In An Age Of Inflation, The Old Recession-Fighting Tools Won’t Work

The pandemic has left governments in the developed world with bigger deficits and debts. But there’s a more pressing problem: high inflation. Covid spending helped cause it, many economists reckon. And with supply chains still snarled, the standard recession-fighting measure of putting more cash into consumers’ pockets risks adding to the already intense price pressures.

That’s the backdrop to the budget fights heating up in many countries, which have already claimed one high-profile casualty in Italy. Mario Draghi’s government collapsed on July 21 after his coalition allies withdrew their support, saying a proposed aid package for households and businesses struggling with record energy bills wasn’t big enough.

In the UK, the contest to succeed Boris Johnson as prime minister is dominated by an argument over fiscal policy, with one candidate promising immediate tax cuts and the other offering a small targeted relief and warning that anything larger would just undermine the Bank of England’s mission to tame inflation.

The risk of budgets and central banks pushing in opposite directions applies beyond Britain, according to the International Monetary Fund. In countries suffering from high inflation, “fiscal policy can do targeted things to support vulnerable households, but it must do so in a way that is non-expansionary in the aggregate,” says the IMF’s chief economist, Pierre Olivier Gourinchas.

Plenty of countries in the developing world don’t have that option anyway. Coming on top of the pandemic, a combination of soaring food and energy prices and rising debt-servicing costs has forced many to seek help from the IMF.

Austerity, a standard prescription for taming inflation, gets an endorsement from economists and investors. But it’s hardly popular with the people it’s imposed on. Also policymakers in many countries can point to inflation that’s coming from outside their borders, rather than from out-of-control demand at home. That could leave room to boost economies without fanning price pressures.

Even in the US, where pandemic stimulus was biggest and the consumer boom strongest, Congress would probably take action if the economy deteriorates badly enough, says former Federal Reserve economist Claudia Sahm. “I think this still holds: the idea that in a recession, Congress will do something,” she says. “People will expect them to act.”

For now, recessions are just a risk in most of the world, while inflation is a reality. Like central bankers, the politicians in charge of budgets are having to factor in both.

● ItalyCalls for additional spending to alleviate the sting from the energy crisis will dominate campaigning for elections in September. Draghi said there was room to spend without widening Italy’s budget gap, thanks to European Union aid and better-than-expected tax revenues. He backed subsidies for energy bills and a higher minimum wage, saying they wouldn’t trigger more inflation.

Some of his partners wanted more. In a debate held before Draghi’s ouster, Matteo Salvini called for “€50 billion in Italian pockets” by the end of the year. Salvini’s League party is part of a right-wing bloc that’s favored to win the most seats in Parliament. Yet it’s unlikely any Italian government will have the freedom to spend on the scale he’s outlined.

That’s because the continent’s most indebted country needs help from the European Central Bank to keep speculators at bay. When the ECB raised interest rates on July 21, it said it’s ready to buy more bonds from financially weaker countries such as Italy to avert a rerun of last decade’s sovereign debt crisis. There will be conditions for that kind of support, though nobody is sure exactly what they’ll be, adding to investor jitters.

● United KingdomTrade-offs between supporting growth and curbing inflation have been front and center of the Conservative Party’s leadership contest to choose the UK’s next prime minister. The race pits Rishi Sunak, the former finance minister, against Foreign Secretary Liz Truss. To spur growth, Truss wants to instantly cut payroll taxes and scrap a planned increase in the corporate levy. Sunak has promised lower taxes but only “once we have gripped inflation.” The one exception is his plan to temporarily suspend the added tax on domestic fuel bills if the average annual energy bill for households rises above £3,000 ($3,614), as expected by October. Doing so would cost about £3.5 billion but help damp inflation slightly, since it would lower prices.

With inflation running above 9%, many economists wager a UK recession will be hard to avoid. “The Treasury needs to think very carefully about austerity,” says David Owen of Saltmarsh Economics.

The government has already offered £37 billion worth of cost-of-living support for households, including £15 billion in May for low-income families. That only added 0.1 percentage point to inflation, the Bank of England estimates. But Sunak warns of the impact on mortgage holders and the government’s debt-service costs if further fiscal stimulus just passes through to prices, forcing the BOE to raise interest rates even faster.

● United StatesAcross the Atlantic, the Fed is relying on jumbo-size rate hikes to wrestle inflation down from a four-decade high. Many lawmakers and economists argue too much pandemic stimulus is the culprit, so there’s little appetite to loosen the purse strings, even if a downturn hits.

The economy isn’t flashing alarm signals that would require action before November’s midterm elections, when Democrats must defend thin majorities in Congress, says Tobin Marcus, a strategist at Evercore ISI, an investment research firm. Even after that, “it’s hard to imagine things getting bad enough that we would see a quick, concerted turn to delivering bipartisan fiscal relief.”

President Joe Biden has been unable to get many of his longer-term spending programs through Congress. Swing-vote Democrats like Senator Joe Manchin of West Virginia argued that they’d make inflation worse, though Manchin agreed on Wednesday to back a slimmed-down version of the Biden plan that includes more tax increases than new spending. It’s even tougher to marshal enough votes for a policy that the UK and many other European countries have adopted: subsidies to households struggling with high fuel and power bills, financed by windfall taxes on energy companies.

The White House said last month that it’s studying several proposals from Congressional Democrats on how to fund rebates for households. Yet unlike Europe, the US is an oil and gas powerhouse, and that makes the politics around energy different. Republicans are more interested in blaming Democrats for helping drive up prices by over-regulating producers than they are in discussing subsidies for consumers, says Marcus.

● BrazilThe South American country spent more money in the pandemic’s first year than almost any other emerging nation, but President Jair Bolsonaro’s right-wing government assured investors it was a one-off. Once everything got back to normal, Brazil would revert to a fiscal rule that bars above-inflation increases in public spending.

Now, Bolsonaro—up for reelection in October, and trailing in the polls—is bypassing the budget cap for a third-straight year, with programs worth more than 40 billion reais ($7.5 billion) to help Brazilians suffering from rising food and fuel prices. The president has vowed to extend the measures into 2023 if reelected.

Brazil’s public finances suggest there’s room to spend. After ballooning in 2020, the national debt is declining again. And scrapping the spending cap isn’t an explosive election issue—it’s one of the few things on which Bolsonaro and his main rival, left-wing former President Luiz Inácio Lula da Silva, agree.

It’s in the financial markets that tensions over fiscal policy are more likely to surface. Brazil’s big-spending history means there’s always a risk of scaring off investors and triggering a currency slump. That makes the task of monetary policy harder. The central bank has already raised interest rates by 11.25 percentage points since March 2021, one of the world’s most aggressive tightening cycles, and still inflation is at above 11%.

“Both candidates that lead the polls said they want to review the spending ceiling,” says Jeferson Bittencourt, a former Brazilian treasury secretary and now an economist at asset manager ASA Investments. “But they do not offer a reassuring alternative for the country’s solvency.”

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