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Winning the Battle Against Inflation Also Requires Supply-Side Reforms
Raising interest rates alone won’t tame rising prices
By Veronique de Rugy and Jack Salmon
Despite several interest rate hikes by the Federal Reserve (five so far, totaling 300 basis points), inflation remains alive and well, with core inflation continuing to tilt upward. That’s because the Federal Reserve can’t fight rising prices by itself. Stopping inflation will require continued monetary tightening as well as fiscal deficit reduction. But winning the battle against inflation will also require supply-side reforms that make the economy more dynamic and more competitive.
Before we discuss supply-side solutions, let's remember how we got here: During the pandemic, and while the economy was closed and then later only partially reopened, government officials engaged in big money printing, big borrowing and big spending. As if that wasn’t enough, when the economy was almost back to normal, Congress and policymakers didn’t move to end the party, but instead announced that big deficit spending would continue. And it did, even as inflation began to tick up.
Now we are in a mess. Everyone fundamentally understands why inflation is a problem: Earnings and savings buy less and less. That’s why it now tops the list of average Americans’ concerns. What is not so well understood is how much worse the problem of inflation can be during a period of high government debt. We won’t bore you with all the details, but if you must know one thing, know this: While the best way for the Federal Reserve to control inflation is to raise interest rates, the higher interest rates go (and with the 10-year Treasury rate being around 3.8%, it is already a whole 2.5 percentage points higher than it was just over a year ago), the larger the interest the federal government must pay on the debt. That can become very expensive, very quickly, since our debt is roughly 100% of GDP, and 30% of our debt is coming due within the next year.
As we wrote in these pages recently, “If the interest rate on the 10-year Treasury note is … 1 percentage point higher than expected, the cumulative deficit will be $2.85 trillion larger over the decade.” And that underestimates the cost, since half of our debt has a maturity of 3 years and those rates are getting higher faster.
What’s Congress and the administration’s role in getting us out of this mess? Well, for starters, they need to tighten fiscal policy so that the new interest payments on the debt aren’t paid with yet more borrowed money. If spending is a contributing cause to inflation, like it is in this case, a failure to tighten will make the problem worse. As economist Eric Leeper states, “Fiscal responses are fundamental, even indispensable, to monetary policy impacts on inflation.” They are “the difference between a Brazilian-style interest rate and inflation spiral and a successful reining in [of] inflation.”
Needless to say, this administration and Congress are not interested. After all, since President Biden came into office, more than $4.8 trillion has been added to our overall deficit. And this number doesn’t include an additional estimated $500 billion from the recently announced student loan forgiveness program and repayment changes.
But politicians at the federal, state and local levels also need to put in place the kind of reforms that will grow the economy by expanding the supply of goods and services. Here are a few suggestions:
Dramatically increase the number of immigrants legally allowed into the country. More immigrants are always a good thing, but liberalizing immigration policy is a particularly good idea when the economy has 11 million job openings to fill. Policymakers might start by modifying the student visa system that currently encourages highly educated foreign graduates to pack their bags and leave after they graduate from American universities with skills the country desperately needs, such as engineering and medicine. The Department of Homeland Security could make some small reforms that would boost innovation, productivity and growth by making it easier for foreign graduates to work here, by removing employer sponsorship requirements, and by streamlining the process to obtain a work visa and permanent residency.
Make changes to our trade policy, starting with abolishing punitive tariffs, duties and quotas. These and other restrictive trade policies only serve to inflate prices by reducing the efficiency of our supply chains. And we should abolish certain trade regulations like anti-dumping and countervailing duties. These rules protect a few politically connected industries at the expense of everyone else.
Eliminate the Jones Act, which mandates that all freight moved between U.S. ports must be handled by U.S.-built, crewed and flagged ships. This would make the shipping of goods less costly and ease pressures on inland transit. Similarly, the Foreign Dredge Act should be eliminated. Older than the federal income tax, the Dredge Act significantly inflates the costs of dredging ports, preventing expansions that could accommodate more and larger ships.
