What is the Real Impact of Fiscal Policy on the Economy?
Former JPMorgan Chase Global Chief Economist & PH.D. in Economics
Liberal advocates argue that when fiscal policy supports desired social goals (e.g., affordable health and childcare), it is a win for the economy with minimal or non-existent impacts on inflation because it will boost the labor supply over time.
Conservative advocates believe incurring fiscal deficits to cut corporate taxes or lower taxes on high-income individuals will stimulate investment and boost the supply of goods and services. Such effects should dampen inflation pressures.
The problem with these two views is that inflation results when aggregate demand for goods and services exceeds the aggregate supply of goods and services produced. That rule applies to both investment and consumer goods.
Even a heterodox economic theory (e.g., Modern Monetary Theory, MMT) not supported by mainstream or orthodox schools of economic thought concedes to the basic tenet that inflation pressures will develop when aggregate demand exceeds aggregate supply. In its simplest form, MMT argues that raising taxes is a worthwhile strategy to dampen inflation pressures. The only time MMT proponents waver is when inflation is already deeply ingrained into the economy. In such instances, MMT supporters argue that it is not easy to solve our inflation problem by raising taxes.
When Can Expansionary Fiscal Policy Benefit the Economy?
Expansionary fiscal policy to support a liberal agenda can help an economy operating at a depressed level of economic activity coupled with reduced inflation pressures but hurts the economy when it is operating above full employment.
Similarly, corporate, and personal income tax cuts favored by conservatives to boost economic incentives can help the economy when the economy is depressed with reduced inflation pressures.
We will leave it to the reader to decide which path of fiscal policy (if any), they wish to support when the economy is operating below its productive capacity.
The Latest United Kingdom Fiscal Policy Experiment
Financial markets went apoplectic after the U.K. government announced that it would reduce the tax rate on the highest tax bracket and begin subsidizing energy price increases. This would reduce government revenues and generate additional unfunded liabilities if energy prices moved higher.
The government would sell more bonds to cover the spread between a base price and actual energy prices. In a world where the U.K. was suffering from high inflation pressures (i.e., +9.8% CPI yearly rise), subsidizing energy prices would fail to allow markets to generate the demand destruction needed to balance the demand and supply of energy.
With the boost in the supply of sovereign debt (aka Gilts), the Bank of England (BOE) would need to raise interest rates which would amplify the effects of Quantitative Tightening (QT) previously announced by the BOE. Not surprisingly, the BOE announced it was postponing QT, and actively intervened by purchasing more than 1 billion pounds of British sovereign debt to support the currency. This represents a policy reversal toward Quantitative Easing (QE).
In a Draghi-like announcement, the BOE said it would buy British Bonds on “whatever scale was necessary,” to address a“material risk to U.K. financial instability.” This caused a sharp drop in the British Pound’s exchange rate (down more than 20% YTD against the U.S. dollar). It also produced a surprise warning from the IMF that the U.K. was not pursuing prudent economic policies. This is shocking since the IMF usually rarely offers policy advice to developed G-7 countries and has traditionally provided such advice mainly to Emerging market countries.
Concluding Thoughts:
Let’s hope the U.S. can obtain bi-partisan support to coordinate both its monetary and fiscal policies. It is an idea that ECB Chief Christine LaGarde and other European central bank officials have advocated within the Eurozone.
Most U.S. inflation pressures caused by supply-side developments will not benefit from fiscal or monetary policy. One instance where we could see some benefits from policy includes the passage of the bipartisan CHIPs act. The problem is that the upfront spending required to generate semiconductors in short supply will take years to pay off as subsidized foundries begin to generate output.
But if a simple reduction in the U.S. budget deficit could solve our inflation problem, we would already have seen progress given that the 12-month federal budget deficit has plunged from its 12-month rolling amount of $4.1 trillion in March 2021 to $1.0 trillion as of August 2022! The U.S. budget deficit has dropped by 15% of GDP and has been declining at an average pace of 1.0% per month since March 2021, while the U.S. Consumer Price Index continues to rise at a yearly rate of 8.3%.
CHIPS is inflationary and there are not enough STEM graduates to fill these plants. It is well known that the US lacks STEM training in schools. If 1980 is one data point, where mortgages got up to 18% and CA GO's were selling at 10%, then there is a possibility of a soft landing. But the geopolitical situation today is much more intense than that of 1980, so this comparison is flawed. This excellent article shows what happens when leaders wait too long to act... https://lawliberty.org/monetary-lessons-from-weimar-germany/