Fighting Inflation: Challenging Common Misconceptions

Many inflation hawks today attribute the current high levels of inflation to excessively loose economic policies, both fiscal and monetary. They point to policies implemented early in the pandemic when public health considerations forced hasty shutdowns across many sectors of the economy. Around this time, Congress passed a massive covid relief bill that directly covered business losses and supported consumer spending; and the Fed sharply increased its purchases of financial assets, keeping interest rates close to zero and ensuring sufficient liquidity to allow the recovery to gain traction.

Would it really have been better to pursue policies that would have postponed these achievements to a later date? I tend to think not. I accept the current level of inflation as a bit of a price to pay to get America back to work. In any case, if you want to blame policy makers for being responsible for our current inflation, it is fair to credit those same people and institutions with precipitating the rapid pace of economic expansion that we have enjoyed over the Past 6+ quarters, culminating in the recovery of virtually all pandemic job losses and the lowest unemployment rate since immediately before the pandemic.

Econ 101 teaches that tight fiscal and monetary policy can be used to curb inflation. In either case, the conventional anti-inflationary remedy requires the suppression of aggregate demand. Fiscal policy achieves this by reducing public sector spending and/or raising taxes to reduce discretionary income, which promotes a slower pace of household and business spending. A tight monetary policy requires reducing the rate of monetary expansion, which precipitates higher interest rates; and these higher interest rates make borrowing more expensive, leading to reduced spending.

Those who blame current inflation rates on previously employed economic policies generally prefer to use fiscal and monetary policy levers to solve our current inflation woes. I agree with this direction in the context of monetary policy, but I am less enthusiastic about the evolution of fiscal policy. I fear that the general fiscal policy designed to rein in aggregate demand is unnecessary and even short-sighted.

Monetary policy is a blunt tool that inherently chooses between directing its efforts to (a) encourage faster economic growth and reduce unemployment or (b) fight inflation. Fiscal policy, on the other hand, is not so binary. While fiscal policy can certainly be used to counter inflation, it must also be used in relation to other policy goals, such as ensuring health, safety, and general welfare. Sometimes — like now — these various goals can be somewhat in conflict; in which case non-inflation targets should not be entirely ignored.

It is 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. More specifically, any expenditure that improves market efficiency or encourages greater participation in the labor market stimulates aggregate supply at the same time as aggregate demand. To categorically view these expenses as inflationary is too simplistic an assessment.

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

Take, for example, the various types of spending initiatives that had been suggested under the Build Back Better program, including funding to (a) maintain and improve traditional infrastructure, (b) expand access to broadband, (c) reduce health care costs, (d) encourage the transition to clean energy, and (e) provide support for families with preschool children. Categorizing all these initiatives as inflationary is dishonest. This is hardly the case. Much of this spending would have directly reduced costs for American households or spurred greater labor participation in a host of newly created jobs. In any case, as originally conceived, all expenditures of the Build Back Better Bill were to be funded by higher taxes. This tax provision alone should have dismissed criticism that the bill was inflationary.

The fact that the Build Back Better plan failed should not preclude further efforts to adopt a smaller version. The current circumstances relating to each of the parts of the bill mentioned above are certainly not optimal; and the absence of any constructive action in any of these areas is indefensible. You can walk and chew gum at the same time. Monetary policy can take on the burden of reducing inflation. Fiscal policy can be geared towards solving other problems.

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