Inflation: The Externality of Generous Fiscal Policies

Over the span of Mr. Biden’s presidency, he has been forced to confront the ugly realities that come with generous fiscal initiatives: inflation. While many hope to make the debate around inflation a partisan issue, it seems more appropriate to relegate sentiments surrounding inflation to understanding the true economic goals of the U.S. economy in both the short and long term. Admittedly, I have some bias as a self-described Moderate Conservative, but the reality is that regardless of the fiscal or monetary policies that followed the massive economic response to the COVID-19 pandemic, the ultimate result of these actions (or inactions) will either yield increases in inflation, increases in unemployment, increases in prices or combinations of these outcomes due to the significant inflow of capital into the U.S. equity markets. Ultimately, we are left to decide, which pill we will choose, but we must choose one, or a jumble of a few. This is not to say or to excuse the fact that the Biden Administration’s fiscal initiatives have exacerbated an already challenging moment in our history.

The beginning of this year brought many discussions from economists on whether the U.S. economy was beginning to overheat. The concern was, and still is, that core inflation is rising because of substantial increases in real GDP and declining unemployment; none of this should come as a surprise. An overheating economy is often characterized as rising inflation rates and low unemployment rates. Using the Aggregate Demand/Aggregate Supply (AD/AS) model to illustrate this scenario one would presume that monetary policies were put in place for the purpose of driving down the federal funds rate. As a potential consequence, in the short run there would be an increase in real GDP and an increase in prices. In the long run there would just be an increase in prices. This would result in an almost immediate AD shift to the right shortly followed by an AS shift to the left in hopes of reaching long run equilibrium. [1]

Under the assumption both inflation and unemployment rates continue to rise then there would likely need to be a shift in both monetary and fiscal policy. A potential solution to the inflation issue would be to reverse course and increase interest rates however by doing so, this may exacerbate the unemployment issues because the “cost” of adding additional staff would be higher for employers. An alternative would be to continue to reduce interest rates in hopes that the increase in real GDP could result in more output and more employment. Lastly, government or fed officials could enact zero monetary and fiscal changes and allow the economy to correct on its own over time.

In an article Titled “Is The U.S. Economy Recovering or Overheating”[2], Delong makes a few important points, and we reach the same ultimate conclusion, he writes: “Moreover, the US economy is emerging from the pandemic recession with a fundamentally altered inter-sectoral balance. Spending on durable goods currently accounts for an additional 1.7 percentage points of GDP, relative to its 2019 level, and spending on housing construction is running at 0.5 points above its 2019 share. At the same time, business spending on structures and consumer spending on energy are both running at 0.5 points below their 2019 shares, and spending on services (hospitality, recreation, and transportation) is 2.2 points below its 2019 share. These sectoral dynamics will be the most important determinants of inflation this year. By the end of 2021, some 4% of all workers will have moved not only to new jobs but to entirely different sectors. In an economy where businesses very rarely cut nominal wages, the pull of workers from sectors where demand is relatively slack to sectors where it is more intense will require firms to offer wage increases to encourage workers to make the jump. But we cannot know how much inflation this reshuffling will cause, because we have not really seen anything like it before. Economists will have a lot to learn this year about the short-term intersectoral elasticity of employment supply. One thing that should be clear, however, is that an uptick of inflation this year is nothing to be upset about. After all, wage and price increases are an essential part of rebalancing the economy. Real production, real wages, and real asset values will all be higher as a result of this year’s inflation, whereas the price level will remain far below what it would have been had the Fed managed to hit its inflation targets in the years since the Great Recession following the 2008 global financial crisis.”

Some weeks ago, I wrote the Fed should reduce its asset purchases which would result in a reduction of free-flowing cash into the U.S. economy, and I believed then, as I believe now, that this action and strategy, although initially painful, would yield the best long-term results and would protect both domestic and foreign capital markets and provide companies with more long-term certainty which would naturally stabilize markets and consumer sentiment over time. I also believed then, as I do now, that the concerns around inflation although real, were a function of market corrections that our economy needed to accept the brunt force of now, rather than during say a looming presidential election.

Edward Abbey perhaps summarizes it best when he said, “growth for the sake of growth is the ideology of the cancer cell.” What we are experiencing now, fortunate, or unfortunately, is the cost associated with living in a society that is inextricably tied to both consumption and production. Free-flowing capital together with prolonged stay at home orders have real consequences and now we are on the uncomfortable path of correcting what appear to be, our pathological ways.

[1]Aggregate Supply and Aggregate Demand Explanation - https://www.khanacademy.org/economics-finance-domain/macroeconomics/aggregate-supply-demand-topic/macro-equilibrium-in-the-ad-as-model/a/test-article-ii [2] J. Bradford Delong - https://www.project-syndicate.org/commentary/us-inflation-shows-economy-is-reshuffling-and-recovering-by-j-bradford-delong-2021-05