The Deficit Reduction Dance
Late on Wednesday, July 27th, Senate Majority Leader Chuck Schumer along with Senate maverick Joe Manchin announced the Inflation Reduction Act, a massive increase in spending accompanied by even more massive increases in taxes (at 725 pages they could have used a bit of inflation reduction on the legislation itself). The bill, as conceived of by Democrats without any input from Republicans, would increase spending for energy security, climate change and an extension of the Affordable Care Act (aka Obamacare) by $433 billion. The bill also includes tax increases estimated to reach $739 billion, resulting in a surplus of around $300 billion to reduce the deficit. Of course, if you add in the recently approved package of subsidies for the technology industries, the so-called CHIPS for America Act, that ballooned from $52 billion to $280 billion, you can see that in reality there is no deficit reduction at all.
What the Democrats are trying to promote with this legislation is the idea that massive increases in taxes will reduce inflation. Republicans have been howling about the increase in inflation generated by huge amounts of deficit spending by the Biden administration to offset the impact of Covid 19 (and to promote pet projects to fight climate change, eliminate fossil fuels and a host of other schemes near and dear to progressives). The Democrats way of thinking is that if deficit spending fires up inflation, huge tax increases to create a surplus must reduce inflation.
This way of thinking is based on a relatively new economic theory called the fiscal theory of the price level, that asserts that government fiscal policy is a greater determinant of the level of prices (i.e.; inflation) than monetary policy (countering Milton Friedman’s famous quote that, “Inflation is always and everywhere a monetary phenomenon”). This new theory (FTPL) is an outgrowth of the New-Keynesian theory that was developed to clarify why Keynesian theory did not do a good job of explaining why the economy did not respond as policy makers thought Keynes had said it would (the concept that they did not properly understand Keynes being beyond question).
But the Democrats have a point. The huge fiscal deficits generated to offset Covid shutdowns created a problem, a problem that was compounded by the Fed’s policy of Quantitative Easing. The Fed began Quantitative Easing during the Great Recession in 2008, buying US Treasury Bonds from members banks to stimulate the economy. These bond purchases (designated QE or QE I) gave cash to the banks that could be relent to companies to support capital investment or other activities to grow the economy. QE increased the size of the Fed’s balance sheet from around $900 billion to around two trillion dollars at the end of 2008. But the Fed continued QE purchases to further stimulate the economy after the Great Recession abated, swelling the balance sheet to around $4.5 trillion by the end of 2014. Amazingly, all the cash pushed out by the Fed did not stimulate the economy or create inflation, but it did help the stock market which skyrocketed from 6,470 in March 2009 to 17,983 at the end of 2014, a 278% increase.
The Fed had started to reduce its balance sheet (i.e.; take money out of circulation) just prior to the pandemic but its balance sheet was still over four trillion dollars. The Fed ramped up QE purchases to counter the effects of the pandemic increasing the balance sheet to over seven trillion dollars by May of 2020 but continued QE purchases after the initial panic as the total balance sheet reached almost nine trillion dollars by the end of 2021. The stock market, after a precipitous drop at the beginning of the pandemic soared to 36,338. The stock market plus other financial assets (including non-fungible tokens and bitcoin) had absorbed much of the inflationary impact of the Fed’s QE purchases. But financial markets had also blunted the stimulative impact of QE on the economy that had been in the doldrums since the Great Recession (secular stagnation as the new normal according to former Treasury Secretary Larry Summers).
Financial markets were already reaching very high levels prior to the onset of the pandemic and began teetering at unsustainably high valuations as the Fed continued QE purchases in 2020 and 2021. Inflation had remained low because most of the stimulus never reached consumers. But that changed when President Trump and then President Biden sent stimulus checks directly to the American people instead of using financial markets. All that cash plus pandemic related supply chain problems and shortages let the inflation demons loose.
Now that inflation has reached levels not seen for over forty years (which means that most people in America have never experienced inflation in their life), the Democrats are getting blamed for mishandling the economy. And just before the 2022 elections. The Bernie Sanders inspired progressive agenda that would have increased government spending by trillions of dollars (an amount Bernie and others still thought was insufficient) was immediately recognized by the people as policies that would put inflation on steroids. Joe Manchin, a blue senator from a red state, balked at these plans unless there were offsets to increase revenue (in other words, higher taxes).
