How Much Money Should the Government Spend?

On October 6 at a meeting with the National Association for Business Economics, Federal Reserve Chair Jerome Powell said the risks of government overspending to pull the economy out of recession were small. Powell has spoken out about fiscal policy perhaps more than any other Fed Chair before him. Then again, the situation calls for unprecedented action.

The Coronavirus Pandemic has devastated the American economy in ways not seen since The Great Depression. The unemployment rate reached a staggering 13 percent in May. 30 million people are at risk for eviction. Job additions since September are already failing to meet expectations and the CARES Act funding is running dry.

Amid this uncertainty, the Federal Government has failed to offer relief.

Fundamentally, Republicans and Democrats disagree about government spending. While Democrats in the House proposed a 2.2 trillion dollar stimulus, Senate Republicans unveiled their own "skinny" 500 billion dollar plan. The gulf between the bills demonstrates a difference in philosophy between the parties.

Jerome Powell is saying, at the moment, government debt is not a problem. Is he right? If so, why are so many politicians wary of spending more money?

What the Fed Did

The Federal Reserve took unprecedented steps to support national--and international--markets with aggressive portfolio and liquidity expansion. The Fed backstopped a broader range of markets than it did in 2008. In doing so, it solidified its role as the lender of last resort in the US and in the global financial system. 

The Federal Reserve has kept the Federal Funds Rate down, effectively setting the national interest rate at zero. With a zero interest rate, debt is cheap and people are more likely to spend than to save. This is meant to spur economic growth. It also opens fiscal space for the federal government.

When interest rates are low, the US Treasury can cheaply auction treasury bonds. Hence, private entities benefit by receiving safe, appreciating assets (bonds) and the Treasury gets cash to spend.

Powell has said the Fed plans to keep the interest rate near-zero for the foreseeable future. Therefore, government debt is less problematic. The only thing that could cause the Fed to raise rates again, is inflation.

Inflation

Inflation is an economist's greatest fear. It reduces buying power and makes debt difficult to service. When inflation picks up, the Fed raises interest rates to incentivize savings. When people save, they spend less and thus demand decreases and prices fall-- countering inflation.

Politicians are often afraid of government spending for its inflationary effects. When inflation picks up, the Fed raises rates and government debt (generally, the interest paid to government-bond holders) becomes difficult to pay back. 

While some Republicans oppose deficits on principle, many resist deficit spending because of inflation. Higher inflation means higher interest which means more debt and bigger debt payments.

For these Republicans the question becomes: are they right to fear inflation from deficit spending at this moment? A corollary: how should the government manage the amount of debt it already has?

Is Inflation the Problem?

Since the stagflation of the 1970's, economists and politicians have been wary of inflationary upticks. As a result, the Federal Reserve has kept inflation on a tight leash by maintaining unemployment near or slightly above five percent. This level of unemployment is commonly known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU). The NAIRU is the level at which employment begins to accelerate inflation, and the Fed must raise rates in response. 

One problem with government spending--according to those who use the NAIRU as their metric for inflation--is that it stimulates the economy and can lower unemployment. As the economy heats up, and fewer people are unemployed, more money is spent. More people who are newly employed are now also spending, which bids up the prices of goods and services. This cycle creates inflation and in turn, all the aforementioned issues with debt service and decreased buying-power.

Here's the catch: this is all theoretical. What's more, the theory does not acknowledge external influences which might alter outcomes.

You might not be surprised, then, to hear 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, in the following months, the inflation rate did briefly get above two percent, but the year-long average was only one point eight percent.

All of this to say: inflation did not explode at a historically low level of unemployment as theory would predict. Nor, did historic levels of government debt create inflationary effects-- even when the economy was doing exceptionally well. There are exogenous effects on the American inflation rate which seem to be depressing it. 

Why is US Inflation Depressed?

Economist David Beckworth has a piece on this which is more detailed. You can read it here. For the purposes of this discussion I will summarize his three explanations. You can read the original to ensure I do not misrepresent him.

Beckworth's first explanation of low-inflation is that people are hesitant to spend. Americans have experienced two massive recessions in two decades. Thus, people are more likely to save their money for fear of future downturns. More money saved is less money spent bidding up prices. The Fed has already lowered interest rates significantly, and people are still saving. This means low levels of inflation until people's fears are assuaged. 

His second point is that the Fed has branched into many other countries. By opening dollar-swap lines abroad, the Fed enshrined international demand for dollars in the long-run. Greater supply for demand shocks abroad means a more stable, less inflationary currency.

Last, as I mentioned earlier, the Fed backstopped the US financial system after the initial shock from the coronavirus. This instilled confidence in international holders of dollar-denominated assets. Confidence means demand and demand means the US can spend without overwhelming dollar holders with too many dollars. Hence, dollar dominance abroad means lower inflation at home.

Beckworth's central argument is that inflation should not stop the federal government from spending money to pull the economy out of the pandemic recession. This echoes Fed Chair Powell's call for more stimulus.

Perhaps this helps explain why the federal government should not be afraid to expand the deficit for stimulus. Hence, those politicians who fear inflationary spikes from stimulus need only see that inflationary shocks will be deadened by predominating deflationary pressures both in the US and abroad.

There are Still Risks

While current fears of inflation may be overblown, fears of long-term debt expansion are not. The US is on track to rack up as much debt as it had during the second World War. That is extreme, and it challenges contemporary models of long-term sustainability.

To better understand this issue, I interviewed Associate Director of the Master’s in International Economics and Finance at Johns Hopkins School of Advanced International Studies (SAIS), Dr. Jason Fichtner. Dr. Fichtner has written prolifically on issues of fiscal policy and debt-sustainability. He explained to me that his greatest concern is excessive debt in the long run will force the government to make hard choices about what 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 higher long-term debt means the government will need to make sacrifices on its aspirations-- and some of its obligations. Massive debt loads, coupled with higher interest rates from an expanding economy, means politicians will have to abandon universal healthcare policy, a green energy transition, and infrastructure investment. "The math no longer works", he said.

Dr. Fichtner is also a fellow at the Bipartisan Policy Center. A few years ago, when the Center did its regular debt-management exercise they "were able to get to 60% debt-to-GDP sustainability." Two years ago,  they were "pushing to get 80. And 80 percent was making people uncomfortable." He continued, "back then, that was 20 trillion dollars in debt, now we're at 27 or 28. The next time we do the exercise it may even be 30. I don't know what debt sustainability looks like anymore."

So what can the US do? While spending will likely not lead to immediate inflation, the implications after interest rates start to increase are concerning.

Dr. Fichtner's response: make fiscal stimulus "timely, targeted, and temporary." Expand Unemployment Insurance so that people who lose their jobs are protected. Ensure also that the Paycheck Protection program is robust and targeted toward those businesses which need it.

Synthesis

Ultimately, the US must help its citizens. The federal government cannot abstain from stimulus for fear of inflation. Rather, the government must spend effectively to help people in a targeted way. Without stimulus, millions of Americans will be left to languish in a depressed market. With too much stimulus, however, we may spend our way into a crisis.

The middle path is this: spend enough to ensure that people are taken care of. 

Many people have lost their jobs through no fault of their own. In order to prevent a vicious cycle of recessionary pressures, the government has to invest in the economy to raise aggregate demand. How the government does this is important. It is the difference between an effective recovery and a long-term debt crisis.

Regardless, people need help. The federal government is the only institution which can offer this help. If Congress cannot reach an agreement soon, millions of people's livelihoods will be lost. And the American economy may not recover.