The recent large rate hikes by the Federal Reserve and the European Central Bank show that policymakers are determined to act boldly to reduce inflation. But where are the legions of economic analysts who have argued for years that fiscal policy, often understood as deficit spending, should play a much more active role in managing business cycles? If it really makes sense to use both monetary and fiscal policy to counter routine slowdowns, why are central banks suddenly trying to achieve a soft landing with inflation at a four-decade high on their own?
Before the global financial crisis of 2008, there was a consensus that monetary policy should take the lead in managing normal business cycles. Fiscal policy should play a supportive role except during wars and natural disasters such as pandemics. When systemic financial crises emerged, it was thought that monetary policy could react immediately, but fiscal policy should follow promptly and take the lead over time. Taxes and public spending are extremely political, but prosperous economies could sidestep this issue in emergencies.
However, over the last decade, the view has gained ground that fiscal policy should play a more dominant role in macroeconomic stabilization even in normal times. This change was influenced by the fact that central bank interest rates have reached the zero lower bound – some, including myself, believe that this argument overlooks relatively easy and effective ways to bring interest rates below zero, but I won’t get into that here. However, the zero limit was by no means the whole argument.
It’s true that helicopter money and other transfer programs have proven extremely effective in the early stages of the COVID-19 pandemic, helping to protect people while reducing long-term financial scars. But here’s the catch: no country, and certainly not a large and politically divided one like the US or the UK, has really figured out how to consistently engage in technocratic fiscal policy, because “politics” is an inescapable part of fiscal policy.
Governments have endless ways of spending money and endless possible criteria for deciding who to support and who to foot the bill. Haggling and application issues mean there will always be inefficiencies, and these tend to get bigger as the spending bill rises. This is exactly what has happened in the US since late 2020, when politically motivated fiscal policy led to too much stimulus too late.
Admittedly, there was some logic in keeping monetary and fiscal policy in a fully expansionary trend as an insurance policy against the worsening of the pandemic or the onset of another crisis, as indeed happened when Russia invaded Ukraine. However, the cost of this approach is now being paid in the form of increased inflationary pressures and a reduced ability to respond to war-related supply shocks. Those who argued that inflation was highly unlikely to pick up stuck their heads in the sand.
What to do when inflation is high and growth is very slow? First, interest rates need to be raised, but central bank governors and the International Monetary Fund appear to be too strict on the pace at which this should happen. It is far from self-evident that the benefits of bringing inflation down to target levels, say by the end of 2023, outweigh the significant risk of another deep recession given the lingering impact of the recent pandemic and the ever so distant financial crisis.
Second, for too long the fiscal policy debate has been dominated by the siren song of pundits promising that real interest rates will never rise and that deficit spending will be a godsend. Modern monetary theory is an extreme exposition of this view, but it is not so different from the belief of some conventional economists that national debt could be much higher without ill effects.
The right way for governments to redistribute income in a sustainable manner, if that is the goal, is to increase taxes on higher-income groups and increase transfers to lower-income groups (and especially the poor). United States Congresswoman Alexandria Ocasio-Cortez understood that when she wore an extravagant gown with the slogan “Taxes the rich” to the 2021 Metropolitan Opera Gala, though she could have added “already up the middle class” of the slogan.
Conservatives must accept that tax increases for middle- and high-income people are not only fair, but necessary to achieve social cohesion. Yes, economic efficiency and dynamism are core virtues of the American system, and they’re a big part of why the West remains able to compete with China and Russia in key areas like technology. But an inadequate Social Security cushion and failure to tax the business elite at the right rate risk destroying the American model from within.
Fiscal policy needs to go back to basics and recalibrate. The old argument that Keynesian fiscal stimulus is the answer to every conceivable economic crisis has been debunked. However, at this point, the rebalancing of macroeconomic policy needs to be gradual if we are to avoid a deep recession.
Kenneth Rogoff He is a former chief economist at the International Monetary Fund and Professor of Economics and Public Policy at Harvard University. © Project Syndicate 1995-2022. Translation of news clips.
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