The Inflation Reduction Act concocted by Schumer and Manchin is designed to solve the Democrats’ problem of how to spend more money while reducing the deficit (keep in mind this is reducing the deficit not eliminating the deficit). Even the Committee for a Responsible Federal Budget (CRFB) says this is a step in the right direction. But the CRFB’s review of the proposed bill shows that most of the deficit reduction over ten years occurs in the last five years of the proposal. There is very little impact in the early years. Any pain from deficit reductions has been deferred until after the 2022 and even 2024 elections. And the impact of these tax increases is directed to corporate America and not the average Joe. Even though we all realize that corporations pass these increases in taxes back onto consumers in the form of higher prices.
So, this is the deficit reduction dance. Take credit up front and kick the pain down the road. Of course, that pain will also be deferred. There is no deficit reduction in the first five years of this bill and those reductions will be eliminated if the Democrats stay in power. Keep in mind that part of the spending in the Inflation Reduction Act is for the extension of Obama Care subsidies. Subsidies that we were told would expire in order to reduce the deficit. That’s the dance.
After a bit of analysis, it seems likely that the Inflation Reduction Act is going to do very little to reduce inflation (the Penn Wharton Budget Model projects that the bill would have no impact on inflation in the short term and only a 25 basis point reduction by the late 2020s). Nor would it reduce the deficit or the mountain of government debt outstanding. In fact, the Fiscal Theory of the Price Level that appears to be popular in progressive circles has a method for reducing the mountain of debt to more manageable levels. Inflate it away. I call this the Piketty Solution, as this is the method preferred by Thomas Piketty in his book, Capital in the Twenty-First Century (keeping in mind that Piketty disciples Emmanuel Saez and Gabriel Zucman are advisors to Senators Sanders and Warren). You could also call it the Screw the Bond Investors plan because it is just another way to default on your debt obligations.
In essence, the Fiscal Theory of the Price Level is merely Modern Monetary Theory by another name. Modern Monetary Theory asserts that the government can spend all the money it wants as long as the rate of unemployment is elevated. If the creation of money results in inflation, the theory recommends raising taxes to put the system back into balance (with the side benefit of inflating away the public debt). Sounds a lot like the Inflation Reduction Act.
In fact, tax collections in FY2022 are running ahead of expectations and the congressional Budget Office projects that tax revenue will be up 39 percent in FY2022. Further, the CBO believes tax collections will reach 19.7% of GDP, a record matched only three times previously (and two of those were during World War Two). All of this tax largesse despite the supposedly outrageous Trump tax cut that, with an additional push from deregulation, had helped the American economy grow while reducing unemployment for minorities to record lows.
But in addition to money creation, inflation has been made worse by supply chain problems. Biden Administration efforts to restrict the production of fossil fuels, combined with sanctions against Russia as punishment for its invasion of Ukraine, have driven the price of gasoline up to record levels (although prices have abated recently). Punitive taxes, such as the 15% minimum corporate tax, applied as punishment for companies paying little or no taxes in accordance with the tax laws passed by Congress are not only deceitful, they will further strangle the expansion of US business at a time when inflation has been exacerbated by a shortage of goods. If the Democrats want to change the incentives that Congress has placed into the tax code, then they should dive into the code’s 70,000 plus pages and make those changes. Clearing up that mess would certainly boost the economy.
And to place price controls on drug prices is grandstanding. The Pharmaceutical Research and Manufacturers of America (PhRMA) assert that manufacturers have only increased prices by 1.3% in the last year and that the prices consumers pay have increased by more because of the convoluted supply chain for medical services mandated by federal laws. We must keep in mind the fact that price controls rarely work and often create shortages that, in the case of prescription drugs, could be a matter of life and death. And with price controls and more government mandates, the flow of new and innovative drugs and procedures will dry up.
White House economist Heather Boushey, a member of the president’s Council of Economic Advisers, was on CNBC’s Squawk Box early Monday morning (August 1, 2022) explaining all the subsidies and entitlements contained in the Inflation Reduction Act that Schumer and Manchin assert will lower costs for ordinary Americans. But it is the tangle of subsidies, entitlements and other so-called non-discretionary items that are driving the deficit and the public debt ever upward. The next phase of the deficit reduction dance will require the Piketty Solution. Of course, the inflation necessary for the Piketty Solution will hurt average Americans even worse than bond investors.