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Tuesday, January 19, 2021

Political Posturing

There has always been considerable hyperbole about American elections -- "the most important election since 1920!" or some such. Conversely, from the perspective of economic institutions, it is hard to see any fundamental changes since the early 1990s. Up until earlier this month, my base case was that the Biden administration would be replay of the Obama one. However, one can see a story where things have fundamentally changed.

I am in awkward position with respect to political economy. I believe it is important, but do not like writing about it. (This can be explained that my unusual political biases probably only make a handful of people happy, which is not a great marketing strategy.) However, if we want to talk about the multi-year prospects for inflation, we need to dip into politics.

Inflation an Institutional Process

The past decade has not been kind to inflation theories that rely on a single variable, like the money supply. The debate around $2000 transfer has underlined the basic premise of Functional Finance -- inflation is the result of the stance of fiscal policy.

However, we cannot replace the money supply with a single fiscal variable to get a viable inflation theory; inflation is the result of the interaction of all economic policies with the business cycle. 

The post-1990 era saw an overall policy stance that favoured low and stable inflation in the developed countries. Although the price level certainly jumps around, if we are looking at long-run average inflation, we need to look at the policy stance. For the post-1990 era, the correct answer always was that the policy stance would not change. Is this time different?

Republican Party at a Crossroads

My usual bias is to expect institutional inertia. Before this month, I expected that the Republican Party would act in an obstructionist manner, forcing the Biden administration to follow the path of the Obama one. (This was probably the consensus view.) However, events this month have called that into question.

The first point of difference is that the Republicans lost control of the Senate. The second is that the awkward events in Washington D.C. could easily force a fissure in the Republican Party political coalition. The worst case scenario for the Republicans is for their stance to be driven by extremely polarising views held by 30% of the voting population. That 30% is enough to determine primary winners, but would result in a shellacking in the general election. 

This creates an obvious opportunity for the Democratic Party to enact more vigorous policies. There is no reason to assume that these policies would be inflationary. However, they would represent a structural change, and so inflation risks are higher than would be the case if no changes occur.

Nevertheless, I think it is a mistake to extrapolate what might happen in the next few months too far forward. The past year has demonstrated that governments can run what were believed to be very large fiscal deficits in the midst of a recession without inflationary consequences. The neoclassical centre-left has migrated to a view that recessions are a "get out of jail free card" for fiscal sustainability. However, they are likely to return to their previous "debt worrier" stance once vaccination progress has stabilised the economic outlook. 

Concluding Remarks

It is possible to tell a plausible story about structural changes to economic policy. That said, it is still a story, and institutional inertia has defeated inflation and deflation worriers for the past few decades.

(c) Brian Romanchuk 2021

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