Economic Perspectives

Biden’s economic policy faces a backlash

Print edition : July 30, 2021

President Joe Biden speaking about his ‘Build Back Better’ economic package in Illinois on July 7. Photo: SAUL LOEB / AFP

As President Joe Biden strives to win support for substantially enhanced spending to help the post COVID recovery of the United States economy, critics warn of the impending dangers of inflation.

Policymakers in the United States, including those on the democratic side of the aisle, are increasingly divided over what needs to be done to ensure economic recovery from the COVID-induced crisis. The debate was first triggered by President Joe Biden’s decision soon after taking office to announce a $1.9 trillion stimulus package weeks after the outgoing Trump administration had implemented a $900 billion short-term stimulus effort.

This was followed by announcements of more long-term packages, such as the “Build Back Better” $2 trillion infrastructure investment plan, which has received partial bipartisan approval ($579 billion in new spending), and the proposal to ramp up spending on education and health. As many commentators noted, the U.S. seemed set to leave an era of fiscal conservatism behind. Even the Great Recession that followed the global financial crisis in 2008 had not elicited this kind of a fiscal response.

But the shift to proactive fiscal policies under the Biden administration brought about a quick backlash. In a much-cited intervention in The Washington Post (February 4, 2021), the Harvard economist and former Treasury Secretary Lawrence H. Summers, while recognising the “ambition”, “rejection of austerity orthodoxy” and “commitment to reducing economic inequality” reflected in the $1.9 trillion relief plan, argued that it could “set off inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the dollar and financial stability”. He also speculated that with this package taking the combined value of the post-COVID stimulus packages to 15 per cent of the gross domestic product (GDP), there would be little room left for the much-needed “public investment in everything from infrastructure to preschool education to renewable energy”.

The second of these appears to be an effort on Summers’ part to show that his heart was in the right place. The real criticism was the one that raises the fear of inflation coming down on an aggressive and proactive fiscal policy stance.

Fears of inflation

Summers provided early expert support for what soon became the chorus among financial market players and the voices that amplify their view. Their case has been strengthened by a rapid recovery in labour markets, rising wage levels and evidence of inflation.

The U.S. Labour Department’s June release reported that non-farm payrolls rose by 850,000 that month, well above the 583,000 recorded in May, and topping the Dow Jones projection of 706,000. Average hourly earnings increased 0.33 per cent in June and 3.6 per cent year on year. The consumer price index rose 5 per cent in May from a year earlier and the core inflation rate (excluding food and energy) by 3.8 per cent.
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Even before these numbers were released, The Wall Street Journal (June 12) carried a long-form article flagging the anti-inflation protests of the late 1960s and early 1970s and the biggest increase in the consumer price index in more than a decade, to warn of the danger of a return to the inflationary era. Since then, the clamour to hold back on spending increases has only intensified. President Biden’s willingness to scale down his $2 trillion infrastructural investment plan to a little more than quarter that sum in order to gain bipartisan supports suggests that the deficit hawks are winning again.

History of fiscal conservatism

Ever since the inflationary 1970s, U.S. administrations have led the ideological shift away from a macroeconomic policy stance favouring big spending in order to drive growth to one emphasising fiscal conservatism and privileging monetary policy interventions in order to manage growth and inflation. The rule of thumb to be adopted by the now more powerful central bankers were presented as simple and straightforward: when the economy is sluggish and inflation is low, feed it cheap money to encourage spending; and when the system is buoyant and expectations of inflation are high, rein in money supply and raise interest rates to prevent overheating.

As for government spending, it should be tethered to revenues, with borrowing under control and public debt capped. Fiscal policy should give way to monetary policy as the favoured intervention for macroeconomic management. In time, almost all advanced economy governments internalised these policy principles.

Even when the Great Recession of 2008 set in, after an initial feeble effort at reviving the economy with enhanced spending, the post-1970s ethos survived. The principal stimulus was monetary, with interest rates slashed to near-zero and central banks committed to “quantitative easing” or injecting large volumes of liquidity with regular purchases of targeted volumes of bonds from the market.

