With core inflation still running well north of 5 percent and six-decade lows in the unemployment rate, there’s no better time to put the U.S. budget on a more sustainable path. In 2011, the Budget Control Act resolved a perilous confrontation over the national debt limit. A similar battle today threatens the ability of the federal government to meet its obligations. Could revisiting the framework of cutting government spending help the U.S. avoid a short-term crisis while improving its long-term fiscal future?
The BCA was passed in a very different U.S. economy. In the aftermath of the 2008 financial crisis, the nation was struggling through what economists call a “balance sheet recession,” in which households, stuck under piles of debt accumulated to buy homes that weren’t worth what they paid for them, had limited ability to borrow or spend. While households focused on paying down debt instead of taking out new mortgages, easy monetary policy was unable to transmit liquidity into the economy, and unemployment came down only slowly. At the time, unemployment was about 9 percent; core inflation, while it had just come up to 2 percent, had been running as low as 1 percent a few months earlier, and deflation remained a realistic threat.
After the BCA’s passage, discretionary federal spending contracted by over 2 percent of GDP per year for the following half-decade. The BCA was probably responsible, in all, for a bit over half of this contraction. This fiscal drag on the economy likely slowed the decline of unemployment and contributed to the generally disappointing recovery from the financial crisis. In other words, while sound long-term finances are important, the BCA was enacted at a suboptimal time. Economic policy should strive to be countercyclical—stimulate when the economy is weak, apply brakes when the economy is strong.
By contrast, today’s economy is as strong as, and operating beyond the potential output of, any in recent memory. With inflation running so far above acceptable levels, now would be an ideal time for fiscal contraction.
If fiscal contraction was poorly timed to the business cycle of 2011, then today’s expansionary fiscal stance, with deficits projected to remain north of 5 percent for a decade, is insanity. Such deficits continue to put upward pressure on inflation when we least need it. In doing so, they undermine the Federal Reserve’s attempts to bring down inflation and force the Fed to hike more than it otherwise would—in what economists call the “monetary offset of fiscal policy.”
Theoretically, monetary policy can offset any amount of fiscal stimulus—the Fed can always just hike more. In practice, things aren’t so easy. Elected officials tend to put political pressure on the Federal Reserve to accommodate their fiscal expenditures, chipping away at the quality and independence of our institutions. The sectors of the economy that suffer from higher interest rates—like housing, autos, and government spenders—will complain and apply pressure.
Moreover, central bank offsets can create financial instability. The unprecedented speed of the Federal Reserve’s hiking cycle lifted overnight rates by about five percentage points over the course of a year. For institutions with interest-sensitive assets, this can be fatal: see the Savings and Loan Crisis of the 1980s, for example, or the recent failures of Silicon Valley Bank, Signature Bank, First Republic Bank, and likely more. If fiscal- and monetary-policy mistakes hadn’t forced the Fed into such a quick tightening cycle, those banks might have survived. (Of course, that doesn’t absolve them of the poor risk controls that left them so vulnerable.) Financial instability requires the Federal Reserve to thread the needle of tightening enough to control inflation, but not so much that it brings the financial system crashing down. Too much financial instability could produce a severe recession, as unfolded after the fall of Lehman Brothers.
Today, the Fed is tightening, but fiscal policy is still stimulating, which might ultimately push the Fed to hike rates still more. Rather than having monetary and fiscal policy work against one another, lawmakers should seek alignment by enacting economically significant budget cuts. In such a scenario where fiscal policy helps bring inflation down, the Fed could take advantage of fiscal drag by lowering interest rates somewhat. This combination of policies would put our national finances on a sounder trajectory, cut inflation, and reduce the risk of bank failures and financial instability.
While the caps of the Limit, Save, Grow Act, just passed in the House, are a good idea, it would be better still to front-load more of the spending cuts. The large inflation problem now might not exist several years from now. Per the Congressional Budget Office’s score of the legislation, the spending cuts versus the baseline forecast grow from $130 billion in fiscal year 2024 to $470 billion by 2033. While inflation is problematic today and the economy is operating above potential output, it’s unclear what macroeconomic dynamics will be in future years.
The negotiations to raise the debt limit provide an opportunity to achieve a much better policy mix by harmonizing fiscal and monetary policy, improving our long-term finances, confronting inflation, and making the financial system more secure.
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