Back in September, one of the more widely-derided talking points by the Biden administration regarding the "Build Back Better" agenda was that it "costs zero dollars." The derision was deserved: some versions of the constantly-changing reconciliation bill were adequately paid for through tax increases such that, over a ten-year horizon, they didn't add to the federal deficit, but that's not at all the same thing as saying that they cost literally nothing.
For years, however, it seemed that an ambitious spending agenda did effectively cost nothing, because money cost nothing. With interest rates essentially at zero and the Federal Reserve committed to keeping them there, the incentives were to spend first and ask questions later. Indeed, there is practically a consensus among mainstream economists that one reason the recovery from the Great Recession took so long was that government spending increased too little, and even declined after the first two years of the Obama administration.
Those lessons were amply learned by both the Trump and Biden administrations in their responses to the pandemic. The CARES Act and American Rescue Plan between them added $4.1 trillion to federal spending, with over a trillion dollars more spent on other COVID-related initiatives. That spending both pulled the economy sharply out of free-fall and prevented massive human suffering, and while the deficit exploded there was no obvious economic downside. The stock market recovered sharply and the poverty rate actually fell during the pandemic. It looked like the biggest free lunch in history.
That free lunch is no longer on the menu. With the inflation rate rising to a 30-year high, the Federal Reserve is going to have to accelerate its tapering and even look to rate hikes if it wants to retain its hard-won reputation as the guarantor of price stability. The bond market is certainly signaling that expectation, which means that if the Fed fails to deliver, inflation expectations could rise rapidly, with much worse consequences for the economy. If interest rates do rise, though, then the interest cost of future deficits will once again become a factor in budgeting, constraining future spending and putting a drag on the economy.
Does that mean "Build Back Better" has to be deferred, as Senator Joe Manchin has argued? Not necessarily. It's worth noting that Larry Summers, a prominent critic of the size of the second COVID relief bill, continues to advocate for passing the reconciliation bill, pointing out that it is only one-tenth the size of the American Rescue Plan, which it is fully paid for, and that it addresses important societal needs.
The prospect of higher inflation and higher interest rates doesn't preclude new spending. It just means that it isn't free. It needs to be paid for — and how it is paid for matters as much as whether it is paid in full.
The causes of the rise in inflation are still being debated, with some continuing to argue that it is mostly a weird artifact of the pandemic, along with other oddities of the current economic situation like the persistence of unemployment in the face of widespread job openings. Widely-publicized supply-chain problems are certainly a key factor driving price rises — and if supply-side factors are the key problem, then hikes in interest rates will unfortunately stabilize the economy at a lower-than-optimal level. It would be far better to spend on things that will increase our economic capacity, as my colleague Ryan Cooper has argued, than to take a turn toward austerity.
It's likely, though, that the massive COVID relief bills were the primary culprit. While a supply shock should lead to price spikes, it should also lead to a fall-off in demand as people adjust their overall budgets to higher prices. When people have to spend more on gas and groceries, they should spend less on other goods. That's not what we're seeing though: demand remains extremely robust. People are complaining about price increases, but they aren't cutting back. This is precisely what you would expect if household balance sheets were in generally excellent shape, as in fact they are; if there were lots of pent-up demand due to the pandemic, as in fact there is; and if people were beginning to assume that higher prices were becoming normal — which, if they are, is precisely how you get a self-reinforcing inflationary spiral as opposed to something more "transitory."
That doesn't mean those bills were a mistake. The risk really was higher in under-shooting than in over-shooting, and so the government erred on the side of over-shooting and over-shot. It just means that policy going forward has to respond to the new economic situation. Stimulative spending now has a downside of further boosting inflation, and therefore encouraging the Federal Reserve to hike rates faster. Inasmuch as the reconciliation bill's spending will be stimulative — and its major components like the expanded child tax credit certainly will be — that's a problem.
One way to address that problem would be through the bill's own financing. If new social spending were paid for with other spending cuts, for example, the net result might not be stimulative. Alternatively, if it were offset with an increase in taxes on consumption — such as a carbon tax — that would also offset the stimulative effect of new spending. The current financing mechanisms, however, are focused on taxes on the wealthy. That's a good strategy for redistribution, but a lousy one for reducing demand since the wealthy spend a far smaller share of their income. The theoretical case for broad-based financing of welfare spending has always been there, but it's specifically the better way to respond to current economic conditions.
Alternatively, the Democrats could decide to pass what they like and let the Federal Reserve do what it must in response. That would likely be more popular initially than either offsetting spending cuts or consumption tax increases. But economic policy works best when the Fed and the Treasury are working in tandem rather than at cross purposes. In the aftermath of the financial crisis, Fed Chair Ben Bernanke begged in vain for Congress to be more stimulative because the Fed was having difficulty achieving rapid reflation on its own. In the teeth of the pandemic, we achieved the desired synergy, with Jerome Powell's Fed breaking new ground in monetary stimulus even as the COVID relief bills put money directly into people's pockets. If the Democrats make it clear now that they expect Powell to shoulder the entire burden of inflation-fighting on his own, they may get just what they asked for, and live to regret it on election day.
Or, finally, the Democrats could abandon the remainder of their agenda until they next achieve a Senate majority in the wake of a recession. But apart from the fact that it could well be a long time before that happens, punting implicitly downgrades these initiatives to "nice-to-haves" rather than anything the party is willing to make — or ask — sacrifices for. How enthusiastic is anyone likely to be for a party that treats its purported core commitments that way?
If the only time anything is on the menu is when it is free, you're not going to have very many customers come lunchtime.