Stabilizing a High Pressure Transition Economy
The role of the fiscal authority
In the heydey of Keynesianism, during the 1960s and 1970s, fiscal authority was preeminent and monetary authority was largely neutral. The management of the macroeconomy was very much in the hands of the politicians, with the technocrats at best playing second fiddle. The diagnosis of the neoliberal counterrevolution was that this arrangement was responsible for the stagflation crisis of the 1970s, whose origins lay in the moral hazard faced by politicians. Their short-term electoral objectives introduced an inflationary bias into fiscal policy. Solving this problem was key to re-stabilizing the system. The management of the macroeconomy, it was felt in forward-looking circles, soon to become received wisdom, could not be left to politicians. In the end, the fiscal authority was largely driven out of the arena.
By the 1990s, social democracy had capitulated across the West. Politicians yielded almost all authority over the macroeconomy — and the attendant responsibility for macroeconomic stabilization — to the technocrats. In the high neoliberal system, which lasted from the Clinton capitulation to the global financial crisis, monetary authority was preeminent and fiscal authority was largely neutral. Whereas Keynesianism had introduced an inflationary bias, the response function of the hard currency-issuing central banks introduced a deflationary bias in the system. This was because central bankers fought tight labor markets — hiking in anticipation of inflation based on their projections ultimately grounded in the Phillips curve theory of the inflation process. The deflationary bias of the counter-majoritarian technocracy ultimately drove the neutral rate all the way down to the zero lower-bound.
After the global financial crisis, central banking was thrown into crisis. Faced with secular stagnation and stuck at the zero lower-bound, the central bankers reached for extraordinary measures. Bernanke’s ideas about extraordinary monetary accommodation through balance sheet expansion were implemented with abandon. The Fed’s balance sheet nearly trebled from 5 percent of GDP in 2008 to 14 percent in 2014. Other major central banks — the ECB, the BoJ and the BoE — all followed the Fed’s lead. While the liquidity injections and asset purchases stabilized financial markets and generated asset price booms, the impact on real activity was modest. This is because the wealth effect from booming risk assets was largely confined to the extremely affluent with a low propensity to spend their capital gains. (Nearly a quarter of all corporate equity is ultimately owned by the wealthiest 1 percent, while the bottom 50 percent own less than one percent of corporate equity.)
Meanwhile, fiscal authority remained shackled everywhere. It would take the Covid crisis to unleash the old Keynesian forces. The revival of fiscal authority may have been ad-hoc and event-driven, as it were. But the diagnosis was decidedly secular. The shock of 2016 convinced forward-looking elites that broad-based growth had to be restored as a more or less conscious strategy of political stabilization. The formula for achieving broad-based growth was twofold. First, public spending was to be revived; in the short term, to prevent the collapse of incomes during the acute phase of the pandemic; in the long run, to transition the economy to a low carbon future. Second, and crucially, the Fed abandoned the old fight against tight labor markets; committing to hike if and when inflation actually resurfaced, instead of moving in anticipation of inflation based on the defunct Phillips curve. Such were the makings of the mother of all economic booms.
So, the strategy for political stabilization was to restore broad-based growth by running tight labor markets in a high-pressure transition economy. Great hopes were placed on a decade long great green boom. The stability properties of this new macro regime, however, were not understood at the outset. Soon enough, though, the old nemesis of Keynesianism was back from the dead. Inflation returned to the world economy with some force in 2021, accelerating with the Russo-Western confrontation in 2022. All the hopes placed on the new strategy were now seemingly set to be dashed. While the highly-emotional reaction to this conjuncture is understandable, panic will not solve our problem. Solutions are available. They require careful thinking about the stability properties of the new regime.
It is clear that monetary policy alone cannot stabilize the high pressure transition economy. Neither can the fiscal authority, by itself, take full responsibility for macroeconomic stabilization. Both are needed. But what exactly does this look like?
Too many people are paying attention to ad-hoc solutions without thinking carefully about stability over the whole transition. What we need is not duct tape but institutional innovations that can stabilize the new regime. We need to think harder about this problem. Solving the problem of stability is crucial. It is the key to the whole thing — the whole thing being the high pressure transition economy as a formula for achieving broad-based growth as a more or less conscious strategy of political stabilization.
I have, for some time, been arguing for countercyclical tax rates. Income tax rates should vary systematically over the cycle in a way that is contractionary when inflation is high and rising, and accommodative when inflation is low and falling. The rates don’t need to vary by all that much to act as a robust automatic stabilizer — just a few percent up and down would go a considerable way in balancing the economy. And they should be tied directly to inflation instead of an output or employment gap. In general, the designs of the stabilizers should be consistent with the Fed’s “new mandate” of fighting inflation, not tight labor markets.
Another stabilizer that ought to be seriously considered is automatic mopping up of excess liquidity. The best investment option today is the Treasury’s Series I Savings Bonds. They are designed to offer inflation protection — the rates are tied to consumer price inflation. The going rate as of writing is 9.62 percent, easily the safest and most attractive investment option under current market conditions. The problem is that you’re restricted to buying no more than ten thousand dollars’ worth.
In order to mop up excess liquidity, Treasury should offer a similar product without the 10k limit. I cannot specify the exact rate schedule in advance. But the rates offered should be countercyclical and again tied to inflation (not output or unemployment) to ease the Fed’s burden. The money raised from these bonds can be used to fund the public component of the energy transition and climate adaptation. It would also go a long way towards providing shelter to investors, and temper the boom-bust cycles in risk assets. But the principal goal of the innovation should be to create an automatic stabilizer.
Besides these two, other options for automatic stabilizers should be studied in light of the specific challenges posed by the high pressure transition economy. By allowing all economic actors to distinguish between green and dirty investments, our proposal for a public ratings agency goes some way towards tempering a potentially very damaging boom-bust cycle in green finance. It costs nothing and promises to yield enormous benefits. It’s a low-hanging fruit for Congress. More generally, Democrat policymakers need to think outside the box to implement institutional innovations that don’t require politically-expensive tax dollars but can still help stabilize a high pressure transition economy.
Beyond automatic stabilizers, there’s also a clear need to harmonize the policies of the different arms of the state. For instance, it seems that the macroeconomic implications (and therefore political implications) of US Russia policy are being ignored by foreign policy principals. That’s very unhelpful. In a forthcoming article on Unherd, I argue that, for the sake of price stability and hence political survival, the Biden administration needs to revisit the assumptions underlying it’s Russia policy. A Western peace policy that aims to get the Ukrainians and the Russians to the bargaining table as soon as possible is crucial to temper food and energy prices.
More generally, instead of panicking and reaching for ad-hoc short-term solutions, serious policymakers, economists, and commentators should be paying attention to more permanent solutions to the problem of macroeconomic stabilization in the new regime. Crises can be generative and productive. But only if we seize the moment and articulate real solutions to the great challenge of the day.