PicoBlog

In the 2010s, there was a long-running debate among nerds about how exactly the government should address the problem of chronically weak spending, which was holding back recovery and depressing both inflation and employment. 

Among the participants in this debate was a camp of monetary purists. They argued, first, that central banks had all the tools that they needed to get the economy growing sufficiently fast, even though the main policy rate available to central banks—the overnight interest rate—had in most countries been cut to near zero. Given that central banks had all the tools they needed, some of these purists argued, it was reasonable to conclude that actually inflation and employment were roughly where central banks wanted them to be. And because inflation and employment were roughly where central banks wanted them to be, calls for more fiscal spending to boost the economy were misguided; if Congress spent more, and this spending stood to reduce unemployment and raise inflation, then the central bank would simply respond by pursuing a more hawkish policy path, which would offset the fiscal boost. If you were unhappy with the trajectory of recovery, then, the only sensible course of action was to lean on the central bank to change its policy framework (ideally, most purists argued, toward one which targeted a path of total spending across the economy: that is, nominal GDP).

Early in the 2010s, I had a lot of sympathy for this view, and I still think that growth in nominal spending is a very useful macroeconomic metric which should probably play more of a role in monetary policy-making. But as the decade wore on, it became increasingly clear that many central bankers did not see things the way the monetary purists did: a fact which called many of the purists’ conclusions into doubt. Whatever central bankers could in theory have achieved with sufficiently bold actions, they were not in practice willing to engage in radical steps to raise inflation expectations. They also became increasingly willing, as the years wore on, to advertise their desire for fiscal help in achieving their policy goals. If the folks in charge of monetary policy saw a useful role for fiscal policy, then it was reasonable for everyone else to conduct their policy analyses as though fiscal policy could and did matter.

And this was in fact how policy debates evolved over the course of the decade. Respectable economists became less embarrassed about advocating for fiscal stimulus. Indeed, Larry Summers made a persuasive case that we should be enthusiastic about the use of fiscal policy to shape both the magnitude and the composition of demand. Because of various structural issues across the economy, he argued, private demand was likely to be chronically weak, and when monetary policy did manage to generate adequate private spending it was likely to do so by inflating unsustainable financial booms. Better, then, to engage in lots of deficit-financed public investment, which would boost demand but would also raise the long-run capacity of the economy and so shouldn’t overburden the government’s finances.

Macro being macro, many people in the purist camp and others stuck to their particular view of the world throughout this period. But opinion among those responsible for policy did seem to shift, decisively, toward the view that fiscal policy could and should play an important role in demand management.

Ha, ok, and now? As inflation has risen well above central bank targets, the conversation around policy has shifted dramatically. The nature of the problem has changed, of course, from one in which demand runs chronically short of potential supply, to one in which demand is at least temporarily in excess of the economy’s productive capacity. But policy recommendations have also shifted back toward an approach favored by the monetary purists. Summers himself has urged Fed chairman Jerome Powell to unleash his inner Paul Volcker, and use monetary policy to take control of the inflation situation.

So is that it? Has the old consensus, which was only recently the new consensus, already been scrapped? Are we back to a world in which the central bank is primarily, or perhaps exclusively, responsible for demand management?

There is, I think, a relatively uncontroversial way to hold, simultaneously, the views that became more popular during the 2010s and the views expressed by Summers now. It is to say: that at the moment we face a problem of excess demand; that to address excess demand interest rates need to rise; that central banks are more than capable of raising interest rates without any help at all and should do so, and; that if and when we find ourselves back in a world in which inflation is below target and near-zero interest rates fail to boost spending enough, then we can turn once more to the idea of fiscal policy as an important component of demand-management.

Fine. But let’s for the sake of argument consider a slightly different approach. Is it possible that, in a manner analogous to the arguments made by Summers pre-inflation, fiscal policy could play a useful—indeed a desirable—role in the management of excess demand?

Inflation, as the saying goes, is a matter of too much money chasing too few goods: of too much demand relative to supply. Now, fiscal policy cannot magically create new supply—not in the short-run, at least. It can, however, influence the composition of demand; in particular, it can shift the balance of spending away from consumption and toward investment.

