In American foreign policy, the period from 1990 through the summer of 2001 has been called the “holiday from history.” Between the collapse of the Soviet empire and the 9/11 attacks, the United States drastically reduced defense spending and celebrated what was optimistically assumed to be a permanent end to significant security threats. September 11, 2001, shattered that peace and returned America to its familiar posture of vigilance against security threats.
We may soon look back on the 2009–2021 period as the era of “free-lunch economics,” when hubristic politicians and economists declared that traditional fiscal and monetary trade-offs no longer existed in any meaningful form. Advocates portrayed a new economy liberated from restraints, one in which money-supply expansions and congressional deficit spending could finance benefits that would make even Western Europeans envious, with no economic drawbacks. As in foreign policy, this utopian vision proved to be an illusion. Reality has intruded.
The precipitating event of the free-lunch era was the massive 2009 federal response to the Great Recession. At the time, an $800 billion stimulus bill and $1.3 trillion expansion of the Federal Reserve balance sheet represented a radical (and to many, reckless) divergence from Washington’s typical modest recession responses. And yet the warnings of rampant inflation, spiraling interest rates, and a fiscal crisis did not come to pass. In fact, inflation remained low, and interest rates continued to fall for a decade. The sluggish economic recovery convinced many economists that even this atypically bold response was ultimately too mild.
While the Left was thinking bigger on economic stimulus, the right-wing Tea Party exposed itself as more concerned with temporary bank bailouts, stimulus spending, and Obamacare than with the larger underlying deficits driven by escalating Social Security and Medicare costs. With continued trillion-dollar deficits producing no visible economic harm, both parties saw little reason to keep practicing the traditional “root canal economics.” In 2016, Bernie Sanders nearly won the Democratic presidential nomination while promising the largest peacetime spending spree in American history, and Donald Trump united Republicans and won the White House while promising to cut taxes and shore up Social Security and Medicare’s shortfalls. The next few years saw taxes slashed, discretionary spending caps repealed, and annual deficits creep back toward $1 trillion—again, with seemingly no economic drawbacks. When the 2020 pandemic necessitated a major federal response, both parties eagerly passed a $3 trillion bill that would have been unfathomable even a year earlier.
Up to this point, the most expensive recent federal expansions had been implemented during recessions, with the goal of sustaining demand. But progressive lawmakers, economists, and commentators saw the lack of negative macroeconomic consequences as proof that monetary and fiscal expansions had become a free lunch that could be greatly expanded—even during non-recessionary times. After all, if rising inflation and interest rates have been permanently defeated, then why listen to those paranoid deficit scolds stopping us from ending poverty and building a comfortable social democracy?
Economists like former International Monetary Fund chief economist Olivier Blanchard updated earlier, more cautious, research and now claimed that low interest rates provided substantial fiscal room for spending. Many progressives embraced a fringe concept called Modern Monetary Theory (MMT), which argued that simply printing trillions of dollars could magically finance the progressive wish list without inflation. Right on cue, progressive analysts developed proposals to borrow tens of trillions of dollars to spend on Universal Basic Income, the Green New Deal, a government-funded job guarantee, single-payer health care, and free public college. All this borrowing would be on top of the combined $112 trillion shortfall for Social Security and Medicare that the Congressional Budget Office projected over the next 30 years.
The silly season peaked during the 2020 presidential campaign. In previous elections, Democratic presidential nominees would typically promise up to $2 trillion in new spending over the following decade, most of which would be paid for in taxes and accompany broader deficit reduction measures. In 2020, despite looming trillion-dollar baseline budget deficits, Bernie Sanders promised $97 trillion in new spending over a decade, Elizabeth Warren promised $40 trillion, and Joe Biden was branded a moderate for proposing a mere $11 trillion in new spending. In short, leading Democratic presidential candidates had promised the largest peacetime borrowing spree in history, on the assumption that interest rates and inflation could never again rise, and with no backup plan if events proved that assumption wrong.
