When COVID-19 levelled the global economy, governments and central bankers reacted in textbook fashion. To prevent a deflationary spiral, central banks dropped interest rates to rock-bottom levels, while governments borrowed trillions of dollars and handed them to idle businesses and workers.
The stimulus worked, and the evidence is all around. By last fall, Canada had regained 100 per cent of the jobs lost during the pandemic. By this summer, unemployment had fallen to historic lows.
Stimulus worked, but the gas pedal was pressed a bit too hard and too long, and the side effect is inflation. Some of the inflation was sparked by the Russian invasion of Ukraine, but much of it has to do with the fact that our economic picture is, for the moment, like the negative of a recession.
In a recession, demand evaporates, and the supply of things – goods and workers – is higher than demand for them. With inflation, it’s the reverse.
The classic political response to inflation is to give people money – give them a raise, send cheques, whatever. It’s understandable, because it’s what we all want. If the price of things goes up 10 per cent, you’d like to keep up by having (at least) 10 per cent more dollars in your pocket.
But if government responds to too many dollars chasing too little supply by putting even more dollars into everyone’s hands, the result is likely to be even more inflation.
The textbook economic response to inflation is to lower demand. That’s why the Bank of Canada, the U.S. Federal Reserve and other central banks are all raising interest rates. Over time, higher borrowing costs will reduce demand for goods and workers. If necessary, central banks will raise rates high enough to cause a recession. That’s how the stubborn inflation of the 1970s was broken.
It’s why we want to avoid having fiscal policy pushing in the opposite direction of monetary policy. And it’s why Friday’s surprise quasi-budget in Britain, which promises to boost demand with big tax cuts and a doubling of the deficit, has been so widely criticized. That extra fiscal stimulus is, all else equal, likely to stoke the inflation fire, which means that the Bank of England is likely to have to respond by raising interest rate even higher.
Britain is showing what it looks like to have fiscal policy working at cross purposes with monetary policy. So what would fiscal policy working in tandem with anti-inflationary monetary policy look like?
Well, it might not be very politically popular. But since we aren’t running for office, permit us to lay out some ideas.
The fiscal policy that Ottawa and the provinces pursued during the pandemic was stimulative. It added demand to the economy, via big deficits that financed higher public spending and lower taxes. That’s what you do in a recession.
And in a time of inflation? Do the reverse. That means a fiscal policy to temporarily remove some demand out of the economy. It means smaller budget deficits, or bigger surpluses. In current political discourse that tends to get translated into “government has to cut spending,” and that is of course one way to lower a deficit or increase a surplus.
Another way would be through temporarily higher taxes.
And then there’s a third option: forced savings. (We told you that none of this would be popular).
Conservative Leader Pierre Poilievre has been demanding the Trudeau government fight inflation by suspending scheduled Canada Pension Plan premium increases. However seductive that proposal may be, it gets things backward. A 2022 anti-inflation policy built on the CPP would raise premiums.
Higher CPP premiums on, say, people earning more than the average income would be a forced savings; they’d get their money back, eventually, through higher retirement pensions. But extra money in some pockets tomorrow would be paid for by less money in those pockets today.
We promised an unpopular, politically unsaleable idea to get fiscal and monetary policy leaning in the same direction, and there it is.
But remember, to squelch inflation, the Bank of Canada will likely have to lower economic demand. It may have to go so far as making us all temporarily poorer (and some of us unemployed), by causing a recession. And that approach will, however indirectly and impersonally, involve taking money out of millions of pockets.