Economists often point out that, when spending and output growth in the private sector is moving really fast either up or down, the government can offset this. This fiscal offset can act as a stabilizing force in that it prevents the economy from overheating when private sector growth is running hot, It can also prevent a depression when private sector spending and output is collapsing. But sometimes, governments choose to mimic the private sector and amplify the trend in the economy. This is called pro-cyclicality – and in worst case scenarios, it can be quite destabilizing.

This term, pro-cyclicality, got a lot of buzz in the immediate aftermath of the financial crisis and during the European sovereign debt crisis. In both cases, private demand growth was collapsing and the question was about arresting the fall. And there was a lot of fear that these crises could end up in another Great Depression. Students of economic history looking for fixes first hearkened back to the work of American economist Irving Fisher, who described a process of debt deflation as the real cause of economic depression.

What Fisher said was that depressions are due to a collapse in asset values and successive waves of defaults triggered by forced selling as debtors try to raise cash. In the debt deflation, the first drop in asset values triggers distress for enough debtors that their asset sales to raise cash cause the drop in asset prices to accelerate and widen as they sell whatever they can to raise cash, often their best and most liquid assets. In such a way, the original asset deflation in one limited market segment infects other asset classes, triggering debt distress in those sectors and ushering in another wave of selling pressure and asset price collapse.

Unless someone steps in to arrest the fall in asset prices, banks that hold the defaulted loans as assets end up bankrupt, setting off a debt deflation within the heart of the financial system, deepening the crisis. In the 1930s, this is exactly what happened in the United States. The result was widespread bank failures, job losses and an economic Depression of unparalleled depth. During the financial crisis a decade ago, Ben Bernanke, as chairman of the Federal Reserve, successfully spearheaded the effort to arrest the debt deflation, not without significant controversy surrounding the methods employed.

But in early 2009, the US economy was still in tatters and private sector growth was in free-fall. This is where pro-cyclicality comes into play. As the private sector collapses, so too do tax receipts, even as government expenses rise to deal with the increased unemployment and economic distress. In short, private sector distress creates budget deficits — and in the case of the US in 2009, where the percentage loss in unemployment was the largest in 60 years, the deficits were huge. If one were to act pro-cyclically and target the deficit, cutting spending and raising taxes, that would amplify distress in the private sector and perhaps precipitate debt deflation. Acting anti-cyclically and allowing deficits to rise transfers money to the private sector that decreases distress.

In the US case, deficits increased significantly and remained high until about 2013 or 2014.

In Europe, by contrast, Greece, which is not a sovereign currency issuer, did not have the fiscal space to increase deficits when it ran into trouble after the initial global recession. That country was forced to undergo austerity after 2010. And although deficits receded initially, documents leaked soon afterwards acknowledged that the planned “expansionary fiscal consolidation” had failed. Moreover, in the end, this pro-cyclical fiscal policy did indeed set off a debt deflation that increased deficits as the private sector collapsed and helped cause a Great Depression-sized loss in economic output.

Things are very different now, as the world has begun a synchronized acceleration in economic growth. In the US, where the Trump Administration is trying to deliver the beginning of what it says should be consistent long-term growth of 3-4%, it is using deficit spending to get there. Irrespective of the composition of those deficits, the key question now is the timing, because this is pro-cyclical fiscal policy.

During the Obama Administration, there was a reduction in the structural budget deficit of 6% of GDP from 2010-2016.

Source: International Monetary Fund, The Financial Times

But now the pendulum is swinging the other way, just as the economy is hitting its stride. And the right question to ask is whether these deficits will cause overheating given where the economy is right now.

That’s the big macro debate among market economists right now. Everyone is positive about the future prospects for the US economy. But what does this mean for inflation given the fresh stimulus from deficit spending? Stimulus is supposed to be the medicine applied to nurse a sick economy back to health. Taking that same medicine when the illness appears to have passed will have very different effects on the patient.

Now if it means higher inflation, this inflation could be transitory, in which case it could reasonably be ignored. At the same time, in the near-term what matters is how the Federal Reserve reacts. If the Fed sees the inflation and believes it could be “embedded”, it might decide on pre-emptive rate hikes. And if it does, the potential for slowdown and recession will rise as speculative and Ponzi borrowers get caught out.

My sense here is that Keynesian and left-leaning economists are mostly against this abrupt policy shift, both because the fiscal deficits redistribute income upwards and because the timing is pro-cyclical and very late in the business cycle. After all, Keynes’ appeal was in large-measure about anti-cyclical fiscal policy. But had the new Trump deficits been created in order to shore up America’s infrastructure or to increase after-tax wages for working-class voters instead of to give tax cuts to corporations and reduce marginal rates on the rich, I reckon praise for his deficit spending would be more bipartisan. For Republicans, the political expediency of pleasing political donors and boosting growth ahead of the midterm elections was a big impetus for doing so much more deficit spending.

Nevertheless, the real test here is about inflation and the Fed. And With Jerome Powell, a new Federal Reserve Chairman, at the helm, there is a lot of uncertainty. If the Fed reacts to pro-cyclical fiscal policy with the same caution it has used in raising rates so far, long-term interest rates will remain low unless inflation rises. And that could allow for continued growth in the economy and in corporate earnings, which ultimately helps stocks too. But since pro-cyclical policy amplifies the business cycle, it could cause overheating. if inflation rises or the Fed becomes more aggressive, the Trump Administration’s stimulus could boomerang — causing an initial bump in growth that is followed by a steep fall, not just in asset markets, but in the economy too.