Will excessive monetary and budget policy experimentation end in tears?
All economists agree that in the wake of the COVID-19 pandemic, the United States is engaged in a period of extraordinary monetary and budget policy experimentation. They also all agree that this experimentation is taking place at a time of a global “everything” equity price and credit market bubble of epic proportions.
Where there is legitimate room for disagreement is in how the current economic policy experiment ends. While the Biden administration believes that this experiment will usher in a period of prolonged and stable economic growth, an influential group of distinguished economists, including former Treasury Secretary Larry Summers and former International Monetary Fund (IMF) chief economist Olivier Blanchard, believes that it will result in an unwelcome inflationary burst and another leg down in the economy.
There is also the distinct possibility that inflationary fears will lead to higher interest rates that would burst today’s everything bubble. That, in turn, could lead to the sort of global financial market dislocation that followed the September 2008 Lehman bankruptcy and that produced the deflationary Great Recession.
One indication of today’s extraordinary economic policy experimentation is the very rapid rate at which the Federal Reserve is printing money. In the short span of nine months, Fed Chairman Jerome Powell has increased the Fed’s balance sheet size by a staggering $4 trillion through the Fed’s highly aggressive bond-buying activities. That, in turn, has led to a 30 percent increase in the broad money supply, which is by far the fastest rate of such growth in the past 60 years.
Another indication of policy experimentation has been the unprecedented amount of peace-time budget stimulus that the U.S. economy has been receiving. Following the December 2020 bipartisan $900 billion budget stimulus, the Biden administration is proposing another $1.9 trillion in budget stimulus. If enacted, the Biden package would result in total budget stimulus for 2021 of some 13 percent of GDP. That would be more than three times the size of the 2009 Obama fiscal stimulus.
Summers is now arguing that today’s large scale economic policy stimulus will inevitably lead to economic overheating and higher inflation by early next year. In making his case, Summers is highlighting that today’s policy stimulus far exceeds the degree to which current economic output is falling short of its potential. Whereas the nonpartisan Congressional Budget Office estimates that today’s U.S. so-called output gap is around $600 billion, or 3 percent of the economy’s size, the amount of monetary and budget stimulus the economy is receiving is running into the trillions of dollars.
A key point that inflation hawks overlook is that today’s U.S. economic policy experiment is occurring in the context of a global everything asset and credit market bubble. It is not simply that today’s U.S. equity valuations are at very lofty levels last seen on the eve of the 1929 stock-market crash. It is also that very risky borrowers, including highly leveraged U.S. companies and overly indebted emerging-market economies, have been able to raise massive amounts of money at interest rates not much higher than those at which the U.S. government can borrow.
Also overlooked is the fact that today’s global everything bubble is premised on the indefinite maintenance of ultra-low interest rates. But if the expectation of an overheated economy forces interest rates higher, there is the distinct risk that today’s equity and credit market bubbles could burst. That this is a real risk would seem to be underlined by the very rapid rise in the key U.S. 10-year Treasury bond rate, from less than 1 percent at the start of the year to around 1.5 percent at present, on the fear that excess policy stimulus could lead to economic overheating.
In 2008, the bursting of the U.S. housing and credit market bubble roiled world financial markets and brought on the Great Recession. Considering that today’s bubbles are more pervasive and larger than those in 2008, the Biden administration would be playing with fire in running policies that risk bursting today’s bubbles and ushering in a new deflationary period.
There is good reason to fear that today’s excessive U.S. monetary and budget policy experimentation will end in tears. But the jury is still out as to whether it ends in a sustained bout of higher inflation or in a considerable degree of financial market dislocation.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.