Fiscal policy to control inflation?

In 1968, President Johnson tried to use tax increases to control inflation. The policy was a miserable failure. This policy experiment helped to launch the supply side movement. Economists like Art Laffer and Robert Mundell argued that a combination of tax cuts and monetary austerity was the best way to achieve a combination of growth and low inflation.

Now we have some progressives arguing the exact opposite, claiming that the best way to control inflation is with higher taxes and less emphasis on contractionary monetary policy. I’d prefer that we don’t use fiscal policy in either direction.

Here’s Simon Balezon and Milan Singh (at the Matt Yglesias Substack), with one of the more thoughtful pieces advocating a role for fiscal policy in fighting inflation:

The collapse of Silicon Valley Bank is in part a story of mismanagement and poor regulatory supervision, but it’s also in an important sense a consequence of the decision by the Federal Reserve and other major central banks to fight inflation by raising interest rates. Which in turn should put on the table the long-ignored question of why exactly interest rate hikes have become the world’s preferred anti-inflationary measure.

A big part of the answer is simply that raising interest rates is a thing that central banks have the legal authority to do, and there’s widespread belief that it makes sense to delegate macroeconomic stabilization to central bankers. But if you step back from that aspect of institutional design, there’s a strong argument that taxes are a superior inflation-fighting tool, one that would slow inflation in a more direct and more predictable manner. If the main problem with fiscal policy as an anti-inflationary measure is that the main inflation-fighting institution isn’t allowed to use it, then maybe optimal policy would involve adding a fiscal dimension to the Fed’s authorities.

After all there is something deeply perverse about raising interest rates to slow the economy only to flip around and do bailouts to prevent interest rates from slowing the economy too much.

I have several problems with this analysis. Let’s start with interest rates, which are a bad way to think about monetary policy. Tight money leads to slower NGDP growth, which leads to lower interest rates. So it’s a mistake to assume that an anti-inflation policy is a high interest rate policy.

Yes, a tight money policy will temporarily cause the market rate to rise about the natural rate of interest, but 90% of interest rate variation is movements in the natural rate, and the Fed reduces the natural interest rate when it adopts a tight money policy.

So then why did interest rates rise in 2022? Because the Fed had an expansionary monetary policy, leading to really fast NGDP growth. (I explain this in more detail at Econlog.)

If you want to reduce the sort of wild interest rate volatility that is occasionally associated with banking distress, then adopt NGDPLT. That won’t completely eliminate interest rate volatility, but it will greatly reduce volatility.

One counterargument is that NGDPLT has (at best) only a 10% chance of being adopted in the foreseeable future. OK, but what are the odds of this Balezon and Singh proposal:

You could imagine a set of institutional arrangements where the Fed (or any nation’s central bank) is authorized to raise or lower the VAT at its regular meetings to control aggregate demand.

Yes, I can “imagine” that. But I’d say there’s less than a 10% chance of the US adopting a VAT in the next few decades, and less than a 10% chance that Congress would give the Fed control of VAT rates if this hugely unpopular tax regime were adopted.

Of course, just because something is a difficult sell doesn’t mean it’s not worth thinking about. But as we saw in 1968, fiscal doesn’t work if monetary policy is off course. And if monetary policy is doing its job, you won’t see all the negative side effects cited by Balezon and Singh.

Let’s focus on getting a sound monetary regime (NGDPLT). If that happens and we find there are still issues to be addressed, then we can start contemplating a role for fiscal policy. Right now I fear that side effects due to bad monetary policy are wrongly seen as being the inevitable side effects of any monetary policy regime. That’s not true.



24 Responses to “Fiscal policy to control inflation?”

  1. Gravatar of John Hall John Hall
    23. March 2023 at 11:31

    Primary fiscal deficits were larger during the COVID period than during Johnson’s time in office, and the path of spending doesn’t look so good.

    You say “fiscal policy doesn’t work if monetary policy is off course”, but if fiscal policy is off course, is monetary policy always able to bring things back on course or are there conditions where it is unable?

    I think this is related to “Unpleasant Monetarist Arithmetic”.

  2. Gravatar of Aladdin Aladdin
    23. March 2023 at 12:09

    “After all there is something deeply perverse about raising interest rates to slow the economy only to flip around and do bailouts to prevent interest rates from slowing the economy too much.”

    I do think this statement is broadly correct but the solution is pretty clearly, don’t do bailouts, rather than back off on monetary solutions.

  3. Gravatar of ssumner ssumner
    23. March 2023 at 12:22

    John, You asked:

    “is monetary policy always able to bring things back on course or are there conditions where it is unable?”

    Yes, monetary policy is enough in the US. Not in Zimbabwe and perhaps not in Argentina.

    Aladdin, That’s right.

