It’s time for a budget policy U-turn

Ecclesiastes teaches that for everything there is a season. That lesson is particularly appropriate for macro-economic policy. Just as there is a season for very stimulative economic policies, so too there is a season for economic policy restraint. That season is upon us.

In early 2020, at the start of the COVID-19 pandemic, there was a need for very stimulative monetary and budget policies, albeit not on the unprecedentedly large-scale that occurred. The economy found itself in the deepest post-war economic recession on record, unemployment exceeded 14 percent, there was a threat of deflation and the financial markets threatened to freeze up. If that was not the time for the boldest of monetary and budget policy responses to avoid slipping into an economic depression, one has to wonder when that occasion would be. 

Fast forward to today and we have a totally different economic and financial market situation. The economy has fully recovered from the pandemic, inflation has risen to a 39-year high, unemployment is back to close to pre-pandemic levels and wage pressures are everywhere in evidence. At the same time, the country’s public debt-to-GDP ratio has risen to a higher level today than was experienced at the end of World War II, and the Congressional Budget Office warns that the country is on an unsustainable debt path.

Another important factor that has changed since 2020 is that the country now appears to be experiencing an asset price and credit market bubble of epic proportions. This has been the direct result of the $5 trillion in Federal Reserve bond purchases over the past 18 months. Not only are equity valuations now at lofty levels experienced only once before in the past 100 years. U.S. housing prices are now at higher levels than they were on the eve of the 2006 housing market bust, even in inflation adjusted terms, and they continue to increase at a 20 percent annual rate.

In today’s circumstances of high inflation and low unemployment, it is clear that monetary policy is inappropriately very loose. The Fed’s maintenance of its policy interest rate at close to zero has resulted in interest rates that are increasingly negative in inflation adjusted terms. Meanwhile, the Fed’s continued bond-buying is adding additional froth to asset price markets that already appear to be in bubble territory.

In today’s world of asset and credit market bubbles, there are clear limits to the degree to which the Fed can raise interest rates to bring inflation back under control. Too large an increase in interest rates would risk bursting those bubbles. As occurred in 2008, that could lead again to a hard economic landing.

The one way to bring inflation back under control without bursting the asset price bubble would be for the Biden administration to relieve the Fed of at least some of the burden of restoring price stability. It could do so through a more restrictive budget policy. But for that to occur, the Biden administration would need to make a budget policy U-turn. Instead of going ahead with its Build Back Better plan, which the Congressional Budget Office estimates would add yet another $750 billion to the budget deficit over the next five years, the administration should entertain the idea of some combination of tax increases and public spending with a view to reducing the size of the budget deficit.

To be sure, it would not be politically easy to make a budget policy U-turn especially in the run up to next year’s midterm elections. If that indeed turns out to be the case and the Fed is forced to slam on the monetary policy brakes to get the inflation genie back into the bottle, we must hope that today’s economic policymakers do not get caught out as flat-footed by an economic and financial market hard landing as their predecessors were in 2008.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.