Stimulus: Between a Rock and a Hard Place

The Fed acted today to provide $2.3 trillion in loans to households, local governments, and small and large businesses in a move that essentially sees the Fed acting as a Lender of Last Resort to a struggling economy.

The move comes as the unemployment weekly claims showed some 6.6 million more initial claims for last week, taking the total to approximately 16.8 million over the past four weeks and suggesting that roughly 10% of our approximately 168 million strong labor force are out of work.

The Fed's action, coupled with prior policies that have seen its benchmark interest rate slashed close to 0% and expanded quantitative easing, comes on top of the $2.2 trillion dollar stimulus package (CARES Act) provided by Congress in a third round of fiscal stimulus to help sustain the economy during the ongoing pandemic.

The US House of Representatives is currently floating a fourth stimulus package that among other things is intended to boost incomes of frontline healthcare workers and first responders as well as prospective new hires in these areas. The incentive or heroes fund being considered in the plan is said to be about $25,000 for existing workers and $15,000 one time bonus for new hires.

All this stimulus is good and perhaps very necessary during this pandemic.

The logic behind it goes something similar to this:

The need to mitigate the spread of the coronavirus requires that we implement social distancing and lockdown policies. This means a reduction in production, and the current projection is that we are going to lose close to a third of our first quarter GDP when the numbers come out.

Facing reduced revenues from having no output to sell, businesses face the unpleasant decision to lay off or furlough their workers, which are a huge part of business costs of production.

So other than the businesses and government agencies that are producing essential services, those that can facilitate online or remote delivery of their products, and those others with previous excess inventories that only require minor packaging and delivery to buyers, many workers have found themselves out of work and having little to nothing to fall back on.

The stimulus in its various forms including the action being taken by the Fed is intended to cushion this by either providing direct wage replacement, or by providing incentives for businesses to keep their workers on their payrolls.

However we must take this logic to completion. All of the stimulus is not actually getting output to increase, except perhaps in the key remaining functioning businesses, so they are mopping up any stimulus spending by households, and because the demand for their products has increased, the prices needed to increase quantities supplied will also be expected to go up.

The only way prices do not go up is either if there is already an existing supply of excess inventory waiting to be called upon by the resulting stimulus spending otherwise we are looking at too much spending relative to too few goods, and so an inflationary scenario.

The Rock

Having no, or not enough, stimulus would be the death of the current administration. It would also condemn us to a very severe painful recession that would snowball at a rapid pace to a possible Great Depression era type economic outlook, and possibly worse.

As responsible governments are expected to act to prevent or mitigate any impending downturn in their economies, some form of fiscal stimulus is therefore expected.

Besides, there is a glaring negative externality problem associated with the coronavirus pandemic such that the policy of social distancing and self isolation, along with other restrictions to services, means subsidies per unit should be provided equal to marginal private cost associated with complying. That is, allocative efficiency requires that wages and other private benefits lost, should be fully compensated for.

So the rock here means not providing stimulus or not enough of it to achieve this, and to live with the consequence of a very likely disastrous economic outcome.

But why would anyone want to choose this at all? Let's consider the hard place.

The Hard Place

There is no such thing as a free lunch. I must admit that there has been considerable restraint in both the media and many agencies when it comes to thinking about the cost of the stimulus. Perhaps we need to be empathic since, unlike unfortunate millions, we apparently still have our jobs intact. We hear $2.2 trillion, another $350 billion, $2.3 trillion. We hear that everyone who has lost their job will get paid etc. and we welcome and laud those actions without asking where the money for all of this would come from.

There are only two places really: The printing press and willing lenders.

The printing press

For the uninformed, this is the Fed. All of our money - dollar bills - are Federal Reserve notes. The Fed is authorized by law to provide the US with fiat money. That is, money that is not backed by anything other than the good faith authority of the US government that it can serve as a medium of exchange and will be accepted to meet liabilities owed it by the public.

The Fed therefore can create money at will, to serve its Congressional mandate - to promote maximum employment, stabilize prices, and foster economic growth. At present we have unemployment falling rapidly well below its full or maximum level, so the Fed can take extraordinary measures such as it is proposing to do now in lending directly to non-bank entities. This is accomplished by simply printing the amount of money it needs to do this. In practice this will take the form of electronically crediting the relevant entity bank balances with the amount it needs :)

Willing Lenders

For the uninformed, surprise surprise, for all the might of the government, it can only spend out of tax revenues or from borrowed money. The US government currently owes over $23 trillion dollars from years of borrowing since beginning of the Union to date.

Prior to the pandemic we were projected to run about a trillion dollars in deficit for the current fiscal year, but that is very likely to increase to anywhere above $4 trillion. Feel free to do the math: First, we have the $2.2 trillion approved stimulus. Now add to that the loss of projected tax revenues from the fall in business and corporation profits and hence lower corporation tax receipts, lower wages and joblessness, hence lower income tax receipts, and an expansion in unemployment benefits, and we see how the previous pre-pandemic trillion deficit projected could easily double to $2 trillion.

Who is going to lend the US government this money? I seriously do not know, but the likely candidates are willing US individuals and corporations with very deep pockets in this dire time of economic hardship, who will have to be enticed to buy US treasury securities rather than invest in other interest bearing assets. Other likely candidates will necessarily be foreigners with similar characteristics and preferences... enter China.

The hard place is a combination of possible inflation and future drag on the economy, but it also means all that, with only a modest retreat from the recession prognosis.

Traditionally, when the Fed expands money supply (colloquially, prints money), in the short run, the additional spending it enables would increase output if the current level of output is well below the economy's potential level because unemployed resources can be employed at little to no cost. However we are not in that traditional scenario.

Workers cannot be employed (or return back to work) because of the lockdown. Broken global supply chain networks persist with national borders mostly being shut, so output will fall, and once existing business inventories are depleted, any lingering stimulus will only lead to an aggressive bidding process by households and businesses over scarce resources and output. So inflation results: prices go up and purchasing power falls.

The future drag on the economy results because the scarcity of borrowing sources will mean that the government has to offer higher interest rates on its debt in order to borrow. This causes our debt and interest liabilities to grow at a faster rate and reduce our future consumption levels.

The higher interest rate though could lead to a crowding out of some private planned spending, weakly offsetting any stimulus provided so that any economic downturn that results from the pandemic is only mildly mitigated. Currently investors are rushing to hold cash from which spending can be readily carried out. To hold government bonds instead would imply a reduction in that spending.

The Choice

It is apparent that we have chosen the hard place, and countries globally facing similar challenges will likely also choose the same. Political expediency favors the hard place, and the hard place has a moral appeal to it.

Provided we find a way to relax the social distancing and self isolating policies in the immediate future, the hard place will turn out to be the superior choice.

However if social distancing has to continue because we still have not been able to address effectively the coronavirus, then the stimulus provided by the hard place will show up to be a mirage even in the short term, and we might be the worse for it.