Fiscal Policy and Growth Prospects

Eakinomics: Fiscal Policy and Growth Prospects Eakinomics warned you. It warned you in September and in November. Nevertheless, it is still daunting to see the headline in The Wall Street Journal: “Fiscal Stimulus Is Turning Into a Fiscal Drag, in a Big Headwind for Growth.” Recall that the logic underlying “fiscal drag” is that discretionary increases in federal deficits (tax cuts, spending increases) have a greater than dollar-for-dollar impact on growth in gross domestic product (GDP). So, the key belief is that the big pandemic-induced federal spending spree has had a huge impact on near-term economic growth. Yet it is doctrine on the left that by stopping extraordinary spending, the swing is negative, and the economy will crater. There are lots of reasons to be skeptical about the simple version of the fiscal drag story. Much of the checks sent by the government was saved by households; there was no stimulus impact last year to be removed this year, so no drag. Also, if the main impact of stimulus in 2021 was to produce inflation – not increases in output – then the main impact of any pullback will be to reduce inflationary pressures. “Inflation drag” doesn’t sound like a very threatening phenomenon. And to be fair (which feels very weird and unnatural for Eakinomics), The Wall Street Journal article carefully listed these caveats. The reality is that the private sector is well-positioned to drive growth and, just as the Fed desperately needs to exit extraordinary monetary policy stances, the federal government needs to normalize fiscal policy. The move from extraordinary pandemic responses to business as usual will mean smaller spending and deficits. But it will not mean the end of growth. There are some legitimate concerns about headwinds to growth. In the aftermath of the dark day of Russia invading Ukraine one can expect higher global oil prices, higher global commodity prices, and diminished global growth consequences. And there is truth to the notion that shifts in fiscal policy can shape the path of aggregate demand. But take apocalyptic claims about “fiscal drag” with a grain of salt.