COVID-19: Recession & Recovery
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How much money should the government spend?
By Leif Olson
During the October 6th meeting of the National Association for Business Economics, Federal Reserve Chair Jerome Powell said that the risk of the government spending designed to pull the economy out of the recession is small. Powell has perhaps been more outspoken about fiscal policy than any other Fed Chair before him. However, this may be unsurprising, as unprecedented challenges call for unprecedented action.
The Coronavirus pandemic has devastated the American economy to a degree unmatched since The Great Depression. In May, the unemployment rate reached a staggering 13 percent. By August, over thirty million people remained at risk for eviction. Additionally, since September, job growth fails to meet expectations, and the CARES Act funds are close to running dry. Despite overwhelming uncertainty, the Federal Government has as-of-yet failed to offer relief.
Recently, after House Democrats proposed a 2.2 trillion dollar stimulus package, Senate Republicans unveiled their own “skinny” 500 billion dollar plan. This resulted in more political deadlock, reflecting the fundamental disagreement between Republicans and Democrats regarding government spending. For instance, Republicans are wary of growing national debt, at least according to their rhetoric.
Even so, Fed Chair Jerome Powell claimed that, at least at the moment, government debt is not a problem. If he is right, why are so many politicians, especially Republicans, hesitant to spend more money?
How has the Fed responded to the recession?
The Federal Reserve took unprecedented steps to support domestic markets — and international markets — with aggressive portfolio and liquidity expansion. For example, the Fed backstopped a broader range of markets than it did in 2008. In doing so, the Fed solidified its role as the lender-of-last-resort not only for the United States but for much of the rest of the world as well.
The Federal Reserve has kept the Federal Funds Rate low, effectively setting the national interest rate at zero. With an almost nonexistent interest rate, debt is made cheaper, and people become more likely to spend than save. While this is meant to spur economic growth, it also opens fiscal space for the federal government, allowing greater flexibility.
When interest rates are this low, the US Treasury can auction-off treasury bonds for much less. This benefits both the private sector and the government. While private entities get safe, appreciating assets in the form of bonds, the Treasury gets extra cash to spend.
Powell has said that the Fed plans to keep interest rates at near-zero for the foreseeable future. The only thing that could cause the Fed to raise rates again is inflation, which makes an increased national debt much less problematic.
What are the risks of inflation?
High inflation is an economist’s greatest fear. Inflation leads to higher prices, and high inflation leads to price increases that outpace wage growth. This reduces consumer buying power and makes debt more difficult to service.
Whenever the rate of inflation picks up, the Fed responds by raising interest rates to incentivize saving. This is because when the savings rate increases, spending necessarily decreases. In turn, consumer demand decreases, and prices fall, thereby countering inflation. Politicians are wary that whenever the Fed raises rates in response to a spike in inflation, it becomes much more difficult for the government to make interest payments and keep the national debt under control.
While some Republicans oppose deficits based on principle, many resist deficit spending based on inflationary risks. Even so, are they right to fear inflation from deficit spending at this moment? More broadly, how should the government manage its present debt?
Is inflation really such a threat?
Because of the stagflation crisis of the 1970s, economists and politicians alike became much warier of any inflationary upticks. Since the crisis, the Federal Reserve has kept inflation on a tight leash by keeping unemployment near a rate of five percent, commonly known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU). The NAIRU is the level at which employment increases begin to accelerate inflation, causing the Fed to raise interest rates in response. According to those who use the NAIRU as their metric for inflation, the major problem with government spending is that it stimulates the economy while simultaneously increasing employment.
When the economy heats up, the unemployment rate decreases, and consumer spending increases. With the newly employed spending more as well, the prices of goods and services go up. This contributes to an inflationary cycle, including all the issues mentioned above with debt servicing and buying power. But here’s the catch: this is all theoretical. What’s more, this theory doesn’t acknowledge any of the external influences which might alter outcomes.
You might not be surprised to hear, then, that in September of 2019, when the unemployment rate hit three and a half percent (a 50-year low), inflation remained stubbornly below two percent. It is worth noting that the inflation rate did briefly surpass two percent in the following months. However, the annual average ended up being one-point eight percent (1.8%).
Inflation failed to explode despite historically low levels of unemployment, as theory would predict. Likewise, historic highs of national debt failed to result in dangerous inflationary effects — even when the economy was doing exceptionally well. This made it apparent that exogenous factors are depressing the rate of inflation.
What is depressing the rate of inflation?
