Freedom Caucus in charge: Implications for economic policy

I remember taking my first economics course in college and feeling like I had just unlocked the key to understanding how the world works.  I’m especially talking about the macroeconomic part of the course. Macroeconomics, for the uninitiated, involves the study of large-scale economic issues, such as economic growth, inflation, and unemployment. The counterpart to macroeconomics, of course, is microeconomics, which concerns itself with individual economic agents, such as the consumer or businesses facing different degrees of competition.   The macroeconomics of my time was largely based on the foundation of Keyne’s General Theory. In that book, Keynes provided a framework to understand how fiscal and monetary policy could be used to achieve various economic policy objectives.

The critical lesson I (and every other economic student) learned was how to assess the effect of any policy change. We do this by assuming ceteris paribus conditions – i.e., that everything else remains the same, except for the change in the policy.  The problem is that in the real world, ceteris paribus conditions don’t hold. Thus, when economists posit the effects of implementing some economic policy, those projections must be tempered by the realization that other effects, possibly offsetting or possibly augmenting, may come into play concurrently with the implementation of the policy under consideration.  Just because a policy initiative would have an influence in the economy in one direction doesn’t mean that that outcome is preordained.  Other influences may override.   Often, we can discern how these competing influences have played out in retrospect, but it’s considerably harder to anticipate the dominant effect beforehand.

The current effort to lower inflation offers a good example of the phenomenon of multiple economic influences occurring coincidently. Conventional economic theory suggests that a contractionary monetary policy – i.e., where the growth of the money supply is retarded and interest rates rise – will have a cooling effect on the economy, thereby slowing economic growth and subsequently reducing the rate at which prices are rising.  Many economists saw the lower economic growth as being a necessary condition to get inflation lower, and they’ve been surprised by the fact that, in the current situation, we’ve seen a drop in inflation even as economic growth has proceeded at a reasonably healthy pace, with the unemployment rate remaining near post-war minimums. 

The fact that inflation has cooled considerably even without any serious reduction in economic growth presents a bit of a conundrum.  How is it that inflation ebbed, even though economic activity and job creation seemed largely unaffected by the monetary tightening?  Two contributing factors: First, inflation initially heated up, not so much as a consequence of overly expansive monetary and fiscal policies as some may claim, but rather because of the shutting down of the economy in response to the covid pandemic.

This shutdown fostered significant interruptions to supply chains. While it took longer to resolve than many had expected, those interruptions were temporary, and many of the price spikes caused by those disruptions ultimately reversed.  Secondly, the Fed did an excellent job in managing expectations. By word and deed, the Fed committed itself to fighting inflation – and people believed them!  Arguably, the hardest thing about reducing inflation is breaking the psychology that inflation will worsen; and the Fed deserves credit for doing exactly that. The open question, at this point, is whether it will be necessary for the Fed to resume its tightening, or will inflation continue to decline of its own accord.

One could also ask why the economy has held up as well as it has. in the face of monetary tightening. In this instance, the ceteris paribus assumption has been violated.  To a large extent, fiscal and monetary policy have been working at odds – at least until recently. That is, while the monetary authorities have been tightening, ratcheting interest rates ever higher since March of 2022, the fiscal authorities – i.e., those who control government spending and taxation -- have undertaken an expansionary posture, with increases in government spending coming from the various Covid relief acts, the Chips Act, and the Inflation Reduction Act.  This dialectic has worked well, allowing inflation to decelerate while at the same time keeping the economy growing and unemployment rates low.  

The fear of fiscal policy being too expansionary and thus necessarily exacerbating inflation has largely been debunked by our experience. Critically, any significant deviation from current policy stances – both fiscal and monetary – could throw us off the knife edge of positive economic growth, low unemployment, and decelerating inflation.

Despite the commendable conditions we’re currently experiencing, the Freedom Caucus -- a vocal contingent in the Republican party – is demanding dramatic spending cuts to domestic support programs, aid to Ukraine, and funding for the FBI and Justice Department.  They’re threatening to force a government shutdown as a bargaining chip, and that outcome appears increasingly likely to happen.  Drastic times may call for drastic actions, but that characterization simply doesn’t apply in the current instance.  Outside of the Freedom Caucus, there is widespread consensus – nearly universal -- that Congress’s job is to keep the government functioning, and a shutdown should be avoided. 

I find the apparent willful disregard of the fragility of our economic situation on the part of Freedom Caucus members to be astounding.  We’re operating on as close to a goldilocks path as we’re ever likely to be on with inflation coming down coincidently with full employment; and we take a drastic detour at our peril. A shutdown of the government would be just such a detour, particularly if the shutdown persists.  Why take the chance?  A small faction of economically ill-informed legislators, fueled by hubris, an apparent lust for attention, and cult-like devotion to Donald Trump have hijacked the system and abused its processes to get their way.  Unfortunately, it seems we’re stuck with this disfunction for as long as Republicans are in the majority in the House. November 2024 can’t come too soon.