Through monetary and fiscal policies, the federal government is creating a capital shortage. If stagflation does arrive by late summer, neither the Biden administration’s spending and taxing policies nor the Fed’s changing the rate of growth of the money supply or changing interest rates, can be used to solve the stagflation problem.

On a fiscal policy note, the federal government has nearly tripled the public debt since 2010, from $12 trillion to more than $35 trillion. In 2010, $7.5 trillion of the debt was held by the public while the remaining $4.5 trillion was purchased by the Federal Reserve, which simply (electronically) prints money to make the bond purchases.

By mid-2022 the Fed’s purchases of government bonds totaled $9 trillion. But starting in June 2022 the Fed began to reduce its holdings by $95 billion per month by essentially selling some of the bonds that they hold. Today the Fed’s total holding of U.S. bonds is down to $7.4 trillion.

These actions by the federal government will help create a capital shortage, which will slow economic growth and cause more inflation.

That’s simply because, for business to expand output and grow the economy to meet any new demand, there are two basic inputs that are needed: Labor and Capital. The mix of the two can vary depending on business’ choice to expand output through a labor intensive or capital-intensive process.

In the U.S., even with the economy beginning to slow as noted by the meager 1.6% annual growth rate in the first quarter of this year, there continues to be a labor shortage. Today there are about 2 million more job openings than there are unemployed American workers. That means business cannot expand using a labor-intensive operation.

The only other way to expand output is using a capital-intensive operation, meaning workers are replaced by automation, technology, or artificial intelligence. In order to replace labor with capital, business will obviously need access to capital.

The federal government continues to spend trillions more than it receives in revenue each year. That means when the government sells bonds to finance the deficit, there is less capital available to business. That is already creating a capital shortage that will raise the cost of capital and result in less capital available to business.

At the same time the Federal Reserve continues to reduce its bond holdings by selling some of the bonds currently on its balance sheet. When it does that, the public purchases the bonds, which pulls more money out of capital markets, contributing to a capital shortage.

If inflation continues to increase, which is very likely, and if the economy continues to slow, we could have stagflation. Neither monetary policy nor demand oriented fiscal policy can solve a stagflation problem. That’s because if either policy tries to stimulate demand to end a recession, upward pressure is put on prices, thereby making inflation worse.

If either policy reduces demand to put downward pressure on prices, that will slow economic growth even further.

So how can we end stagflation?

Any policy geared toward changing total demand cannot be used. What can be used is what President Reagan did in the early 1980s.That is to adopt a supply-side oriented fiscal policy. That means the Fed holds its monetary policy steady by neither tightening nor loosening.

Cutting taxes by 10% for the wealthy will create more capital. That’s because when taxes are cut, disposable income increases. Lower income earners they will use the extra disposable income to increase their spending, i.e. consumption.

For higher-income earners who already spend to maintain their lifestyle, the increase in disposable income will not be spent but, rather, will increase their savings. This, in turn, also creates more capital and would be consistent with supply-side economics.

Then, to expand output and put downward pressure on prices, fiscal policy is geared to increase the aggregate supply of goods and services. Increasing supply will grow the economy and put downward pressure on prices. Fiscal policy should reduce tax rates especially for those who create capital and should remove counter-productive regulations that stifle business growth.

The key is to create more capital to soften the impact of capital shortages. Politically this is difficult. To create more capital the tax rates for the highest income earners and for corporations must be reduced. Politically that is a tough sell.

It took decades for the government to create this capital shortage. We can begin to ease the shortage by using supply-side economic policies. The current administration will never do that, but maybe in November a new president, who understands supply-side economics, will be elected.

If not, stagflation may be with us for some time.


Michael Busler is a public policy analyst and a professor of finance at Stockton University in Galloway, New Jersey, where he teaches undergraduate and graduate courses in finance and economics. He has written op-ed columns in major newspapers for more than 35 years.

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