The maddening modernity of fiscal policy

Posted Oct 25, 2022, 7:45 AM

Europe has entered the era of shields. Across the continent, governments are forging fiscal protections to protect individuals and companies of inflation. Beyond the thundering announcements, they are leading a silent revolution.

A revolution, because these shields blur the principles of economic policy applied for more than four decades. So far, it was simple: monetary policy had to fight against inflation, fiscal policy against recession. But faced with a price surge that exceeds 10%, this distribution has exploded in flight.

A heavily indebted Europe

It must be said that central banks are poorly equipped to fight against this form of inflation. And this for two reasons, which their independence, granted to carry out their sometimes politically painful mission, does not allow this time to overcome.

First, this inflation is very largely due to an external shock, which caused energy costs to jump. It would even withstand a recession that monetary policy could cause through a massive rise in interest rates.

Then, the world in general and Europe in particular became very indebted, even more so after the health crisis. If, as in the 1980s, the central banks raised their rates well above inflation, up to 13 or 15%, several States would very quickly experience a collapse in their public finances.

3% of GDP against inflation

Monetary policy is therefore no longer able to fight against inflation. This does not prevent the rise in prices from hurting. Even if, in a country like France, the lowest incomes are largely protected by the indexation of the minimum wage and several social benefits to rising prices.

The weight of budgetary anti-inflation measures (in % of GDP)source: “Whatever it takes reloaded? », Allianz Research, October 17, 2022

Since monetary policy is powerless, governments have decided that fiscal policy should take over. According to calculations by the insurer Allianz, they have decided on nearly 500 billion euros in public spending to fight against the damage of inflation, or 3% of GDP.

As soon as one accepts this strange idea that budgetary policy now assumes the fight against inflation, surprising observations or decisions are easily explained.

industry concern

If Germany has launched a 200 billion euro super-plan, it is not out of selfishness. Quite simply, it is the country on the continent that hates inflation the most, having experienced its dreadful effects twice during the first half of the last century.

And if the Berlin plan provides colossal amounts to support its companies, it is not to favor its companies, it is because the German executive really cares about its economic fabric and in particular its industry. Unlike France, where the government immediately flew to the aid of individuals, before realizing very recently that tens of thousands of companies risked disappearing if nothing was done.

Against tax cuts

The German plan obviously raises questions of competition that will have to be settled. But when someone drowns, we send him a buoy before possibly wondering who owns the buoy. That’s what Berlin does.

The new role of fiscal policy is accepted even in the financial markets, where people usually adhere to conservative reasoning. When Prime Minister Liz Truss announced her crazy budget plan, investors reacted initially, not against the enormous 150 billion pound anti-inflation shield… but against the massive tax cuts which were weakening the financing of the said shield.

Political choice

This is all very strange. Because in reality, fiscal policy does not fight against inflation, it only cushions its damage. In doing so, it supports demand, which helps push prices up even further. And it inflates an already high public debt. Central bankers are annoyed. The IMF mentioned in its latest report the risk of a “more expansionary fiscal policy which could force central banks to tighten their monetary policy further”.

This reversal of roles is a political choice. It is not based on any economic reasoning. This time around, the “doers” are not “the slaves of some past economist”, to use the economist John Maynard Keynes’ phrase.

terra incognita

The only researchers to have imagined an inversion between budgetary and monetary tools are the proponents of “modern monetary theory”, which we heard a lot about a few years ago. Except that their idea was very different.

For them, monetary policy must finance growth and full employment. And it is up to fiscal policy to fight against inflation, not by increasing spending like today, but on the contrary by raising taxes to lower demand. They should now be demanding tax increases at the top of their voices. On the contrary, they remain silent, giving credence to the hypothesis that they are only masked partisans of the all-out stimulus.

After monetary policy, fiscal policy is sinking into the fog of terra incognita. It is easy to predict a disaster. But for a good decade, a number of easily foreseeable disasters did not ultimately occur.

The maddening modernity of fiscal policy