The Next Round of Fiscal Stimulus (US)
As the debate continues in Washington DC about the pending $1.9 trillion fiscal stimulus plan put forth by President Biden and supported by Democrats in Congress, I thought it would be interesting to briefly discuss the reasons why the size and composition of this mega-stimulus package has proven so controversial. Harvard professor Lawrence Summers, who served in the Clinton and Obama administrations, summed up his concerns about the proposed package in a recent op-ed in The Washington Post, which you can find here. The Economist presented its concerns, which are similar, in its February 6th edition in an article that you can find here: “Why Joe Biden’s proposed stimulus is too big”. Both publications make the case that the proposed stimulus plan is larger than what is needed and is not sufficiently targeted. Mr Summers went on to add that the size of the proposed stimulus package and the likelihood that it will be pushed through the Senate using the reconciliation process could very well crimp the administration’s ability to pass a much-needed public investment plan later this year, including investment in infrastructure.
President Biden and Treasury Secretary Yellen have a different view on the proposed package, which has been named the American Rescue Plan Act of 2021. Their perspective is that it is better to do something sooner rather than later, even if it is too large and / or has some elements that are not perfectly targeted. How does the Fed feel? During his grilling before the Senate Banking Committee earlier this week, Fed Chairman Powell kept his cards close to his chest as far as commenting on the size and composition of the proposed fiscal stimulus plan. However, Mr Powell emphasised that the US employment situation remains dire, probably even worse than the headline unemployment figure indicates, and that he remains committed to the twin targets of lowering unemployment to pre-pandemic levels and achieving an average inflation rate of 2%. I think he was less emphatic about fiscal stimulus than in the past, although his comments on the weak state of the economy led me to believe that additional fiscal stimulus of some magnitude is needed to more quickly return the US economy to full employment.
In this article, I will address some of the more interesting attributes of the proposed $1.9 trillion fiscal stimulus package, known as the American Rescue Plan of 2021, and the likely timing and economic effect of the stimulus package should it be approved.
How much is $1.9 trillion anyway?
In short, $1.9 trillion is a lot of money! Perhaps the best way to try to understand it is to look at the amount in the context of the annual budget of the US, US GDP, and aggregate federal debt.
The US federal budget in 2019-20 (appropriations year runs from October 1st to September 30th each year) called for $4.5 trillion in expenditures and $3.6 trillion in revenues, resulting in the largest-ever projected budget deficit of $900 billion. This budget was of course developed and passed before the pandemic appeared, and the actual deficit ended up being more than three times larger than what was expected because of the pandemic. The proposed $1.9 trillion Biden stimulus plan is 42% of the amount budgeted for outlays (of $4.5 trillion) in the 2019-20 budget. If the $2.3 trillion CARES Act (March 2020) and the $900 billion COVID-19 Relief Bill (December 2020) are included alongside the full amount of the proposed Biden stimulus plan, the total of $5.1 trillion of stimulus is well in excess of total outlays in the US for an entire year!
If you consider the total amount of the three stimulus measures in the context of US GDP, $5.1 trillion is nearly 25% of US GDP ($20.9 trillion) for the year ended December 31, 2020 (source: Bureau of Economic Analysis).
The US will have spent by far more than any other country in the world on fiscal stimulus, as you can see in the graph on the right from Moody’s Analytics (source: “The Biden Fiscal Rescue Package: Light on the Horizon”). Of course, these stimulus packages have been very helpful in mitigating the decline in GDP, as the biggest spenders – the US and Japan for example –
have suffered less severe declines in GDP than other countries that have spent less, including most of Europe.
As far as the national debt, the US ended the budget year 2019 (September 2020) with $26.9 trillion of gross national debt and $21 trillion of debt held by the public (so excluding debt held by agencies), with the latter being about 100% of GDP. The CARES Act was included in this amount. For this budget year, the CBO is projecting gross debt and publicly-held debt of $28.5 trillion and $22.5 trillion at the end of the budget year (September 30th 2021), respectively, although I do not think this includes the COVID-19 Relief Bill and certainly not the proposed $1.9 trillion stimulus package that is working its way through Congress. Keep in mind though that the stimulus, regardless of the final size and construct, will undoubtedly juice GDP. In fact, Moody’s Analytics expects the $1.9 trillion Biden stimulus plan to push real GDP in the US to 8% in 2021 and 4% in 2022, adding 10 million new jobs over this period. The GDP growth rate for 2021 is expected to be nearly double that compared to a “no stimulus” scenario.
