Government is creating a capital shortage that will worsen stagflation

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 total $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 US 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 the business’ choice to expand output through a labor intensive or capital-intensive process.

In the US, 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.  To replace labor with capital, business will obviously need access to capital.

The Federal Government continues to spend trillions more than they receive in revenue each year.  That means when the government sells bonds to finance the deficit, less capital is available to business.  That is already creating a capital shortage which will raise the cost of capital and result in less capital available to business.

At the same time the Federal Reserve continues to reduce their bond holdings by selling some of the bonds currently on their balance sheet.  When they do 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 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 their monetary policy steady by neither tightening nor loosening.

Then to expand output and put downward pressure on prices, fiscal policy is geared to increase total supply. 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 administration, who understands supply-side economics, will be elected.

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

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