$1.9tn is too much stimulus and it eclipses the economic benefit

The US entered the pandemic with a federal budget that was on an unsustainable trajectory, with spending outstripping revenues as far as the eye could see. It will exit the pandemic with the highest level of debt, even relative to gross domestic product, in the nation’s history, and an even more dire trajectory. Yet the Biden administration claims the economy requires another $1.9tn in federal spending.

This proposal raises two questions. First, has the pandemic-related spending so far been justified?
Second, does the economy need another massive fiscal injection and, if so, what is the right amount and how do we pay for it?

Certainly, a tremendous amount of spending was necessary to support the economy over the past year. Between the fourth quarter of 2019 and the second quarter of 2020, GDP — roughly the value of production and income in the US — fell by $2.2tn. Congress responded with the Coronavirus Aid, Relief, and Economic Security Act, which added $2tn to the deficit. A 10% of GDP problem merited a near 10% of GDP response.

But additional deficits only make sense if they are targeted at the problem. Unlike past recessions, the problem is not a massive loss of wealth, as in the financial crisis that spawned the recession of 2007-09. Nor is it an aggregate decline in income, as that rose in 2020. The problem is that household spending on services, particularly that of more affluent households, collapsed because going out risked infection and transmission of the virus. So, it makes sense that the president’s request of another $1.9tn contains roughly $400bn for vaccines, distribution, testing and contact tracing. Eradicating the coronavirus is the top economic priority.

The remaining $1.5tn is being advertised as stimulus that will boost the pace of the recovery. Recall that the theory of stimulus is that when the economy is below full employment, government stimulus — tax cuts, cheques, spending — will boost spending. This will, in turn, stimulate business activity, which will begin a cycle of additional income to workers, more spending and more hiring. Because of this virtuous cycle, $1 of stimulus is expected to have (much) more than a $1 effect — the multiplier effect. That is the theory — it just has nothing to do with the current policy debate. There will be no stimulus as long as the virus stops households from spending freely. Further, the $1.9tn size of the package eclipses the economic need. Real GDP is below potential GDP, with the difference being the output gap.

According to estimates by the Congressional Budget Office (CBO), the output gap is slightly above $650bn, thus the administration and congressional Democrats claim a stimulus of more than  twice the size of the output gap is needed to get the economy back to its pre-pandemic shape. Don’t forget that Congress in December already passed an additional $900bn in Covid-19 relief spending.

Based on any reasonable economic theory of stimulus, $1.9tn is far too large. In analysing the effect of the Cares Act, the CBO found that a $1 change in cheques, unemployment insurance and state local aid had cumulative multiplier effects ranging from 0.38 to 2.5, with the low end reflecting little progress in defeating the virus. So the $1.9tn request for Covid-19 funding only makes sense if the vaccine programme is expected to fail. Otherwise, it is far too large to be consistent with the administration’s stated thinking.

Could the benefits of economic growth be enough to cover the cost of the spending? Not even close. The CBO estimates that each 0.1 percentage point of growth closes the annual deficit by roughly $30bn. It is not remotely conceivable that growth will offset the cost, even over 10 years.

On the campaign trail, Joe Biden pledged to raise the corporation income tax rate from 21% to 28%. That will raise $700bn or so, but it was originally pledged to cover the costs of clean energy, health and infrastructure spending still to come.

There is an alternative way to look at these efforts: as relief that replaces income to relieve the burden of the crisis, with no pretence that there will be stimulus. From that perspective, the funds should be targeted at those in financial distress, but the latest proposal is far too broad. The request to send cheques includes individuals even if they did not miss a day of work or a single pay cheque. It would be better to target the long-term unemployed. Labour department figures indicate that nearly four million people have been unemployed for 27 weeks or longer. They each could receive a cheque for more than $96,000 with only a fraction of the same pool of money. While that is unrealistic, $2,000 more to the long-term unemployed would cost only $8bn.

The upshot is that the $1.9tn request violates the rule that additional deficits make sense only if the spending genuinely addresses the economy’s problems. Any additional pandemic-related spending must be scaled appropriately and target the areas of greatest need. Pretending that any amount of spending is justified at this moment is short-sighted and aggravates the hard political realities of controlling spending and raising revenue.

Douglas Holtz-Eakin is the president of the American Action Forum and former director of the Congressional Budget Office

This article was published by MarketWatch.

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