  4. Gravatar of Sara Sara
    23. March 2023 at 13:07

    The reason why they are discussing taxes, and particularly in the form of VAT, is because CBDC’s give them the power to control every transaction.

    Tyrants love to convince others that if only they had more power over, we’d all live in a wonderful utopia. As you can see, Sumner’s banking monopoly is scared of public blockchains. This is why they are racing to develop a private one. Disagree with them? Fine. Your bank account will be frozen. Did you buy too much food this month? Okay, that was bad, fines will now be deducted from you. I see you traveled outside your designated location, as such more fines will be issued in the name of the environment. Protest did I hear you say? Okay you uncooperative deplorable, go to the gulags. Causing problems in the gulags? if you refuse to “recalibrate” your mind and “reimagine” finance then you and your family will disappear.

  5. Gravatar of Justin in Texas Justin in Texas
    23. March 2023 at 13:29

    A variable VAT would make life so much more complicated, injecting price volatility into everything. Budgeting would become harder, for households but maybe especially for firms. The Fed would come under even greater political pressure.

    The current system took a long time to develop, and works remarkably well, we just need to get them to consider the NGDP trend implications a little more. As you’ve been saying for years, moving to a new instrument (I like the TIPS spread) would get people to stop unproductively focusing on interest rates. Rates would be very similar if they had a different instrument but sought the same policy goals.

  6. Gravatar of Stephen Stephen
    23. March 2023 at 14:42


    As you know, a lot of talk recently has been about the feds balance sheet increasing in size because of the new loans that were created. Is that “easier” money. There are many quotes showing the size of the fed’s balance sheet and show that 2/3 of the QT has been erased because of these new loans. The argument continues which states this is going to push inflation back up again. Is the feds recent action with regards to the loans to banks inflationary?

  7. Gravatar of Solon of the East Solon of the East
    23. March 2023 at 15:32

    I probably agree with this post. But it would be nice to see someone examine what Bank Indonesia did during the pandemic.

  8. Gravatar of ssumner ssumner
    23. March 2023 at 18:48

    Stephen, By itself, these actions probably won’t be inflationary. But that’s not to say the inflation problem has gone away, just that I don’t see this making it worse. (Having said that, I oppose these bailouts, especially when based on loans that exceed the market value of collateral.)

  9. Gravatar of Physecon Physecon
    23. March 2023 at 18:48


    Regarding “Primary fiscal deficits were larger during the COVID period than during Johnson’s time in office, and the path of spending doesn’t look so good.”

    I’m pretty sure what you have articulated a categorical reason for contracting the fiscal deficit. In other words regardless of whether inflation is above or below target the deficit needs to be reduced. And the Fed can adjust their stance accordingly.

  10. Gravatar of ssumner ssumner
    23. March 2023 at 18:52

    John and Physecon, Just to be clear, I support bring the deficit down. I was considering whether fiscal policy should be used to control inflation.

  11. Gravatar of Kangaroo Kangaroo
    23. March 2023 at 20:04

    higher taxes to fight inflation! I love that! For Progressives, the solution is higher taxes. The problem is whatever scary monster is under the bed at the moment. Housing crisis? Higher taxes!! Opiod crisis? Higher taxes!! Shark attacks? Higher taxes! Too high taxes? Higher taxes!

    But what’s funny is that they’ll undermine the any conceivable inflation fighting effect higher taxes **might** have by spending the new revenue and then some. When inflation keeps rising, they’ll blame Jeff Bezos for having too much money and call for higher taxes.

  12. Gravatar of postkey postkey
    24. March 2023 at 04:16

    ‘Apparently agreeing with my critique that pure fiscal policy does not result in economic growth unless it is backed by credit creation, Blackrock had argued at Jackson Hole that the “next downturn” would require central banks to create new money and find “ways to get central bank money directly in the hands of public and private sector spenders” – what they called “going direct”, bypassing the retail banks. The Fed knew this would create inflation, as Blackrock later confirmed in a paper which stated that “the Fed is now committing to push inflation above target for some time”.

    This is precisely what was implemented in March 2020. We know this both from available data and because the Fed, largely without precedent, hired a private-sector firm to help it buy assets – none other than Blackrock.’?

