US stimulus debate highlights the global risks of diverging fiscal policy paths - Capital Economics
The Chief Economist’s Note

US stimulus debate highlights the global risks of diverging fiscal policy paths

The past week has seen Joe Biden’s fiscal strategy come under fire from the most unlikely of places: it has caused a high-profile rift between Democrat-aligned US economists, setting the stage for a wider debate about the role of government in the post-pandemic recovery.  

There are several strands to the argument, but the core of the issue is the sheer size of the $1.9trn (10% of GDP) stimulus package that has been proposed by the Biden administration and which looks increasingly likely to be passed by Congress. A group of what would ordinarily be termed “fiscal doves”, led by Larry Summers, who had senior roles in both the Clinton and Obama administrations, has warned that stimulus on this scale risks causing the economy to overheat and inflation to take off. This has prompted a response by another group of doves, led by Paul Krugman, who argue that these risks are low and that the bigger costs lie in doing too little to support the economy. (A discussion between the two economists is available here.)

Our Chief US economist, Paul Ashworth, will weigh into the debate in a Focus to be published this week (contact us if you would like access). A key point is that while the distortions caused by the pandemic make it difficult to judge how much stimulus is appropriate, the answer is almost certainly likely to be less than 10% of GDP. At the same time, the stimulus comes at a time when there was already a growing list of factors pointing towards a period of higher inflation over the medium-term. We don’t expect US inflation to explode and warnings about a return to 1970s-style inflation are overdone. But we do expect it to run at moderately higher rates of 2-3% on the CPI measure over the course of this decade.  

There are three broader points worth making:  

First, this is a good example of how data distortions caused by the pandemic have muddied the policy debate. The usual approach to assessing how much stimulus is “too much” would be to compare the size of the program to the size of the output gap. But the output gap becomes a meaningless concept when shortfalls in GDP are caused by restrictions needed to control the virus, rather than an underlying weakness of aggregate demand. Without the usual analytical tools at our disposal, the economic policy debate becomes unmoored.  

Second, while the size of the Biden plan and the likelihood that it triggers an upsurge in inflation has provoked debate, there remains widespread agreement that a rise in inflation itself would be a concern. It is certainly true that at some point inflation becomes a problem: rapid price increases distort savings and investment decisions, and weigh on economic growth. But this point is unlikely to come at moderately higher inflation rates of, say, 3-4%. As we’ve noted before, governments and central banks may well end up concluding that a slightly faster rate of inflation is a price worth paying to achieve other policy goals. Accordingly, any evidence that fiscal stimulus is fuelling price pressures may not provoke the aggressive monetary response that many seem to expect. And in a world of flatter Phillips Curves, the bigger risk may be that ultra-loose monetary and fiscal policies inflate asset price bubbles rather than push up consumer prices. 

Finally, while economists and policymakers in the US are wrangling about how much additional stimulus is required, no such debate is playing out in other advanced economies. In the euro-zone, there is broad agreement among governments about the need to keep national fiscal support programmes in place until the virus is quashed and restrictions on activity can be lifted, notably through continuing with the short-time working schemes. But there is no debate about, and little prospect of, additional stimulus. In fact, Germany has already reduced its support by reversing the temporary VAT hike it implemented last year. Meanwhile, at the EU level, the disbursement of funds under the Next Generation EU plan has not yet begun and is expected to be spread over six years, ending in 2026: this is long-term investment rather than short-term fiscal stimulus and will have much less impact on GDP growth this year or next.  

The difference with the UK is potentially even more stark. Here, far from providing additional support, the debate has started to shift towards the need for tax increases to repair the damage to the public finances caused by the pandemic. Chancellor Rishi Sunak appears (rightly) to have backed away from announcing these as soon as next month’s Budget, but he may still use his statement to prepare the ground for tax hikes later this year or in 2022. 

Despite the lack of formal co-ordination through groups such as the G20, the fiscal response of governments to the pandemic has until now been broadly similar. However, developments over the past couple of weeks suggest that fiscal trajectories are now likely to diverge. This risks causing the global recovery to become unbalanced, which in turn could make it both weaker and more vulnerable to new shocks than would otherwise be the case. 

As we move toward the end of this global crisis, we should be mindful of the spillover effects of overstimulating economies, just as we should of those associated with withdrawing support prematurely. This is why the debate about the size of Joe Biden’s fiscal package isn’t just an argument for US politicians and policy wonks.

In case you missed it:

  • We have revamped our COVID recovery monitor and made key charts available to download in a dashboard on CE Interactive.
  • Despite talk of a new “super-cycle”, Oliver Allen argues that returns from commodities are likely to lag behind US equities in the coming years.
  • Finally, we’re holding our latest Global State of Play webinar this Thursday. Our senior team will discuss everything from the virus and vaccines to the outlook for growth, inflation and policy in the world’s major economies. Sign up here.