Part 1 of 3
Presidents always want to take credit for good economies while their opposition blames them when economic times are bad. Interestingly, we currently see President Joe Biden claiming credit for Bidenomics, setting forth arguments explaining why he believes the economy has improved during his presidency, while his opponents contend that Bidenomics sucks.
Is there merit to either position?
To answer that question, there are several principles at play that must be understood — monetary policy, fiscal policy, fiscal lag and the economic consequences to certain executive branch actions taken by the president or Treasury Department. This three-part column discusses governmental economic policies and the role that the president plays in steering the economy.
An economy’s monetary policy is generally set by its central bank. In our case, that is the Federal Reserve Board, or Fed. A central bank controls the amount of money that is in circulation. This is called the money supply.
To understand how this works, one must understand that money is created through bank lending and is retired when loans are repaid. Assume an economy that has two individuals, A and B, and a bank. A has $100 which he deposits in a bank account. At this point the total money supply is $100. Now, the bank loans $50 to B, who deposits the loan proceeds into a bank account. Now the total amount of bank deposits is $150 and the money supply has increased by 50%.
Generally when people borrow money, they spend the loan proceeds, which creates economic activity. When the economy is at the bottom of the economic cycle, spending is reduced and there is less economic activity. This is when the central bank encourages lending to stimulate economic activity to expand the money supply.
Conversely, at the peak of an economic cycle, the demand for goods and services is at its peak, potentially causing prices to increase if there is an insufficient supply of the demanded goods and services. This results in inflation. To reduce the demand for goods and services, the central bank discourages lending and may even encourage the repayment of loans to contract the money supply, thereby reducing inflationary pressures. Stimulating an economy at its peak is frequently inflationary.
Banks cannot loan all of the bank account deposits held because they need to have money on hand to fund customer bank account withdrawals. The excess of the money and loans held over the amount owed to depositors is the banks’ equity, which is referred to as capital reserves. The Central Bank sets minimum capital reserve requirements that banks must maintain.
The Central Bank encourages lending in several ways. First it may reduce interest rates to reduce borrowing costs. Second, it may purchase loans from the banks so the banks can use the sales proceeds to make more loans. Finally, it can decrease the banks’ capital reserve requirements, which allow the banks to lend a great portion of the deposits it holds.
During the economic downturn that started in 2008, central banks around the world, including the Fed, employed all of these actions, resulting in unprecedented levels of monetary expansion. This was referred to as “quantitative easing.” The 2008 downturn was the most severe since the 1930s and quantitative easing was continued for many years. When I retired nine years ago, economists and financial advisors were surprised that years of quantitative easing had not triggered inflationary pressures. Part of the reason for this was technological innovation and offshoring reduced the cost of goods and services, thereby offsetting inflationary pressures.
Pandemics always disrupt supply chains and cause inflationary pressures. In the middle ages, the plague killed the serfs who farmed the fields, which resulted in a shortage of food in economies that were dominated by agriculture. More recently, the Russian influenza pandemic of 1889 and the Spanish influenza pandemic of 1919 were followed by inflationary periods. So it was perfectly foreseeable that the recent coronavirus pandemic would also be followed by an inflationary period.
However, during the period of the pandemic, the global economy took a sharp downturn, causing central banks to increase monetary expansion. Not surprisingly, as the pandemic became endemic, significant inflation resulted and central banks around the world reacted by implementing contractionary monetary policies, causing the money supply to shrink.
While inflation has slowed, prices are still high relative to where they were before the pandemic. Many, especially those on fixed incomes, still feel inflation’s pain. Furthermore, if the Fed does not take its foot off the brakes at the appropriate time, the contractionary monetary policies risk putting the economy into a recession.
My next column will discuss fiscal policy.
Jim de Bree is a Valencia resident. If you are interested in learning more about this topic, College of the Canyons offers the course, “ECON 201, Macroeconomics.”