The Shock, the Recovery, and the Excess
Covid, Stimulus, Inflation, and the Dollar
The world economy is struggling to escape the Covid-19 economic shock. During the worst of this pandemic, the world’s developed economies provided an enormous fiscal stimulus on a scale not seen since the second world war.
Now, however, the US is proposing to more than double its already generous fiscal stimulus. Is this a good idea or excessively risky?
Go Big, But Where?
For its proponents, the idea of “going big” is designed to be a transformative political moment. But too much appears allocated inefficiently, and it may simply be irresponsible.
An easy money era produced only anemic growth. But the scale and direction of additional stimulus look more like irresponsible fiscal policy leading to significant overheating and the waste of resources. While there is a strong case for a more aggressive approach to fiscal policy, that policy still needs to be grounded in economic realities and reasonable priorities. These are not.
A “wishful” transformative approach to fiscal policy could end in economic and political disappointment, or worse. There are important factors to be considered.
· The US is dedicating close to one-quarter of GDP to enormous stimulus packages — $900 billion in December 2020, $1.9 trillion in March 2021, and now possibly a longer-term investment package of up to $3.0 trillion to $4.0 trillion.
· But Covid reduced wages to American households by $20 billion to $30 billion a month, with that figure declining over the year. So, a $250 billion to $300 billion hole in wages is going to be filled with somewhere between $2.5 trillion and $5 trillion.
The economic shortfall is much smaller than the cash injections intended to fill it. This may cause several potential outcomes.
1. Rising inflation and, more importantly, an increase in inflation expectations. It is expectations that drive Fed policy, and if inflationary expectations increase, it is likely the Fed will need a sharp and surprising increase in interest rates, decelerating the economy into recession.
2. A euphoric boom and optimism that leads to unsustainable bubbles likely to burst spectacularly and detrimentally to the overall economy.
3. It could all work out well.
This scale of this stimulus policy extended over multiple years and adding up to several trillion dollars doesn’t seem likely to work out well. It looks substantially excessive.
The US and global economy pre-Covid were at near-zero real interest rates, with a substantial gap between private savings and investment (caused by a combination of demography, cheap capital goods, inequality, and technology).
That substantial gap meant a deflationary tendency, one towards sluggishness and for savings to flow into existing assets and create potential asset bubbles. Very low interest rates carry substantial risks because future cash flows are more highly valued in a low interest rate environment. Often those valuations, even with a minor change in discount rates, can differ substantially.
And the Money Rolled In
The first round of fiscal stimulus was 14% percent of GDP, seemingly overdoing the requisite response. The scale of the problem was overwhelmed by the magnitude of the response. This $1.9 trillion is not a large-scale, multi-year program of public investment responding to our deepest societal concerns. It’s paying people, sending money to families in the 90th percentile of income distribution and the unemployed receiving more in unemployment insurance than they earned when working. Policies like this are not effective resource allocation, often create excessive demand, and are problematic overall because they can dramatically impact the value of the dollar and cause substantial inflationary pressure.
There Goes the Dollar
If we create excess demand in the US, as the Fed moves to tighten, higher US interest rates will increase the value of the dollar relative to other currencies. This in turn is likely to destabilize global currency and debt markets as the dollar rises. This threatens emerging-market debt because borrowing around the world is mostly denominated in dollars, causing substantial increases in dollar-denominated debt potentially causing a crisis similar to the debt crisis and contagion we saw throughout Latin America, Asia and Russia both the 80s and the 90s.
It may not result in a crisis, but what is likely is that in the US we may experience a temporary boom, a rising current account deficit, increased protectionism, and a strong dollar, while other countries experience a magnification of their debts. But at some point, there may also be a strong sense that the US is printing its currency indiscriminately, and combined with substantial public debt, the dollar’s value and importance in global economics will be impacted.
Perhaps the forces will balance themselves, at least over time. But significant volatility is being created by policymakers, whose role should be to stabilize markets but instead are destabilizing them with their actions — and that is not going to stop anytime soon.
Even if inflation rises to 3.0%, the Fed is likely not to act because it will expect a return to lower inflation. It is believed that future spending plans, which amount to approximately $3 trillion, are going to be covered by taxes, and will not have inflationary pressure. This assumption has never proven true in the past regarding excessive spending, and it is unlikely to be true this time.
Covid-19 has wrought colossal changes in the global economy. But, while Covid will pass, these massive expenditures will not. Even though it is expressed that they are only temporary expenditures, too many people are calling this a new era in progressive policy, and any change that is considered temporary typically ends up being structural. Therefore, these expenditure policies will continue over a substantial interval, and relying on their transience is a mistake.
It’s the Expectation
If the Fed has an entirely new paradigm for fiscal and social policy, it’s a bit hard to understand why expectations should remain predictable. What is unfolding we have not seen since the 1970s, and it stands to reason that would lead to significant changes in expectations. If expectations change, Fed policy and interest rates change along with them.
Is Stimulus a Component of a Permanently Larger Public Sector?
The short answer is yes. Public expenditures are increasing and more complex, and taxpayers are going to be handed the bill while deficits, and potentially interest rates, skyrocket.
· There is a demographic timebomb of an aging population. There are insufficient funds to manage this large and predictable public outflow.
· The cost of education and healthcare, increasingly part of the public budget, has increased dramatically.
· Redistribution of wealth equates to more transfer payments funded with deficits. Tax revenues cannot make up for these projected distributions.
· An increasingly dangerous world will create more international obligations.
Whatever the expectation for the right size of government was, there is a substantially larger one today and its growth is inevitable.
A larger government requires larger taxes. There is a point of diminishing returns, and it may be closer than this government understands. While it is easy to sell a more level and just tax system to the masses, the reality is that it will be neither, and it is likely to undermine economic growth and business creation. Those with skin in the game tire quickly of subsidizing the entire economy, especially when the fiscal budget is filled with unconstructive expenditures or ineffective investments in the economy.
Economic Growth Begins and Ends with the Cost of Capital.
Interest rates drive the cost of capital and expected returns. This is the true driver of economic well-being and wealth creation. Public policy should enable the greatest access to opportunity and reasonable return on capital through prudent policymaking. We are not seeing that prudence now and the cost of capital may rise to become a meaningful constraint on investment. In that light, do massive deficits make sense? Under this scenario, they are far more counterproductive than the short term jolt to the economy they provide.
The laws of economic arithmetic cannot be suspended easily and then hope that it all somehow works out. Any attempt previously has ended disastrously. There is a significant risk that this is happening again now.