A few weeks ago, the federal government enacted a $1.9 trillion stimulus bill, and another $3 trillion bill is already in the works. These once-unthinkable spending levels exceed what was spent on World War II. Yet the Biden administration’s new mantra is that the real risk lies in spending too little, citing a revisionist history of the 2008-09 recession that argues that the recovery dragged on because the stimulus was too small and too short. This position ignores the data, along with several risks: higher inflation, of course, but also destabilized financial markets and reduced growth.
The economics profession is divided on how effective fiscal policy can be in generating growth. Some consensus exists that well-targeted spending can be helpful in the right circumstances—and certainly many Americans and small businesses have suffered from the pandemic and need relief. But these bills are not well targeted to help them. Even the infrastructure bill, which in theory could grow the economy with smart investments, appears to be driven by politics, not economics. Nor is it clear why spending of this magnitude is needed, or how it will be paid for (save for tax hikes on high earners and corporations, which won’t put a dent in the debt). This time on the money-go-round also feels different, because many mainstream economists of all political persuasions are nervous. Larry Summers, normally a fan of big spending, worries about inflation or even stagflation.
Inflation is indeed a risk when the government hopes to stimulate an economy already poised to grow on its own. We’re putting money into the pockets of almost every American, from the additional $1,400 checks and the new child tax credit to potentially massive government projects. Meantime, many households saved their money last year and have considerable pent-up demand. The result could be lots of spending without a meaningful increase in output, resulting in inflation. Some economists also believe that the presence of large unfunded debt is enough to increase inflation.
Though runaway inflation may be unlikely, higher inflation remains a risk. Even at more moderate levels, inflation, when less predictable, imposes costs. The stability of inflation provides as much value as does its level. Predictable inflation helps people plan, invest, make contracts, and live on retirement income. Some members of the Biden administration admit that inflation is a (remote) risk but point out that the Fed can always lower it if it wants to.
That raises the question: who will buy all this new debt? Over the past year, the Fed was the biggest buyer, absorbing more than half of new government debt. If the Fed needs to start clamping down on inflation, it will have to start selling bonds instead of buying them, and it will be doing so in a market already awash with U.S. Treasury bonds. The risk here is that the Fed won’t be able to rein in inflation with small interest-rate hikes and won’t have the political will to cause a recession with a big hike. If inflation isn’t controlled, the Fed’s credibility could be undermined, giving it less space to run the economy hot in the future when it wants to.
The bigger risk may be the turmoil in bond markets that all this big spending could trigger. The odds are that most of the borrowing for these bills will be short-term debt. Without the Fed buying bonds, there is a risk of dislocations in the fixed-income market, causing higher and more unpredictable interest rates. If rates continue to rise, debt payments will become an even larger part of the federal budget and potentially require cutting spending—or, more likely, sharp tax increases. High interest rates will also crowd out other forms of investment in the private sector and depress stock prices, causing a rude awakening for retirement savers, who have become accustomed to watching their portfolio values continually rise.
Potentially even more worrying than interest-rate levels are their volatility and unpredictability. In the past, unforeseen spikes in bond yields have resulted in financial crises that destroyed growth. Bond prices touch everything, from asset valuations to how much investors are charged for credit. This is not a market you want to take chances with.
It’s possible that everything will work out. A likely economic boom this year will paper over many fiscal sins. And if we see a big productivity boost from the new technology we’ve been adopting, the U.S. could get enough real growth over the next few years to outrun all these risks. Still, it is a big gamble.