President Joe Biden’s top legislative priority goes by two names: “COVID relief” and “stimulus.” The two terms help reporters and politicians avoid repetition, but they also point to the two main purposes the bill is supposed to serve.
It would, among other things, send $1,400 checks to most households. That can be defended as relief: It helps people who have been harmed by the economic fallout of the pandemic. It can also be defended as a stimulus: Recipients will spend some of the money, and their purchases will boost the economy.
Critics of the bill as a form of stimulus mostly say it would be too stimulative. The economy, they say, won’t need federal help as more and more of us get vaccinated, and a big stimulus bill will leave the nation with too much debt and too much inflation.
I don’t share the worry about inflation. Market indicators of expected inflation, adjusted for some measurement issues, currently suggest that it is going to run well below the Federal Reserve’s 2% target during the next five years.
My concern about spending federal money for the purpose of stimulus is different: I think it’s unlikely to have much stimulative effect. It will increase the federal debt without leaving the economy appreciably bigger than it would have been without the bill.
The case for fiscal stimulus relies heavily on models suggesting that when an economy is operating below its potential, government spending can close the gap. The models also suggest that too much spending can cause the economy to “overheat.”
Much of the debate has concerned how far we are from reaching the economy’s full potential, and which of these results is therefore more likely. But the models don’t take adequate account of how fiscal and monetary policy interact.
Consider one scenario: Congress, moved by Biden’s warning that previous stimulus measures have been too small, expands the bill from its current $1.9 trillion to $3 trillion and passes it. Expected annual inflation jumps, for the first time in decades, above 3%.
The cries that the Fed must act to stop overheating get louder. The Fed, which wanted inflation to rise but not this rapidly, responds by raising interest rates faster than it would have done without the huge stimulus bill and the spike in inflation expectations. Those expectations then drop back down.
In that case, the Fed would have undone at least a significant fraction of the stimulative effect of the bill. It would have counteracted the stimulus not out of a deliberate aim to subvert it, but out of a desire to keep inflation under control. If it overreacted, the Fed could more than completely counteract the stimulative effect of the bill: It could throw the economy into a recession it would not otherwise have entered.
Or consider another scenario: Congress passes a large stimulus bill, but expected inflation doesn’t rise much, because markets assume that the Fed would act to keep it in check. Household and business decisions about consumption and investment reflect the expectation that the economy isn’t going to get much hotter. Total spending levels don’t rise much, that is, in response to the bill.
In this case, too, the stimulative effect would be weak. The composition of the economy might be significantly affected: By spending money on certain things, Congress can direct resources toward some sectors of the economy and away from others. If Congress decided to spend all the money in North Dakota, the state would have a boom at the expense of other places. Federal debt projections would look more ominous. But the economy wouldn’t have expanded much overall.
Several conclusions follow from these thought experiments.
First, any stimulative effect of increased federal spending depends on how the central bank reacts to changing economic conditions and how businesses and households expect it to react.
Second, because of this, fiscal stimulus will have a smaller positive effect — possibly one quite a bit smaller, and possibly even a negative one.
Third, increased expectations for inflation and for total levels of spending in the economy would expand the economy even if accomplished through means other than a stimulus bill.
Taken together, these points don’t obliterate the case for the legislation before Congress. Spending money to speed the pace of vaccination will likely help the economy, just not via the route of putting dollars in people’s pockets.
But if fiscal stimulus leads to a significant degree of monetary offset, it shrinks the case for that legislation — and suggests that the legislation itself should shrink, too.
Ramesh Ponnuru is a Bloomberg Opinion columnist. He is a senior editor at National Review, visiting fellow at the American Enterprise Institute and contributor to CBS News.