Fiscal policy should return to basics

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Recent significant interest rate hikes by the US Federal Reserve and the European Central Bank suggest that monetary policy makers intend to act forcefully to reduce inflation. But where are the dozens of economic commentators who for years have argued that fiscal policy – ​​that is, usually deficit spending – needs to play a much more active role in managing business cycles? If it really makes sense to use both monetary and fiscal policy to counter a routine slowdown, why are central banks suddenly on their own trying to engineer a soft landing with inflation at its most high level in four decades?


Prior to the global financial crisis of 2008, the consensus was that monetary policy should take the lead in dealing with ordinary business cycles. Fiscal policy should play a supportive role except in times of wars and natural disasters such as pandemics. When systemic financial crises occurred, it was thought, monetary policy could react immediately, but fiscal policy had to follow quickly and take the lead over time. Taxation and government spending are intensely political, but successful economies could overcome this problem in an emergency.

Over the past decade, however, the view that fiscal policy should also play a greater role in macroeconomic stabilization in normal times has gained traction. This change was influenced by the fact that central bank interest rates ran into the zero rate limit. (Some, including me, think this argument ignores relatively simple and effective options for reducing rates below zero, but I won’t repeat it here.) But the zero bound was by no means the whole argument.

It is true that helicopter money and other transfer programs have proven extremely effective during the early stages of the Covid-19 pandemic, helping to protect individuals while reducing long-term economic scars. But here’s the thing: No country, and certainly not a large, politically divided country like the US or the UK, has quite figured out how to conduct technocratic fiscal policy consistently, because politics is hard-wired into politics. budgetary.

There are a myriad of ways for governments to spend money and a myriad of possible criteria for deciding who deserves support and who should foot the bill. Bargaining and implementation issues mean that there will always be inefficiencies, and these tend to be greater as the spending bill rises. This is exactly what happened in the United States from late 2020, when politically motivated fiscal policy resulted in too much stimulus too late.


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Illustration: Binay Sinha


Certainly there was some logic in keeping monetary and fiscal policy on a full expansionary tilt as an insurance policy against the worsening of the pandemic or the outbreak of another crisis – as happened when Russia invaded Ukraine. Yet the cost of this approach, in terms of increased inflationary pressures and reduced ability to respond to war-triggered supply shocks, must now be paid. Those who argued that a surge in inflation was highly unlikely had their heads in the sand.

With inflation high and growth slowing significantly, what to do? First, interest rates need to rise, but central bankers and the International Monetary Fund seem to be overzealous about the rate at which this should happen. It is far from clear that the benefits of bringing inflation back to its target by the end of 2023, for example, are worth the significant risk of another deep recession, given the lingering effects of the recent pandemic and of the not-so-distant financial crisis.

Second, the fiscal policy debate has been dominated for too long by the siren song of pundits promising that real interest rates will never rise and deficit spending will be free. Modern monetary theory is an extreme representation of this view, but it is not so different from the belief of some mainstream economists that government debt could be much larger without any negative consequences.

The right way for governments to redistribute income in a sustainable way, if that is the goal, is to raise taxes on high-income people and increase transfers to lower-income segments of the population (and in particular very low income). US Democratic Party Congresswoman Alexandria Ocasio-Cortez had that right when she wore a flamboyant “tax the rich” dress to the 2021 Met Gala, though she could have added “and the upper middle class” to the tagline.

Conservatives must accept that higher taxes on high and upper middle income people are not only fair, but also necessary to achieve social cohesion. Yes, economic efficiency and dynamism are fundamental virtues of the American system and a big part of why the West is still able to compete with China and Russia in key areas such as technology. But an inadequate social safety net and failure to tax the economic elite at an adequate rate threatens to destroy the American model from within.

Fiscal policy needs to go back to basics and be recalibrated. The longstanding argument that Keynesian go-go fiscal stimulus is the answer to every economic shock imaginable has been exposed as a failure. Nevertheless, at this stage, the readjustment of macroeconomic policy must be gradual if a deep recession is to be avoided.



The author, former chief economist of the International Monetary Fund, is professor of economics and public policy at Harvard University. © Syndicate Project, 2022





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