The problem with fiscal policy
Most fiscal policy consists of adjustments in taxes and transfers. However, the effects of this type of fiscal policy are largely offset by changes in monetary policy, at least when the Fed is doing its job. Defenders of fiscal policy respond that changes in real government spending can directly boost output even when there is complete monetary offset of the effects of budget deficits on nominal spending. In practice, however, even this sort of “real” fiscal stimulus is unlikely to be effective at stabilizing the economy, as Congressional decisions to spend money on new projects is driven by political factors, not the state of the economy. Here’s the National Review:
As New Hampshire GOP governor Chris Sununu observed, Congress allocated $1.2 trillion for new infrastructure projects, but none of it has been spent yet, which means yet another inflationary pressure is looming. What’s more, 50 states and an untold number of localities are about to try to launch hundreds of large-scale infrastructure projects simultaneously during a period of runaway inflation, lingering supply-chain problems, price spikes in raw materials, a construction-labor shortage, and an unprecedented spike in the cost of diesel fuel. This is just about the worst possible time to try to start a massive number of construction projects from coast to coast.
Of course it is possible that these projects will get built during the next recession. But it’s also possible that they won’t get rolled out until the next recession is over. We just don’t know.
Intuitively, one might assume that a series of random fiscal shocks would make the business cycle neither more nor less unstable. After all, random fiscal stimulus would be just as likely to occur when economic output is above average as when it is below average. In fact, macro models suggest that adding random shocks to an unstable economy makes the business cycle even worse than otherwise.
The Covid fiscal stimulus was mostly taxes and transfers, and hence was subject to monetary offset. But even if you don’t believe that monetary offset occurred, the fiscal stimulus appears to have been a mixed bag. The early portions of the stimulus would have made the Covid recession less severe than otherwise, whereas the fiscal stimulus in 2021 would have contributed to economic overheating.
At the time, I argued that fiscal policy should focus on relief for the unemployed, not stimulus. Subsequent events have made me even more confident of that view.
At the time, I argued that monetary policy should focus on getting NGDP back up to trend, but not above trend. Subsequent events have made me even more confident of that view.
PS. Commenter Cameron directed me to a graph showing fiscal policy tightening over the past year. (Note: The graph shows the deficit, despite being labeled “budget”). This may be why many economists underestimated the recent inflation surge. If you (wrongly) assume that fiscal policy determines aggregate demand, then you might have assumed that the shrinking budget deficit would relieve inflationary pressures. But it’s monetary policy that drives AD, not fiscal policy.