What does the proposed $1.9 trillion stimulus package look like?
Different articles I have reviewed break down the components of the $1.9 trillion Biden fiscal stimulus package in different ways. The most significant areas to which stimulus would flow – additional one-off stimulus checks, unemployment pay top-off, and assistance to state and local governments – comprise close to two-thirds of the plan. I thought the best breakdown was provided by Moody’s Analytics in their January 15th 2021 piece (here, worth reviewing), and I have extracted the table below which provides the various categories and the periods over which the money would expected to be spent.
Republicans responded initially on January 31 with a much smaller $600 billion plan, saying that they are concerned about both the absolute size of the package (and its effect on deficits and future indebtedness), and the components of the plan which they deem poorly targeted. The major differences between the Republican counter-proposal and the Biden plan are i) the amount of direct stimulus checks, the income thresholds for receiving these checks, and the income levels for scaling the amounts down; ii) the length of time to pay enhanced unemployment benefits (Republicans want these benefits to end in June, not September as per the Biden plan); and iii) state and local aid, which Republicans view as un-needed because the two fiscal stimulus plans already approved have kept state and local funding programmes relatively safe. On the last point, the Republicans view the inclusion of state and local government funding as a disproportionate tilt towards Democratic states, showing their clearly partisan preference in this matter.
What is the process for approving the plan, and when it is likely to be approved?
Perhaps you remember that a subsequent round of fiscal stimulus following the CARES Act began to be discussed by Congress and the Trump Administration last summer, but nothing was approved until the end of the year, six or seven months later. So how can this $1.9 trillion plan possibly be approved, as President Biden has promised, by mid-March, relevant because the provisions of the COVID-19 Relief Plan begin to expire then?
When the formal approval process for the bill started in early February, both the House and Senate voted to proceed along party lines, meaning the Democrats – with majorities in both the House and Senate – had enough votes to start the formal process for considering the stimulus package. However, once the details of the package are finalised and the bill returns to the Senate for final approval, it would require super-majority approval, meaning 60 out of 100 affirmative votes in the Senate would be needed to pass the bill into law. This would be highly unlikely, at least based on the current construct of the package, simply because it would require 10 Republicans Senators to break ranks with their party and side with the Democrats. Since the package is unlikely to be approved through usual channels, both Leader of the House Nancy Pelosi and Senate Majority Leader Chuck Schumer have made it clear that they will rely on a budgetary process known as reconciliation to get the package through the Senate. Reconciliation is a process put in place under the Congressional Budget Act of 1974, which applies to spending, taxes and federal debt limits, and eliminates filibusters. Reconciliation has been used before, perhaps most recently when Congress approved the Trump-sponsored tax reform bill in 2017, so it is not at all unconventional. Rather than go into the detail in this article, suffice it to say that the reconciliation process only applies to certain budgetary items and can be used infrequently, but would likely work for most provisions of the Biden stimulus package.
I would be remiss if I were not to say the President Biden and the Democrats would like to reach consensus on a package with the Republicans on a bipartisan package, but the gulf seems so wide at this point and the time pressure so great that I doubt we will see such a resolution.
What will this and other federally-mandated fiscal plans mean for the US budget (and cost of borrowing)?
As you can gather from earlier comments, the decrease in GDP caused by the pandemic and the increase in national debt caused by two - and about to be three - sizeable fiscal stimulus plans, has increased the often-monitored fiscal debt-to-GDP ratio to record levels. The US already has the largest amount of debt of any country in the world, although it does not have the highest debt-to-GDP. Japan’s gross debt-to-GDP for example was 225% in December 2020, while US gross debt-to-GDP stood at 133% as of the end of December 2020 (based on $27.25 trillion of gross debt and 2020 nominal GDP of $20.9 trillion). The US deficit was already deteriorating quickly under President Trump well before the pandemic struck, caused by – amongst other things – Mr Trump’s Tax Cuts & Jobs Acts of 2017. In spite of promises to the contrary, the Trump tax plan came nowhere near to paying for itself. National debt increased from $18.2 billion in 2015 – the last year of the Obama administration – to $22.7 billion at the end of 2019 (pre-pandemic). The graph below from the CBO shows US net debt (excluding interagency)-to-GDP since 1940, illustrating that we are quickly approaching post-WWII highs.