Build, Baby, Build, as economist Bryan Caplan would say. At the state and local level, there is a strong, and now bipartisan, case for housing deregulation. That’s because there is a well-documented shortage of new homes due to zoning and related rules. The inadequate supply jacks up prices and keeps people from moving to better job opportunities. Reform these rules, build more homes, lower prices and grow the economy.
Residential housing isn’t alone in suffering from these excessive rules. Reforming commercial zoning, land use regulations, and permitting rules for warehouse construction in or near ports would remove the barriers to building or expanding storage and container structures. These changes would increase the effectiveness of American ports, none of which even make it to the bottom of the list of the 50 most efficient port facilities in the world. That alone would help alleviate the supply chain issues that caused so many product shortages during the pandemic.
As the recently enacted infrastructure law reminds us, politicians love spending public money on things like roads, ports and bridges. However, instead of spending $1.2 trillion we don’t have, they would be better off unleashing private sector investment in infrastructure that is currently held back by burdensome regulations such as the environmental-impact reviews required by the National Environmental Policy Act of 1970. The act and the reviews it requires should be terminated or at least significantly scaled back and streamlined since they cause delays and drive up costs on infrastructure projects while rarely delivering on promised environmental protections.
Stop proactively restricting energy supplies. Over the past 12 months, energy costs have added an average of 1.6 percentage points onto headline inflation. On his first day in office Biden revoked the cross-border permit for the Keystone XL Pipeline—a long-term investment that would have brought over 800,000 barrels of oil into the U.S. every day.
To make matters worse, a week later the president halted all new leases for oil and gas drilling on federal lands and has since refused to renew the federally mandated five-year offshore drilling plan. Now, 21 months after Biden was sworn in, crude oil production remains 8% below 2020 levels and Americans continue to pay a hefty premium at the gas pump.
So, a good place to start would be to reverse these two self-defeating gestures and allow the pipeline to be completed and drilling on federal land to resume. This would not only increase the country’s supply of oil and gas in the next few years, but would send a message to the energy industry that the government is no longer interested in slowly suffocating it.
Government Is the Problem
Lower prices and improved economic efficiency come not from increased regulation, but from increased competition. Presidents Jimmy Carter and Ronald Reagan both knew this as fiscal and monetary authorities used all the tools in their arsenal to curb inflation in the late 1970s and early 1980s. For instance, Carter presided over the historic deregulation of the airline and trucking industries. In 1981, Reagan noted that “in the present crisis, government is not the solution to our problem, government is the problem.”
And these pro-competition reforms shouldn’t stop at the federal level. Last year, Chris Edwards at the Cato Institute published a paper proposing a host of state- and local-level deregulatory steps that could help, including rewriting occupational licensing rules. Edwards’ to-do list also includes getting rid of certificate of need rules, alcohol licensing rules, bans on marijuana products, and zoning rules that ban, restrict or raise costs for home‐based businesses in residential neighborhoods, which city planners call “home occupations.”
Deregulation as supply-side economic policy unleashes the growth potential of the market, which works to ease inflationary pressures caused when excess demand outstrips supply. Decades of empirical literature demonstrate that market deregulation reduces inflationary pressures. One 2014 study published in the “Journal of Macroeconomics” finds that during the period 1985 to 2007, every 1 point decrease in regulation (as measured by the Energy, Transport and Communications regulation index) leads to a decrease of about 0.8 percentage points in the inflation rate.
As John Cochrane noted in a speech at the 2021 Cato Institute monetary policy conference, “The lesson of 1980 is quite simple. Inflation stabilization, when it comes, is always monetary, fiscal, but also microeconomic. The trifecta of policies is what stopped inflation.”
The tightening of monetary policy in recent months is a good start, but again, the Fed cannot tame inflation on its own. Until Congress and the administration are willing to restrain federal spending, there isn’t much that can be done about that. However, there is a lot of bipartisan support right now for pro-growth, supply-side reforms, which would go a long way in aiding the Fed’s attempts to quell inflation.