Could Biden’s rescue package lead the US down a dangerous road?

Former US Treasury Secretary Lawrence Summers has provoked a fierce debate in the US by essentially asking whether, with Joe Biden’s proposed $US1.9 trillion ($2.5 trillion) new COVID relief package, there can be too much of a good thing.

In a column published in the Washington Post last Friday, Summers, Treasury Secretary during the Obama administration, warned of the risk that macroeconomic stimulus on a scale closer to War War II levels than normal recession levels would set of inflationary pressures of a kind not seen in a generation, with consequences for the dollar and financial stability.

There are fears that Joe Biden’s proposed COVID relief package will have a number of damaging consequences.
There are fears that Joe Biden’s proposed COVID relief package will have a number of damaging consequences.Credit:AP

His commentary triggered a fierce response from the Biden administration. Its senior economic adviser, Jared Bernstein, called them “flat-out wrong” and argued that the risks of doing too little far outweighed the risks of “going big.”

Summers responded to that criticism and a wider debate his opinions had triggered with another column on Sunday in which he said the issue policymakers had to address was quantitative – whether the $US1.9 trillion ($2.5 trillion) plan, when combined with an earlier $US900 billion package – was too large for an economy with extraordinarily loose financial conditions, reasonably rapid growth forecast, unmet public spending needs and a big overhang of private savings.

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The combination of the two packages would amount to about 13 per cent of US GDP, which he said needed to be justified with more than just qualitative arguments. As the debate over stimulus proceeded, it would be important to consider analyses of the proposed levels of stimulus that could be delivered without setting off inflationary pressures.

A key strand in his argument is that, while there was nothing wrong with targeting $US1.9 trillion, or more, a substantial part of the spending should be directed at promoting long term sustainable and inclusive growth over the rest of this decade and not just supporting incomes this year and next.

Part of the explanation for why Summers’ commentary raised eyebrows was that he has long warned of the dangers of “secular stagnation,” or a long period of minimal inflation and meagre economic and wages growth, with a range of factors including ageing populations, declining productivity, new technologies and widening inequality making traditional monetary policy increasingly less effective in promoting growth.

After more than a decade of central bank interests rates at or below zero, and massive doses of quantitative easing that have poured liquidity into their financial systems, developed economies even pre-COVID were stagnating and inflation rates remained stubbornly low.

Indeed, the US Federal Reserve Board last year changed its policy framework. It is now prepared to tolerate periods of above-target inflation, marking a shift in an inflation-first strategy that had prevailed for more than four decades.

Given the experience of the Trump administration, there is no certainty that any level of spending by the Biden administration would rekindle inflation given how resistant the economy has been to the combination of fiscal and monetary policy stimulus since the financial crisis in 2008.

There is a caveat. There is a school of thought that a major contributor to the low-growth and low-inflation experience of developed economies after the financial crisis has been the explosive growth of China, which has exported deflation to the rest of the world.

Lawrence Summers believes Joe Biden’s $US1.9 trillion rescue plan could be too large for an economy with extraordinarily loose financial conditions, reasonably rapid growth forecast, unmet public spending needs and a big over-hang of private savings.
Lawrence Summers believes Joe Biden’s $US1.9 trillion rescue plan could be too large for an economy with extraordinarily loose financial conditions, reasonably rapid growth forecast, unmet public spending needs and a big over-hang of private savings.Credit:Bloomberg

With China’s economy and labour costs maturing and the escalation of tensions that occurred as a result of Trump’s trade wars and the subsequent full-scale competition for economic supremacy resulting in “reshoring” of supply chains and a decoupling of the US and other western economies from China’s, that influence and the lid on inflation it provided might be waning.

An obvious question that flows from Summers’ commentary is, if central banks have been trying to generate some inflation for more than a decade, why is he so concerned that the Biden relief package might achieve exactly that outcome?

To be fair to Summers, his arguments are as much about the nature of the package and its impact, or lack of impact, on inequality as it is about the risk of a break-out of inflation. He is, however, obviously mindful of the levels of inflation experienced in the 1970s and early 1980s, when it pushed into the teens and was only brought under control with punishing interest rates.

By trying to avoid a recession then, they have created a debt trap of such magnitude that trying to escape from it could trigger something even worse than the experience in 2008.

Given the “debt trap” the US finds itself in, with federal debt already over 100 per cent of US GDP and rising rapidly, it wouldn’t require much of a movement in rates to respond to a rise in inflation – but even a modest movement could cause a recession and even another financial crisis.

The lax monetary policies of the post-financial crisis era have encouraged massive build-ups of debt at every level of the US and other developed economies, inflating property and financial asset prices.

A level of inflation that forced central banks to respond with significant rate rises could trigger implosions in financial asset markets.

The markets could, of course, take matters into their own hands. The US yield curve has been steepening as the prospects for the $US1.9 trillion package have strengthened. Longer terms rates have risen quite sharply.

The US 10-year bond rate has lifted from 0.92 per cent and the start of the year to 1.16 per cent and the 30-year rate from 1.65 per cent to 1.97 per cent. The 10-year bonds traded at a yield of only 0.51 per cent last April, as the severity of the pandemic became, and 30-year bonds yielded only 1.16 per cent.

The steepening of the curve is a sign that bond investors are pricing in stronger growth – and inflation – than they had previously anticipated and want more compensation for the risk of rising inflation.

Rising interest rates threaten financial asset values because those values are effectively derived by discounting the future cash flows they are expected to generate for the time value of money, using a risk-free rate like the 10-year bond rate that incorporates the inflation risk as the core of the discount rate.

So many stocks and properties are, because of the ultra-low interest environment, trading at levels that reflect minimal discounting for time and risk, that even relatively modest increases in rates could burst what would traditionally have been regarded as financial bubbles.

The low-rate/quantitative easing driven environment has been in place for so long that the fallout would be very nasty and destabilising.

It is possible to argue that such a shake-out is inevitable and necessary and that central banks should have precipitated it long ago, even at the cost of a recession, once the financial system had been stabilised after the financial crisis.

By trying to avoid a recession then, they have created a debt trap of such magnitude that trying to escape from it could trigger something even worse than the experience in 2008.

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Source: Thanks smh.com