In spite of what would be considered troubling levels of debt in many countries, it is important to remember that the US remains in the most advantageous of all positions because the US Dollar is the world’s reserve currency and US Treasuries – the lifeline of funding the US government – remain the ultimate risk-free asset. Therefore, there has always been strong demand for both US Dollars and US Treasuries globally in spite of variations in the US business cycle. The simple fact is that the US fiscal situation has not ever affected the ability of the US to issue debt to finance its huge deficits and refinance existing debt, an amazing advantage vis-a-vis every other country in the world. This is one reason why the projected deficit in 2021, which is likely to push gross debt-to-GDP close to 130%, doesn’t seem to concern most politicians, economists, and perhaps – most importantly – investors at the moment. Another reason that the rapid increase in US debt seems less concerning to the Administration, Congress and many economists was articulated perfectly by Treasury Secretary Janet Yellen during her interview with Andrew Ross Sorkin on Monday on DealBook DC (interview here, 30 minutes). Treasury Secretary Yellen emphasised that debt servicing costs are much more important than the absolute amount of debt, and by extension, the debt-to-GDP ratio. In other words, it is most important to focus on the amount of the annual budget revenues that must be diverted each year to service the country’s massive (and growing) stock of debt. I extracted the data below from the CBO, to highlight the debt servicing costs of the US going forward.
As the table illustrates, interest expense is expected to increase to over 30% of the sum of discretionary expenses plus interest expense by 2031, reflecting the combination of ever-growing national debt as deficits increase each year, and higher blended costs of borrowing as interest rates increase to more historically normal levels.
Is the Biden tax plan potentially inflationary, and if so, why?
The concerns about the stimulus plan – and prior fiscal stimulus packages – being inflationary are difficult to separate from the huge amount of monetary stimulus being provided simultaneously in the form of the Federal Reserve’s quantitative easing programme and the fact that the central bank is anchoring the Federal Funds rate near 0%. Still, $1.9 trillion more stimulus absolutely matters even though politicians and economists will never be able to completely agree on exactly what portion of the plan is rescue support from the pandemic and what portion is actual stimulus. Most economists tend to evaluate the potential inflationary effects of monetary and fiscal stimulus by looking at the difference between the potential GDP growth in an economy and the actual GDP growth. This concept is not about business cycles but rather about long-term trends. Again, I do not want to drill down too much into this topic because it is complex, but I would like to make sure that the basics are clear. When the GDP output gap is negative (meaning actual GDP is below potential GDP), an economy is operating below full capacity and is likely suffering from high unemployment. Conversely, when an economy’s actual GDP is higher than the potential GDP, the economy is running hot and inflationary pressures will almost certainly arise.
I will discuss two graphs from FRED Economic Data, both illustrating actual GDP versus potential GDP in the US but over different periods. The first graph covers the period since the beginning of this century.
As this graph illustrates, US GDP slumped at the time of the dot.com bust in 2000-01 and then took until 2004 to return to its natural level of output. The US economy then operated near potential until the advent of the Great Recession in late 2007. This severe recession caused US GDP to plummet and the output gap to balloon, reaching $900 billion at its widest point in 2Q2009, before slowly beginning to recover. One of the criticisms of economists and politicians alike during this period is that the US government – first the Bush administration followed by the Obama administration – did not do enough at the time as far as size and scope of fiscal stimulus to more quickly return the economy to its long-term full employment growth trajectory. The cornerstone legislation which was passed to help the US economy recover from the Great Recession was a $840 billion package put together by the Obama Administration and signed into law in February 2009: the American Recovery and Reinvestment Act. Whilst this was certainly helpful, it can in retrospect be deemed largely insufficient because it was not until 4Q2017 that actual GDP in the US finally reached potential GDP. This is a lesson learnt and not one that the Biden administration or Congress wish to repeat.
The second graph from FRED zeroes in on a shorter and more recent period starting January 1, 2019. Until the pandemic struck, the US economy was running slightly above its potential, although not dangerously so. However, 1Q20 was affected by the onset of the pandemic late in the quarter, while 2Q20 was severely affected – as were most global economies – by governments shuddering large parts of their economies, creating a massive shortfall in the US between actual output ($17.3 trillion) and potential output ($19.2 trillion). In fact, the output gap of almost $2 trillion at its widest was more than double the worst quarter during the Great Recession. The US economy snapped back quickly in 2Q20 as the economy gradually reopened and the effects of the CARES Act kicked in, but then the growth rate of the US economy slowed in the second half of 2020 as the second wave of the pandemic set in. As of 4Q2020 the output gap is still slightly north of $600 billion.
