Is the Economy Overheating?

And have we tried turning it off and on again?

Happy Macro Monday!

As stimulus checks begin to hit bank accounts across the country, I thought it was the perfect time to talk about what’s actually in the stimulus package, formally known as H.R. 1319 — the American Rescue Plan, and what its economic implications are.

I was originally inspired by David Beckworth’s Twitter thread from a few weeks ago to blog about the topic of economic overheating, and as Biden’s $1.9 trillion relief package was signed into law on March 11th, with preliminary checks phased out early over the weekend, the topic has become relevant once more.

What is Economic Overheating?

For my non-economists out there, “overheating” of the economy generally refers to it growing at an unsustainable rate. Overheating occurs when the productive capacity of the economy is in disequilibrium with rising aggregate demand, where growth is below-average but growing unsustainably. I’ll go more in-depth into this later, but first, let’s talk about what’s actually in the stimulus package.

Stimulus Bill Breakdown

There’s been a lot of discussion on the contents of the stimulus bill, and how much funding is directly allocated to aiding American households and individuals, as opposed to how much will be spent on facilitating government programs.

The main buzz around the bill has been on stimulus checks, with the American Rescue plan promising $1,400 checks for individuals who make less than $75,000 annually and for households who make less than $150,000 annually.

I’ve provided a quick overview below, along with a helpful visual using data directly from the contents of the bill.

Stimulus Checks

• As an addition to the $600 checks received in December, the bill provides for $1,400 checks, which makes up approximately $400 billion of the package;

• Initially, the eligibility requirements were expanded to encompass a wider salary range, but as mentioned above, were narrowed to individuals who make less than $75,000 annually and households who make less than $150,000 annually.

Unemployment Benefits

• Following the $900 billion stimulus bill in December, 2020, the $300 weekly unemployment benefit has been extended through September 6th, 2021;

• Provisions for a tax break on $10,000 in unemployment benefits.

Child Tax Credit

• Tax credit of $3,000 per child between the ages of 6 and 17 and a credit of $3,600 for each child under the age of 6. The current credit is $2,000 per year for children between birth and the age of 16.

State and Local Government Aid

• Total of $350 billion for states and local government, aimed at aiding state and local public jobs as approximately 1 million state and local government workers have lost their jobs as a result of the pandemic.

• Broken up further, approximately $155 billion of this will go to local governments and territories, $195 billion to state governments, $10 billion to infrastructure, and $0.4 billion aims to create paid leave and other programs for federal workers.

COVID-19 Response

• $160 billion allocated to a nationwide vaccine program, as well as programs such as testing and contact tracing.

• There is an additional disaster relief fund that aids in covering expenses related to COVID-19 caused deaths.

Additional Allocations

• $130 billion in funding to help re-open schools, through means such as improved ventilation, additional sanitary measures, and additional PPE;

• Extension of eviction bans through September 30.

What’s Missing

• $15 minimum wage increase;

• Student loan forgiveness (this one hurt a little bit).

All in all, the biggest increases in the overall package have come from larger stimulus checks, more funding devoted to education, and COVID related policies and programs. The first wave of relief in March of 2020 allocated stimulus of $1,200 per person while the package from December of 2020 allocated $600.

In terms of education, the package provides for $136 billion dollars of funding more than its March 2020 allocation, and $95 billion more in COVID related policy and programs.

How is it Financed?

The American Rescue Plan is a fiscal stimulus package financed by deficit spending. Deficit spending is any spending that exceeds revenues and the budget deficit, and is financed through borrowing as opposed to via taxation.

The U.S. is no stranger to deficit spending, and has displayed a continual pattern of running deficits over the last decade.

In terms of economic theory, deficit spending implies a Keynesian approach. In Keynesian economics, the likely cause of short-run recessions and economic downturns is assumed to be a lack in aggregate demand. Coupled with sticky wages and prices, and following the Keynesian school of thought, the aggregate demand shocks will lead to greater economic downturn and recessions unless the government intervenes. Thus, in order to boost demand and jumpstart growth, the government should look to increased spending.

I, personally, do not subscribe to the Keynesian school of thought, and believe that a majority of the issues caused by the pandemic stem from a supply shock, as lockdowns have prevented many workers and companies from supplying goods and services, but that is neither here nor there. Of course, the mass unemployment we initially saw has resulted in some level of demand pullback, but what was the root of unemployment? A cutoff of supply, caused by nationwide closures. But alas, I am just here to report on what the implications of the stimulus package are.

Where does financing for deficit spending come from?

There are a few ways in which governments can finance deficit spending, with one of these ways being through the sale of government securities and Treasury bonds. In addition, the funds can be minted through an expansion of the money supply.

