The big news regarding the Administration’s budget proposal has been Senator Manchin’s rejection of much of the Democrat’s compromise budget proposal, including measures to address climate change. Senator Manchin claims he has been right about inflation and has indicated he will not negotiate any more about increased government spending until inflation comes down.
Journalists reporting on this have generally written that Manchin has been correct about inflation. However, the story is more complicated. In fact, reading what prominent economists say indicates considerable confusion. It could be that Manchin is using inflation as an excuse to oppose climate change measures which affect fossil fuels.
One of the arguments currently being used is that government spending generates inflation by putting more money into the economy. But let’s look at what happens. When the Treasury needs to spend more money than it has on hand, it borrows the funds it needs by selling Treasury securities. In other words, if the federal government is spending more than it is receiving, it takes money out of the economy by borrowing and puts it back in by spending. In the first instance, this is more or less a wash.
That, though, is not the end of the story. There are models addressing how deficit spending affects the economy, with the impact dependent on what else is happening in the economy. Usually the assumption is that deficit spending increases aggregate demand, because it involves direct spending or results in transferring money to those with a high propensity to consume. If the economy is running at near capacity, the increased demand is postulated to increase inflationary pressures. However, some who were more relaxed about the spending measures during the pandemic thught the inflation risks were minimal because some of the recipients would save some of the money rather than spend it.
Left out of much of the discussion of Manchin's and other's inflation warnings is monetary policy. The Federal Reserve, if it decides it is appropriate, can effectively monetize the federal budget deficit by buying Treasury securities. The Fed is prohibited by buying directly from the Treasury, but if it buys roughly the same amount of securities in the market that the Treasury has issued, it has effectively monetized the budget deficit. In other words, it has replaced deficit financing with securities by creating bank reserves. (When the Fed buys securities in the open market, it credits the accounts banks have at the Federal Reserve Banks with the purchase amount. The amounts it credits the private banks are liabilities on its balance sheet and the purchased securities are assets.) The Fed was effectively monetizing much, if not all, of the budget deficit during the pandemic, and this likely has contributed to inflation. (This story can be expanded with more detail, but the details do not matter for the main point of this blog post. Suffice it to say that the effect of monetary policy has been difficult to analyze with short-term interest rates near zero and bank holdings of large excess reserves. These both are unprecdented in our modern history.)
There is a growing consensus that the Fed kept interest rates too low for too long. There may be a price to be paid for that. The Fed has now reversed course, and there is the likelihood that it will not achieve a “soft landing.” If a recession does happen, an increase in government spending would be helpful in pulling us out of it. Mancin appears to ignore this point.
In addition, the current inflation is a global problem. It is hard to make the argument that this is due to excessive U.S. government spending. There are some global factors at work -- among them, war in Ukraine, reduced global grain supplies, oil price increases, reduced production in China due to severe Covid lockdowns, and supply chain issues. What portion of U.S. inflation is due to U.S. government spending and overly loose monetary policy and what portion is due to global issues and supply shortages, rather than excessive demand, is unclear. Except for some economists who project certainty in their pronouncements, there is general uncertainty in the profession about exactly what is going on and what is likely to happen.
While Senator Manchin may believe what he is saying about inflation, focusing the blame for inflation solely on government spending is misguided. Monetary policy needs to be factored in. No one can predict with certainty how long the current inflation will last, but it should not be used as an excuse to avoid enacting urgently, needed measures to address the growing problem of climate change.
(This post was revised on July 22 in an attempt to make it clearer.)
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