In praise of Biden’s fiscal stimulus

The wisdom or otherwise of the American Rescue Plan, which included $1,400 direct payments to individual Americans, has been a constant debate since it was enacted at the end of 2020 and the beginning of 2021. The main criticism has been that it overheated the US economy, and therefore added to inflation already high because of post-pandemic supply problems and energy price hikes. That increase in inflation has led the Fed to increase short term interest rates, and how high those interest rates will need to go to stabilise inflation, and/or whether they will lead to a US downturn, we are yet to see.

In much of Europe, by contrast, there has been no equivalent fiscal stimulus. Instead there was much more general fiscal support, in the form of the state paying a large proportion of many workers salaries to stay at home. Yet while the net effect on the public finances may have been broadly similar, the impact on GDP has been very different. As I noted here, for example, the US recovery from the pandemic has been much stronger than in Europe.

One reason involves the standard observation that the propensity to consume out of a temporary increase in income rises as incomes fall. Give the same amount to rich people rather than poor people and you will see a lot less consumption and a lot more saving among the rich. With the American Rescue Plan, the amount people received actually fell as their income levels rose. That is why it makes sense to talk about that plan as a fiscal stimulus (as well as being an effective anti-poverty measure) while the European style salary payments were more in the nature of general fiscal support.

So we might expect stronger post-vaccine growth in the US compared to Europe, but equally higher inflation in the US compared to Europe. We have seen much higher US post-vaccine growth in the US than in Germany, France and the UK. It is also true that inflation increased earlier in the US than in Europe, and the stimulus is one reason for that. But if (and I know it’s a big if) OECD forecasts released last week prove accurate, then the total amount of inflation experienced by US consumers in the three years after the pandemic will be no greater than in Germany, as the second column of the table below shows.

OECD Economic Outlook forecasts June 2022*

	Total GDP growth 20-23	Consumer deflator  increase 20-23	Employee Compensation increase 20-23	Real wage growth 20-23
US	6.0	14.5	24.0	9.5
Germany	1.5	14.5	12.5	-2.0
France	2.5	11.0	12.5	1.5
UK	2.0	17.5	17.0	-0.5

*Figures obtained from adding annual growth rates, so I have rounded to nearest 0.5.

If we think in terms of a relative growth/inflation trade-off, then these forecasts suggest the US is going to get considerably more growth than Germany or France with little cost in terms of higher inflation compared to those countries over the 2020 to 2023 period. One reason of course is that the Fed has raised interest rates, while so far they remain stuck at their lower bound in Europe. This superior growth performance means that workers in the US are going to be considerably better off than their counterparts in the major European economies.

Of course this is only a forecast. But it does allow me to make two points that are sometimes missing from a lot of the US debate. The first is that post-vaccine inflation has been a world-wide phenomenon, and whether inflation turns out to be worse or not in the US is at least open to question, as these forecasts show. (Latest data on US wage inflation suggests that it is past its peak and slowing.)

Second, fiscal stimulus to enable interest rates to rise above their lower bound is good macroeconomic policy if you believe (as most politicians in all these economies do) that interest rates should be the tool of choice in managing the economy. As long as interest rates are stuck at their lower bound, they are powerless at countering negative economic shocks. Quantitative Easing is a very poor substitute, simply because we have much less experience of its (probably non-linear) impact, and fiscal stimulus in some countries is often in practice a poor substitute because of politics. So ideally we would want interest rates well above their lower bound, and a fiscal stimulus is how you get there.

Will this argument prove incorrect if the US ends up in recession? It’s worth noting that while the OECD are expecting modest US GDP growth through the rest of this year (between 3% and 1,5% at an annual rate), they are expecting very low quarterly growth rates (less than 1% at an annual rate) through 2023. Based on the past reluctance of forecasters to predict recessions, this forecast is a flag that some more quarters of negative growth are quite possible. But for a prospective US recession to unwind the advantages of the Biden stimulus we have seen so far, it would need to be (a) very large, (b) be accompanied by good positive growth in the major European countries, and (c) US inflation would nevertheless have to be more persistent than in Europe. That combination of events is possible, but at this point seems rather unlikely.

In macroeconomic terms the best argument against Biden’s stimulus is that its timing was unfortunate, because it coincided with post-pandemic supply side and energy price inflation. However this largely supply side inflation was not widely predicted, and from a political perspective no other timing for such a fiscal stimulus may have been possible. So from the point of view of the major European economies, the US position at the moment looks a lot better than their own, and the Biden stimulus is the most obvious reason for this.

There may be a more general lesson here. When interest rates are stuck at their lower bound, economies that experience severe recessions (like that created by the pandemic or the GFC) may require a strong fiscal stimulus to successfully recover from those recessions. In the absence of such a stimulus (or worse austerity) the recovery will be weak, will certainly be slower, and may even result in a permanent loss of real income for most of those in the economy. This happened across the world after the GFC, and it seems to be happening in Europe following the pandemic.

If, as some are expecting, the ECB raises rates in a misguided attempt to reduce inflation, this will make the growth gulf between the US and major European economies greater still. Quite what the macroeconomic logic is for the ECB to raise rates following an energy and supply side shock, when the OECD expects demand in the Eurozone to be around 2% below potential this year and next, is difficult to fathom.

What about the UK? In growth terms it is stuck in the doldrums with Germany and France, yet it is expected to suffer the biggest increase in inflation. As I noted here, the UK is unusual because of Brexit, which has both reduced growth and increased inflation. For those who remain unconvinced that Brexit is a key factor, look at the performance of regions since before the pandemic. Besides London, Northern Ireland is the only area to show positive growth probably because it remains in the Single Market. Or look at CER analysis by John Springford that compared the UK to economies that had performed in a similar way in the past, and finds that since Brexit a gap of over 5% has opened up between GDP in these economies and the UK, with the gap in investment much wider.

As long as the UK government remains in denial about this, the UK is likely to stay in the position of having a worse combination of growth and inflation compared to either the US, Germany and France. Instead of modifying Brexit in order to reduce these economic costs, the government is instead starting a new dispute with the EU by breaking the Northern Ireland protocol it signed just two years ago. Unfortunately the main result of the confidence vote against Johnson is that he has become beholden to the largest cohesive group of Tory MPs, and those are the Brexit hardliners in the laughably named European Research Group. Before it entered the EU the UK was called the sick man of Europe, and after Brexit it is taking up that title once again.