In a piece written by economist David Beckworth, he outlined three primary explanations for persistently low inflation. The first explanation is that, despite economic growth, consumers are hesitant to spend. This rests upon the fact that American workers have experienced two massive recessions in just the last two decades. As a result, American workers have become much more likely to save out of fear of a future economic downturn, and more money saved means less money spent bidding up prices. This is the case despite significantly lower interest rates, which means that low inflation levels will persist until their fears are assuaged.
Beckworth’s second explanation is centered around the stability of the US Dollar. The Fed has become increasingly entrenched in the global economy by opening up Dollar swap lines abroad. In doing so, the Fed has enshrined a long-run international demand for the US Dollar. A greater supply of Dollars abroad helps foreign countries weather demand shocks, but it has also made the Dollar a more stable, less inflation-prone currency.
Beckworth’s third and final explanation is the Fed backstopping the US financial system after the initial economic shock of the pandemic, as mentioned previously. This had the effect of instilling confidence in foreign holders of dollar-denominated assets. A high degree of confidence helps maintain a high level of demand, which means the US government can increase spending without running out of holders of Dollars with cash to spare. Therefore, the dominance of the US Dollar abroad has amounted to a lower inflation rate at home.
Beckworth’s central argument is that the threat of inflation alone should not be enough to stop the federal government from spending money. In this sense, Beckworth echoes Fed Chair Powell’s call for more stimulus. Politicians opposing sizeable economic stimulus packages out of a fear of inflation need only see that any shocks will likely be repressed by predominant deflationary pressures at home and abroad. To explore the issue in greater detail, you can read Beckworth’s piece here.
What risk remains?
While anxieties regarding the rate of inflation may be overblown, fears of long-term debt expansion are not. As of now, the United States is on track to rack up as much debt as it had during the Second World War. This fact is extreme on its own, but it also challenges contemporary models of long-term debt sustainability.
To better understand this issue, I interviewed the Associate Director of the International Economics and Finance program at Johns Hopkins School of Advanced International Studies (SAIS), Dr. Jason Fichtner. Dr. Fichtner has written prolifically on relevant issues ranging from fiscal policy to debt sustainability. He explained to me that his most significant concern is the fact that excessive debt, in the long-run, will force the government to make hard choices regarding which programs to fund in the future.
“I am worried about crowd-out on fiscal payments,” he said, “because we are getting to the point now where if you go from a one percent interest rate to a three or three-and-a-half percent interest rate, we start getting annual payments of one trillion dollars a year. That’s what we pay out in Social Security benefits in a year.”
He explained that greater long-term debt would force the government to make sacrifices pertaining to long-term obligations and long-term aspirations. Massive debt loads, coupled with an expanding economy’s higher interest rates, might force politicians to abandon ideas like universal healthcare, a green new deal, or large-scale infrastructure investment. “The math no longer works,” he said.
Dr. Fichtner is also a fellow at the Bipartisan Policy Center where a few years ago, during its regular national debt management exercise, they approximated “sixty percent debt-to-GDP sustainability.” This means that the total national debt translated to sixty percent of the annual GDP. Two years ago, they were “pushing to get eighty,” which “was making people uncomfortable.” He continued, “back then, that was twenty trillion dollars in debt, now we’re at twenty-seven or twenty-eight. The next time we do the exercise, it may even be thirty. I don’t know what debt sustainability looks like anymore.”
What can be done? While continued spending increases will likely not lead to rapid inflation, the implications of the increased interest rates that will follow are concerning. Dr. Fichtner’s suggestion is to make fiscal stimulus “timely, targeted, and temporary.” For one thing, expand unemployment insurance so that people who lose their jobs are protected. Additionally, ensure that the Paycheck Protection program is robust and targeted toward the businesses that need it most.
Looking forward
Ultimately, the United States government must help its citizens. Congress cannot abstain from implementing necessary stimulus packages for fear of inflation. Instead, the government should focus on spending effectively to help American workers in a targeted manner.
Without stimulus, millions of Americans will be left to languish in a depressed market. However, with too much stimulation, we may end up spending our way into another, newer economic crisis. Instead, the government should spend just enough to ensure that people are taken care of.
Many people have lost their jobs through no fault of their own. To prevent a vicious cycle of recessionary pressures, the government has to invest in the economy and raise aggregate demand. How the government does this is incredibly important because it is the difference between a significant recovery and a long-term debt crisis. Regardless, if Congress fails to reach an agreement soon, millions of people’s livelihoods will be lost, and the American economy may never truly recover.
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