An article in the Financial Times (“Joe Biden’s huge bet: the economic consequences of ‘acting big’”) relied on projections from the BEA and Morgan Stanley to illustrate the potential effects of the $1.9 trillion stimulus plan on US GDP. I extracted the graph below, which shows that the Biden stimulus package could in fact return the US economy to its natural rate of growth by the middle of this year.
It is the possible expansion of the US economy so rapidly following a third round of stimulus that is quickly raising concerns about inflation. Of course, this is a theoretical discussion, but my view is that if US GDP grows 8% this year and 4% in 2022, inflation will absolutely surface because this is unprecedented growth for the US economy since I can remember. The focus will then turn to how the Federal Reserve reacts to manages inflation, which I will discuss more below. Even so, it is important to keep in mind that the lethargic recovery of the US economy following the Great Recession was deemed in retrospect to be too slow, and this largely set the stage for where we are today.
Having said this, the reality is that the US economy continues to be plagued by unemployment that is higher than it was before the pandemic struck (6.3% in January 2021, vs 3.5% in February 2020, only 11 months ago and pre-pandemic), and capacity utilisation that is lower than it was before (capacity utilisation index at 75.6 in January 2020 vs 76.9 in February 2021 although it peaked above 80 in 4Q2018). Fortunately, the economy has improved and employment has increased since the national lockdown ended in mid-2Q2020, in spite of the pandemic raging and in fact worsening towards the end of the autumn and beginning of the winter. This fast recovery so far, in spite of the dire backdrop, is mostly attributable to the enormous amount of unconventional monetary and fiscal stimulus that has been unleashed as a response to COVID-19. There is issue often debated about how much of the stimulus has really been spent for people just to survive, and how much has instead found its way into savings and real assets like equities and real estate, simply because – if for no other reason – people can’t spend on services like restaurants, going to cinemas, travelling, gambling, etc. whilst large portions of the service economy remain closed or under severe stress. The excess savings sitting on the side lines ready to be spent as the service economy reopens, plus another $1.9 trillion of stimulus to be dumped into the US economy, are both seen as quickly undoing the damage from the pandemic and pushing the economy not only to its full potential, but potentially well above, eventually unleashing inflationary pressures as demand outstrips supply. Couple this with super-accommodative monetary policy that will continue “indefinitely”, and the recipe for inflation most certainly exists.
Even though inflationary concerns are increasing, the Fed continues to reiterate that it is willing to “let the economy run hot” by accepting inflation well above the target rate of 2% (say in the high 2% area), so long as the long-term average stays around 2%. The Fed has adopted this policy reflecting its objective of reducing unemployment to pre-pandemic levels as its major priority. The risk that will come into play later will be how the Fed manages the gradual unwind of stimulus, including the tapering of bond purchases pursuant to its QE program and gradually raising short term interest rates without causing the economy to tank. There are lessons on how this should (or should not) be managed in the decade following the Great Recession, but this is not a topic for this article.
Conclusion The pending $1.9 trillion fiscal stimulus plan which is likely to be signed into law by mid-March will provide the slowly recovering, pandemic-ravaged US economy with a jolt of momentum, but at what cost? This is hard to tell at the moment, although the combination of three fiscal stimulus packages totalling around $5.1 trillion will have short-term effects (further promotion of asset bubbles), intermediate term effects (upward pressure on prices i.e. inflation), and long-term effects (growing deficits and US debt). Importantly, another short-term negative is that assuming President Biden supports the Congressional process of reconciliation to get the budget approved - necessary because Republicans favour something smaller and more targeted – I believe that this removes the “reconciliation weapon” for use in designing and approving a much-needed infrastructure plan in the US later this year, something very different from the stimulus packages that have been approved so far since they involve investment in the real economy. In spite of this, nearly all politicians and economists agree that a third stimulus plan is needed to assist the economic recovery in the coming months, waiting on the pandemic to slowly fade through a combination of vaccinations, people being more careful, and warmer weather. The slow recovery following the Great Recession is not the timing trajectory that anyone wants.