The context for current inflation is, in part, an extraordinary effort to use fiscal policy to support people’s incomes, which has of course contributed to high levels of spending and thus to inflation. But it is also one in which the level of supply—of productive capacity—is lower than we might reasonably expect it to be. Inadequate supply, in turn, is partly owed to problems associated with the pandemic: like reduced chip production in early 2020, and periodic closures of ports and factories in the months since. But it is also a consequence of years of underinvestment by both the public and private sectors.

Public investment as a share of GDP has on the whole been lower in recent decades than it was during the thirty years or so after the second world war. But investment levels were particularly low during the 2010s: across the rich world as a whole and in the US, after the initial bump associated with the Obama stimulus. The 2010s were also an absolutely dismal decade for private investment, which collapsed in the aftermath of the global financial crisis, then slowly recovered to a level well below that of other recent business-cycle peaks. Our productive capacity is substantially lower than it could be, because—for years—we did not add to and upgrade the nation’s stock of critical infrastructure, plant and equipment.

That was a mistake, as a consequence of which we are now poorer than we ought to be. Now, encouragingly, we are taking some steps to address this. Capital investment has been pretty strong in recent months, and in late 2021 Congress passed an infrastructure spending bill. More would be better—except of course that spending has run up against supply constraints.

In the context of excess demand, an economy faces trade-offs. There are only so many computer chips which can be produced at a time, only so much lumber to go around, only so much transport capacity, only so many workers, and so on. Productive capacity which is used to satisfy consumer demands cannot then be used to accommodate investment. In practice, productive capacity is not perfectly fungible in the short-run; it is not the case that chips coming off a production line can just as easily be used in video-game systems as they can in industrial robots. But there is some margin for substitution. And so we are to some extent in a situation in which we can use our chips and port capacity and lumber to meet demand for consumer goods, or we can use them to build the means to produce more chips and ship more goods and house more people.

There is nothing wrong with consumption, of course; the reason we care about productive capacity is that it increases our ability to meet households’ needs. But if we have invested too little, and if we can thus expect more investment to boost output, then the route to more long-run consumption is through more investment today—and, in the current, supply-constrained context, through less consumption today.

Tighter monetary policy can certainly serve to reduce consumption. Higher interest rates and tighter financial conditions are likely to have a direct effect on borrowing to pay for housing and durable goods, and to the extent that tighter policy results in a weaker labor market we can also expect weaker wage growth, which will in turn depress household spending. But higher interest rates will also weigh on borrowing to finance investment, and workers idled by weak demand aren’t spending their time building new houses and factories any more than they’re building RVs or waiting tables.

What we’d really like to do is selectively reduce consumption spending—on nonessential and luxury items especially. And potentially there is a useful role for fiscal policy to play in achieving that: through a broad-based progressive consumption tax, or in more piecemeal fashion. The politics of such a thing would obviously be difficult. But taxing consumption progressively should help. And couching the measure as a response to the exigencies of war and pandemic, needed to boost the productive capacity of the economy, might also make the measure more palatable. People don’t like paying more for things, but they’re already paying more for things, and might prefer higher costs on luxury goods pursued in the national interest to higher costs on all kinds of things determined by the whims of the market.

There might be other ways to achieve something similar. If every American had access to a no-fee bank account at the Federal Reserve which paid an interest rate controlled by the Federal Open Market Committee (and perhaps capped at some maximum level of money which could be deposited) then the Fed could make monetary policy in part by adjusting that interest rate—and thus influencing the opportunity cost of consumption faced by households. Each household could be offered a carrot for saving, in other words, to spare the whole economy from being beaten with a stick.

But more broadly, we managed to think creatively and productively about countercyclical policy in the context of chronically weak demand. Rather than reflexively falling back on old ideas about monetary policy, and on how labor markets must be punished to achieve lower rates of inflation, we could consider whether there aren’t other avenues worth exploring.

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