  13. Gravatar of postkey postkey
    24. March 2023 at 04:18

    “ . . . whereby the coefficient for ∆g is expected to be close to –1. In other words, given the amount of credit creation produced by the banking system and the central bank, an autonomous increase in government expenditure g must result in an equal reduction in private demand. If the government issues bonds to fund fiscal expenditure, private sector investors (such as life insurance companies) that purchase the bonds must withdraw purchasing power elsewhere from the economy. The same applies (more visibly) to tax-financed government spending. With unchanged credit creation, every yen in additional government spending reduces private sector activity by one yen. . . .
    Equation (22) indicates that the change in government expenditure ∆g is countered by a change in private sector expenditure of equal size and opposite sign, as long as credit creation remains unaltered. In this framework, just as proposed in classical economics and by the early quantity theory literature, fiscal policy cannot affect nominal GDP growth, if it is not linked to the monetary side of the economy: an increase in credit creation is necessary (and sufficient) for nominal growth.
    Notice that this conclusion is not dependent on the classical assumption of full employment. Instead of the employment constraint that was deployed by classical or monetarist economists, we observe that the economy can be held back by a lack of credit creation (see above). Fiscal policy can crowd out private demand even when there is less than full employment. Furthermore, our finding is in line with Fisher’s and Friedman’s argument that such crowding out does not occur via higher interest rates (which do not appear in our model). It is quantity crowding out due to a lack of money used for transactions (credit creation). Thus record fiscal stimulation in the Japan of the 1990s failed to trigger a significant or lasting recovery, while interest rates continued to decline. ”?

  14. Gravatar of postkey postkey
    24. March 2023 at 04:21

    “As a result, the money supply ballooned by record amounts. The US’s “broad” money supply metric, M3, increased by 19.1% in 2020, the highest annual rise on record. In the eurozone, money supply M1 grew by 15.6% in December 2020.

    All of this boosted demand, while at the same time the supply of goods and services was limited by pandemic restrictions that immobilised people and shut down many small firms and affected some supply chains. It was a perfect recipe for inflation – and significant consumer price inflation duly followed around 18 months later, in late 2021 and 2022.”?

  15. Gravatar of Todd Ramsey Todd Ramsey
    24. March 2023 at 05:06

    Can anyone give context to help me understand what this statement refers to?

    “90% of interest rate variation is movements in the natural rate”

    Surely in the early 1980s interest rate variation was caused by expected inflation, rather than movements in the natural rate?

  16. Gravatar of David S David S
    24. March 2023 at 10:25

    Thank you for this post Scott–I hadn’t quite been sure how to react to that SlowBoring post. While I would advocate for no-limit on FICA taxes, that would have nothing to do with monetary stability. Also, I can’t imagine any political party going to bat for any type of VAT.

    I lost a bet with myself that you would have another post after the recent wimpy rate hike with the title: “Wake Me Up When the Tight Money Starts.” Maybe next week.

  17. Gravatar of ssumner ssumner
    24. March 2023 at 10:32

    Todd, I was referring to the nominal natural interest rate; I should have made that clear.

    David, I tend to do those after bad data, not bad Fed decisions. It’s hard to know in real time what interest rate setting is optimal.

  18. Gravatar of William Peden William Peden
    24. March 2023 at 11:25

    VAT is especially bad as a fiscal policy tool for controlling inflation, since it increases headline inflation. For example, in 1979, the UK government increased VAT as part of an anti-inflationary programme. This was one reason why the first year of that government saw inflation increasing, which harmed it politically.

  19. Gravatar of marcus nunes marcus nunes
    24. March 2023 at 11:40

    Surprising lessons from the 1980s!

  20. Gravatar of Michael Sandifer Michael Sandifer
    25. March 2023 at 04:30

    I’m surprised there’s no distinction being made here between short-term and long-term interest rates. Differences in the movements between short and long-term rates often help signal whether a new monetary policy stance is tighter or looser. It’s not 100% reliable, but we shouldn’t pretend there’s never information there.

  21. Gravatar of Spencer Spencer
    25. March 2023 at 12:32

    re Werner’s “Bond-funded fiscal policy vs. bank-funded fiscal policy”

    They both depend upon the uses of the funds, for productive outlets, vs. non-productive ones.

    Werner is lost. Banks don’t lend savings.

  22. Gravatar of Philo Philo
    26. March 2023 at 11:41

    Even with a VAT, having the Fed constantly raising and lowering the rate would be tremendously irritating to the general public. The government prefers to keep the mechanics of executing monetary policy out of sight of as many people as possible. The regime of tinkering with the discount rate or reserve requirement for banks, as well as buying/selling T-bills, is much more satisfactory from a PR point of view than one that involves doing something that directly and unpredictably affects almost everyone (sc., tinkering with the VAT rate).

  23. Gravatar of postkey postkey
    27. March 2023 at 00:54

    ‘An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, “out of thin air”. . . .
    ‘Thus it can now be said with confidence for the first time – possibly in the 5000 years’ history of banking – that it has been empirically demonstrated that each individual bank creates credit and money out of nothing, when it extends what is called a ‘bank loan’. The bank does not loan any existing money, but instead creates new money. The money supply is created as ‘fairy dust’ produced by the banks out of thin air.32 The implications are far-reaching.’

  24. Gravatar of postkey postkey
    27. March 2023 at 08:30

    Spencer is lost?

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