Overstimulation Risk

Overstimulation Risk

Among the many strange, unforeseen changes of the last year is a new respect for Keynesian economic theory. Practically everyone in power now agrees that deficit spending produces GDP growth. They differ only on its expected magnitude and duration. The few exceptions are mostly outside the halls of power.

This matters because deficit spending, already higher than ever, is set to grow even more when Congress passes President Biden’s pandemic relief package. I take it as given they will pass it, since Democrats have the necessary votes and look united on the major items. They may tweak some details to satisfy Manchin or Tester, but the final amount will be somewhere close to the desired $1.9 trillion.

Coming on top of trillions already authorized in prior bills, a budget deficit that was already approaching $2 trillion before the pandemic, and the Federal Reserve stimulating in its own ways, people are asking whether this is too much. The answer depends on the coronavirus' “Gripping Hand.” If the vaccines work well enough and are administered widely enough to stop the new variants and enable economic normalcy later this year, all that money might be excessive. Rising consumer demand combined with supply constraints could spark inflation.

If, however, the pandemic continues into summer, it will mean the Gripping Hand is still squeezing us. Employment won’t recover and more small businesses will fail. This relief package, as large as it is, may prove necessary and maybe even too small.

The experts I trust are split on this question, and of course no one really knows. But the debate is important philosophically. Nothing underscores this more than the comment from my personal economic bête noire, Modern Monetary Theory exponent Dr. Stephanie Kelton. When asked whether she was worried about the stimulus bill causing inflation, she said:

"Do I think the proposed $1.9 trillion puts us at risk of demand-pull inflation? No. But at least we are centering inflation risk and not talking about running out of money. The terms of the debate have shifted."

This is precisely what should concern us. No one, except a few old classical economists, is afraid of growing the debt. That argument is seemingly over, and its absence may be the real story here. Today I’ll explore where all this may lead.

The Case for Inflation

The concern that we may overstimulate took off this month when former Treasury Secretary Larry Summers, a Democrat, pointed out that it will far exceed the “output gap” shown in the latest Congressional Budget Office economic projections.

What is an output gap? Gross Domestic Product measures (or at least tries to) economic growth. Economists also calculate “potential GDP,” which is how much the economy could grow, if every available worker and other resource were fully employed. Inflation tends to occur when actual GDP exceeds potential GDP because the economy is “running hot.” An output gap is when it goes the other way, with the economy operating well below its potential. That’s what we see in recessions.

Of course, all this involves numerous assumptions. GDP itself has problems, too, but it’s still a useful framework for analysis. Government and central bank policy should aim to keep the economy running roughly in line with its potential: not too hot, not too cold.

Larry Summers noted the Biden relief package will inject around $150 billion per month, while CBO says the monthly gap between actual and potential GDP is now around $50 billion, and will decline to $20 billion a month by year-end (because it assumes the COVID-19 virus and all its variants will be under control).

If correct, that would mean (at least to Summers and former Senator Phil Gramm, who wrote almost simultaneously a similar editorial for The Wall Street Journal) we are about to inject far more money than the economy can handle. It will have to emerge somewhere and may do so as price inflation. Here’s Summers:

"While there are enormous uncertainties, there is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the dollar and financial stability. This will be manageable if monetary and fiscal policy can be rapidly adjusted to address the problem.

"But given the commitments the Fed has made, administration officials’ dismissal of even the possibility of inflation, and the difficulties in mobilizing congressional support for tax increases or spending cuts, there is the risk of inflation expectations rising sharply. Stimulus measures of the magnitude contemplated are steps into the unknown. For credibility, they need to be accompanied by clear statements that the consequences will be monitored closely and, if necessary, there will be the capacity and will to adjust policy quickly."

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