This policy package was not all too successful in reviving the economy, with a prolonged, even if geographically unevenly distributed, recession and persistent slow growth thereafter. What the cheap and easy money policy did was to stir up asset markets, as investors accessed cheap money to chase profits in asset markets. Asset prices rose to levels that had no relationship whatsoever to economic fundamentals.

This perverse consequence of the monetary stimulus created a peculiar situation: central banks found it difficult, even after a decade, to unwind these “unconventional” monetary policies which were over-fattening the balance sheets of central banks and hurting the profits of banks focussed on routine banking because of the zero or even negative interest rate regime. If the policy of quantitative easing or large-scale bond buying was tapered out and interest rates raised, investors riding on cheap money would pull out from financial assets in developed and emerging markets, which could set off a chaotic decline with consequences for the real economy.

Even the suggestion in 2013 that the U.S. Federal Reserve was considering unwinding its quantitative easing policy, triggered the “taper tantrum” in which investors rushed out of financial assets, especially in emerging markets, leading to capital flight and depreciating currencies. If these policies are unwound, a financial collapse may push sluggish economies into another recession. The better alternative seemed to be to stick with quantitative easing even if it kept asset markets on the boil.

Central banks stayed cheap and easy money policies and justified their monetary policy excesses with the argument that while there is no danger of inflation, the recovery was not yet robust. That was true only because the monetary stimulus was not working. But not wanting to roil markets, central bankers promised to stay with their easy money policies. The COVID crisis came in handy. With economic activity brought to a near halt by the pandemic, the case for cheap money policies seemed strong.

Given the nature of the crisis, which required governments to ramp up spending on health and vaccination, cash transfers to affected sections and support for businesses and social protection, fiscal conservatism had to take a back seat if governments had to retain their legitimacy.
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This explains both the Trump and Biden stimulus packages that increased spending significantly and brought on the backlash. However, the grounds that drive the backlash have created new problems for conservative policy advocates.

If inflation and an adequate recovery from the COVID-induced crisis are the reasons given for a return to fiscal prudence, then monetary policy, too, must adjust to address those inflationary tendencies, setting aside the growth objective temporarily. Interest rates must be raised, and excess liquidity sucked out of the system. But that would amount to unwinding the cheap and easy money regime that underpinned asset market buoyancy. A withdrawal from that regime could trigger investor pull-out and a bust in asset markets. So, a retreat from an easy money regime cannot occur when the economic effects of the pandemic are still being felt. Even when the retreat occurs it must do so in a manner that ensures “orderly” adjustments in asset markets.

This peculiar position where the threat of inflation is held out to argue for conservatism on the fiscal front but is not seen as reason to reconsider cheap and easy money policies is an obvious contradiction. Unable to resolve it, the chair of the Federal Reserve has decided to downplay the inflation threat by arguing that the observed near-30-year-high core inflation rate of 3.8 per cent recorded in May was “transitory” and will soon “start to abate”. But his colleagues demur. Of the 15 members in the Federal Open Market Committee, the number of those who think the risk of above-target inflation is high rose from five to 13 between March and June.

The Fed’s official position in June was that it expects to raise interest rates only in late 2023. James Bullard, president of the Federal Reserve Bank of St. Louis, on the other hand, has said he expects a rate increase next year.

Besides the impact this would have on asset markets, a higher interest rate would mean that there is little the policy establishment will be doing to keep the economy on track to recovery, since it seems set to roll back the fiscal push. Neither monetary nor fiscal stimulus will be. That is an odd situation for the world’s leading capitalist economy to be in when growth is not back to potential. Not surprisingly, President Biden is stretching himself to hype the threat from China to win support for substantially enhanced spending. But as of now, it appears that after this round of spending the economy will be left to its own devices. And that could spell a return to an era of exceptionally low growth.

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