Following their 2020 victories, Democrats began the new spending spree with the $1.9 trillion American Rescue Plan—even as the $3 trillion expansion of the Federal Reserve balance sheet was still winding through the economy. ARP represented a historic new experiment in deficit spending in that: 1) it was one of the most expensive peacetime bills in American history in terms of annual cost (the 2001 and 2017 tax cuts each had a similar total cost that would be spread over ten years, while ARP concentrated nearly all of its costs within a two-year deluge); and 2) it was implemented when the economy was out of recession and only $420 billion (or 2 percent) short of operating at full capacity. Not content to stop there, Democrats expanded discretionary spending by 7 percent and enacted a (relatively bipartisan) $550 billion infrastructure bill. Most boldly, they designed a Build Back Better plan with $2.4 trillion in new benefits that—if its temporary policies are extended, as is likely—would cost $5 trillion over the next decade, with only a small portion offset by taxes. The spending debate had shifted so far to the left that critics ridiculed West Virginia senator Joe Manchin as an anti-government right-winger for trying to trim BBB’s price tag to a still-historic $1.5 trillion.
The “free-lunch” experiment has collapsed. Inflation has jumped past 8 percent for the first time in 40 years—reaching 8.6 percent in May—interest rates are rising every month, real wages are falling, and economic growth is dipping. Budget deficits are now projected to soar past $2 trillion within a decade, even assuming peace, prosperity, and the scheduled expiration of most of the 2017 tax cuts. This is not a coincidence. Economists such as Lawrence Summers warned that the ARP would worsen inflation, and research from the San Francisco Fed has confirmed it. America’s inflation rate has thus exceeded those of European countries with smaller fiscal responses.
This economic failure has brought political disaster for the Democrats. President Biden’s approval rating has crashed into the 30s, and Republicans are poised to capture control of the House and possibly the Senate in November. Perhaps even more importantly, BBB appears dead in its current form, and voters will likely continue to associate trillion-dollar spending bills with inflation and economic chaos. The inflation of the 1970s and early 1980s scarred a generation of voters and induced central banks to fear rising prices for 40 years. Today’s version may similarly doom trillion-dollar spending programs, and no amount of liberal research challenging the link between spending and inflation is likely to negate the voter perception. MMT is now dead as an economic theory, if it was ever really alive in the first place.
The inflation and declining real wages that have followed this spending binge are not the only factors killing the era of free-lunch economics. The popular argument that low interest rates allow Washington to afford massive deficit spending never made sense: Washington never locked in those low interest rates with long-term bonds, so it left itself dangerously exposed to any future interest-rate increases because they would apply to nearly the entire federal debt. These rates are already rising, and every percentage point that they rise will cost the federal budget an additional $400 billion in annual interest expenses within a decade. Retiring baby boomers are also driving Social Security and Medicare shortfalls that will bring $2 trillion budget deficits within a decade.
And it is not clear who will purchase this deluge of debt. China and Japan essentially stopped purchasing American bonds more than a decade ago, and the Federal Reserve has pledged to unwind its balance sheet. That leaves American lenders and those from smaller countries to finance nearly all of the $112 trillion avalanche of 30-year baseline deficits. This will almost surely require higher interest rates.
Consequently, even Biden is now promising deficit reduction as a key piece of his anti-inflation strategy. This will ultimately prove fatal for the bold progressive spending agenda because no plausible package of tax increases could finance even a portion of that wish list. Even a unified Democratic Congress has not been able to pass a $2 trillion tax increase targeting multinational corporations and wealthy Americans—supposedly the lowest-hanging fruit of tax hikes.
What will replace free-lunch economics? Perhaps more modest economic policies that had long prevailed before this fever. Obviously, this does not mean balanced budgets or even strong (but rarely seen) fiscal responsibility, but it could mean more modest fiscal expansions, with at least some attention paid to budget deficits. In the pre-2009 era, Washington tore itself apart over a 2003 Medicare expansion whose cost—$400 billion over the decade ($628 billion in today’s dollars)—represented the largest spending increase in decades. Such fiscal modesty is not always popular, yet Congress’s refusal to spend more lavishly between the mid-1970s and 2009 (while keeping tax revenues near the historic average) reflected a voter consensus that Washington should practice at least some restraints on deficits. Going forward, lawmakers may have to offset major new initiatives with tax increases, eliminate lower-priority expenditures, or provide incentives to the private sector to take a lead role in an “abundance agenda” (as described by The Atlantic’s Derek Thompson) that expands American capacity in health care, housing, energy, and infrastructure.
For more than a decade, progressive lawmakers, economists, and activists sold Americans a fantasy in which the printing press and ambitious deficit spending could buy a European-style welfare state without incurring costs. With Washington already facing $112 trillion in baseline deficits over the next three decades, adding trillions more in unfinanced benefits was never realistic. Congress must come back to reality: there is no free lunch.