In severe cases, where the government cannot finance deficits through bonds at all, financing comes from printing drastically more money and thus leads to dramatic increases in inflation.

In terms of how the Fed plays into this, a recent Forbes article, titled Inflation Has Not Shown Up Yet, But It’s Coming, does a good job of summarizing recent Fed actions, with main points summarized below:

1. Over the past 12 months, the monetary base has jumped over 50%;

2. The stock of money (including paper currency and bank balances) has increased by 26%.

To the keyboard warriors on Twitter who fought on me on whether or not the Fed would be playing a role in rising inflation expectations — the money printer does, in fact, go brrrr.

So where’s the inflation?

Although we’ve seen large increases in the money supply, inflation has not risen to the surface just yet as consumers have turned to saving and investing as opposed to spending. In addition, stimulus checks were also primarily utilized for paying down debt, and not successful in boosting aggregate demand amongst those who had the option to save or spend. Particularly, the Fed has a history of undershooting inflation expectations, making large fiscal stimulus seem appealing to politicians who wish to quickly please their constituents. I don’t think we’re headed for anything like Venezuela, but we will certainly see devaluation of the dollar in the coming years.

Is the Economy Overheating?

In short, no, not quite — yet.

As I mentioned above, economic overheating plagues economies that are expanding at a rate that is unsustainable. Generally, the overheating is preceded by lower than average growth, as its productive capacity cannot match a growing aggregate demand. The lower than average growth grows at an unsustainable rate, leading to “booms” where inflation increases due to unsustainable growth and suppliers produce an excess of goods and employ excess labor that cannot be sustained in the long-run. The typical central bank response to overheating is to tighten monetary policy in order to match increase inflationary expectations and reduce investment eagerness through a higher interest rate. The increase in consumer wealth that causes the mis-allocation of supply crumbles as a result, and the common outcome is a “bust” a.k.a. recession.

The Federal Reserve, on the other hand, is doing the opposite. Despite expectations for economic recovery, the Fed is keeping interest rates low, and undershooting inflation as they continue to fluff-up the money supply.

Beckworth brought up valid points in his thread, primarily noting that “If we are getting worried about inflation (and implicitly the dollar size of the economy) now when we are still far from pre-pandemic trends and thus far from successful catch-up growth, imagine how challenging this discussion will be as we get closer.”

Beckworth also noted that his concerns were not about debate on the size and composition of the relief package, but that the debate on overheating “is spawning a hostility to very thing the Fed's new framework is trying to accomplish: catch-up growth.”

Sure, we’re a ways out from full recovery — the chart below is an estimation by the Bureau of Economic Analysis published by the Brookings Institute of GDP projections, with a “return-to-normal” as early as Q3 of this year — but what happens when we get there, and planning accordingly, is of chief importance.

The Brookings Institute noted that “By late 2021, we would likely see the economy operating above its maximum sustainable level. That positive output gap would likely put upward pressure on inflation, which the Federal Reserve has said would be welcome. A risk worth noting is that the return of GDP back to its maximum sustainable level may create a difficult economic period after 2021.”

I don’t think the above scenario is a far-off from what we may see in the near future. While the economy doesn’t seem to be heading for a catastrophic overheating and economic meltdown, I do not believe we should downplay the potential inflationary consequences of large stimulus packages in an economy that is already projected to see a return to growth, and this appears to be an instance in which I would disagree with Beckworth and say that size really does matter.

Calculating the size of the multiplier is tricky. But it is possible that we could see a demand increase anywhere from two to three times that of the output gap, leading to a level of output that far exceeds the economy’s true potential and leads to a much stronger inflation rate than that of the 2.5% projected by the Fed.

Thinking Rationally

Put the oven mitts away and relax, there’s no need to panic (again, yet)

My views on the current state of economic overheating lay somewhere between George Selgin and David Beckworth. I do not think we are headed toward an immediate inflationary spike, like some folks on twitter seem to think, and we certainly won’t be needing to tout dollars around in wheelbarrows like post-WWI Germany anytime soon. However, I do not think we should blow off the consistent inflationary undershooting by the Federal Reserve. And in terms of whether or not the size of the stimulus package is reasonable to debate, I think Selgin summed it up well in his thread:

In this case, I am slightly less concerned with the stimulus package being too large and more concerned with the Fed’s promise to keep the interest rate low despite growth expectations, as well as its consistent eagerness to undershoot inflation and boost the money supply.

That being said, personally, I was glad to see the narrowing of eligibility benefits from the bill’s original proposal. It’s important that money gets to where it is needed, and not where it is mindlessly mis-allocated in a desperate attempt to boost an “aggregate demand shock” that is really stemming from an aggregate supply shock.

And as to whether or not we’ve tried turning the economy off and on again - the answer may surprise you.

See you on Friday!