Generals fighting the last war
By Scott Sumner
During 2008, the Fed became increasingly concerned about high inflation, which was partly driven by rising oil pr ices. This caused them to refrain from rate cuts between April and November, resulting in an unintentional tightening of monetary policy. They were focused on inflation when recession was the real threat. In retrospect, the Fed should have focused on NGDP growth, which was slowing during 2008.
What will be the next example of economic policymakers fighting the last war? Perhaps fiscal policy. I don’t have much confidence in the Keynesian view that the stance of fiscal policy has a big impact on the business cycle. But let’s say I’m wrong. Here’s what I expect to happen:
1. The President and Congress will enact deep tax cuts and increases in military spending, which will cause the deficit to balloon. Entitlement spending will also rise as boomers retire.
2. The deficit will rise to unsustainable levels, with the national debt steadily increasing as a share of GDP.
3. By the time the next recession is on the horizon, there will be a political backlash against expansionary fiscal policy. Policy will tighten and become effectively pro-cyclical.
I hope that I am wrong, but this is the danger I see from running a series of large budget deficits when the unemployment rate is 4.5%. What will we do if unemployment rises to 7.5%?