Stuart's Breakfast Orange; Roaring Twenties or a Pig in a Poke

 

There is a great deal of talk about the Roaring Twenties. In the depth of winter lockdown, it's not surprising that economists have crowded around the zoom campfire telling tales of better times to come. Moreover, there has also been the retrospective justification of buoyant risk markets. The narrative is adjusted to fit the performance. The Roaring Twenties, the decade of strong growth that followed the last global pandemic, Spanish flu, was primarily an American affair. Most other counties were constrained by the inappropriate return to the pre-War Gold Standard exchange rates.

However, the American-centric Roaring Twenties narrative is also supported by the President's decision, together with his Treasury Secretary and former Fed Reserve Chair, Janet Yellen, to go large and larger still on fiscal policy. Donald Trump continues to exert his malign influence on the Republican Party, further reducing the scope for bipartisan agreement over Biden's $1.9tr additional fiscal expenditure. There are only three weeks until the latest supplementary pandemic unemployment support runs out, and hopes for a cross-party deal are fading. Ironically, triggering the Reconciliation process will increase the stimulus to the economy as the initial size was exaggerated to allow for negotiation; reconciliation will provide for near enough the full amount.

The Biden spending program would add to the $900bn agreed in December and bring total pandemic fiscal support to $5tr, or nearly a quarter of annual GDP. The pandemic and its associated lockdowns left deep and temporary sinkholes in GDP, and remedial spending was necessary to prevent permanent economic scarring of the economy. However, covering holes is one thing; trying to kick start the economy with a massive sugar rush of fiscal stimulus is another. Moreover, although $5tr has been allocated, only a minimal amount will boost the economy's productive potential. To be sure, it will prevent any further deterioration, but potential growth was weak before the pandemic; the Fed and Congressional Budget Office both estimated that it was in the 1.8-2.0% range, and the stimulus won't do anything to change that.

Larry Summers, who revived the concept of secular stagnation in 2013 and was Treasury Secretary during the GFC, has criticised the scale of the latest package. He is a strong proponent of fiscal policy to escape this secular stagnation trap but worries that it is the wrong sort of stimulus. Summers listed his concerns in two commentaries. First, he acknowledges that it would have been better for the Obama Administration to have provided a much larger stimulus in 2009, which he argued for at the time, but he notes that in 2009 the gap between actual and estimated potential output was about $80bn per month and increasing, while the 2009 stimulus provided an incremental $30-40bn, or roughly half the shortfall. Secondly, taking into account last year's fiscal stimulus and the previous month's $900bn package, the gap between actual and potential output will fall from about $50bn per month at the start of the year to $20bn by the end of the year. This output gap will be dwarfed by the Biden stimulus, which will add $150bn per month. In terms of wages and salaries, the shortfall is running around $30bn below pre-Covid levels, and the stimulus will add $150bn, five times the gap and even more significant for lower-income families where the stimulus is targeted. Thirdly, Summers is concerned about the composition as well as the scale of the stimulus; the two packages do little to address the low productive potential of the economy, which is necessary to raise the economy's sustainable growth rate, boost the natural rate of interest from current zero and enable the Fed Funds rate to rise materially from the zero lower bound.

Mervyn King, former Governor of the Bank of England [winner of the Ignis CBOY award 2008 through 2011], echoed Summer's concerns. King is concerned that conventional stimulus is the wrong prescription for an unconventional recession. King believes that support should be "support and shift". "Support" in the short-term for those most affected by the pandemic and "shift" in the longer-term to redeploy resources where they will be most effective in reducing surplus savings.

King and Summers careers and eminence entitle them to pass judgement on the package. While I agree with their conclusions, the requirement for much lesser economists is description and prediction rather than prescription. I think the Administration will achieve its progressive package. This enormous fiscal package's maximum impact will be in the second quarter when the $1400 per adult stimulus cheques, adding to last month's generous $600 gift, land. The economic sugar rush will coincide with the likely opening up of the regional economies following the successful vaccination of the vulnerable population, enabling a significant proportion of the $1.6tr in forced savings accumulated through lockdown to be spent.

Goldman Sachs has crunched the numbers and assumes that the impact of fiscal stimulus on GDP will peak at 6.0% in the second quarter. It will be 5.6% for the full year, but this fades rapidly to 2.5% in 2022, 1.1% in 2023 and 0.9% in 2024. It is the nature of fiscal stimulus that it is the rate of change of the boost, which matters for growth, and this implies that fiscal policy will be restrictive from 2022. If the packages proponents are correct, this negative impact will be overwhelmed by a robust and self-sustaining recovery; the promise of the roaring twenties.

During the Middle Ages, pigs were sold in sacks, and unscrupulous sellers would often substitute cats for the pigs, giving rise to the expressions "selling a pig in a poke" and "letting the cat out of the bag". For the stimulus to deliver the promised bacon, it will have to lead to a strong, but not too strong, recovery and an acceptable inflation level. The Fed has acknowledged that inflation will be higher due to this package, but the new flexible inflation targeting strategy allows inflation above the 2% target for a time to make up for the low inflation of the past decade. I think inflation can easily reach 4%, driven by pent up demand for goods, services and investment as lockdown ends, which in turn will unleash pent-up demand. The second quarter will be the epicentre of this explosive growth and the estimates for the second quarter are too low. Fiscal multipliers are enhanced at the zero lower bound, and actual activity will be exaggerated by the misleading seasonal adjustment process. Growth should be significantly higher than 10% on an annualised basis during the period. It remains to be seen if the Fed can hold their nerve and look through this higher inflation, yielding to pressure to act will undoubtedly let the cats out of the bag.

 

Stuart Thomson is an independent economist and portfolio strategist. His writings reflect his personal views and are intended for the reader's entertainment and to elicit debate. They are not intended to constitute investment advice