funded by higher taxes. By itself, that tax provision should have obviated the criticism that the bill was inflationary.

The fact that the Build Back Better plan has failed shouldn’t preclude further efforts to pass a more scaled back version of it. Current circumstances relating to each of the bill’s component areas mentioned above are certainly not optimal; and failure to embark on any constructive action in any of these areas is indefensible. We can walk and chew gum at the same time. Monetary policy can bear the onus of bringing down inflation. Fiscal policy can be directed toward solving other problems.