Gaps, Traps and Stimulus Plans

Just when Washington’s politicians seem ready to move forward with a Covid relief bill, some of its economists are voicing doubts about whether further stimulus is necessary. In this case, the politicians have the better argument.

It’s not just the latest Congressional Budget Office report, which projects a return to the pre-pandemic economy by mid-2021 based solely on the stimulus that has already passed. An analysis by the Committee for a Responsible Federal Budget looks at the so-called output gap, the difference between actual gross domestic product and the economy’s maximum potential. For 2021, it says, the gap could be closed with a mere $250 billion in stimulus, and $500 billion would be enough to shore up the economy through 2023.

For comparison’s sake, President Joe Biden’s plan would spend $1.9 trillion this year. The counteroffer from moderate Republican amounts to $600 billion.

The problem with the two budget analyses is twofold. First, the CBO has consistently underestimated the size of the output gap, and there is reason to believe it is still doing so. Second, closing the gap isn’t enough. The U.S. economy needs to “overshoot” in order to repair the damage of the last two recessions.

Like most advanced economies, the U.S. is caught in what was once known as a “liquidity trap,” which famously afflicted Japan following the burst of its real-estate and stock bubbles in 1989. In Japan’s so-called “lost decade” of the 1990s, private-sector savings rose and investment fell, as both households and businesses became more risk-averse. When Japan’s economy finally started growing again, it remained trapped in this suboptimal equilibrium and never made up for lost ground.

A similar phenomenon started to take hold in the U.S. following the dot-com crash in 2000. Investment rapidly declined, and the kind of risk-taking that characterized the early internet economy disappeared. Complete stagnation was briefly avoided by the real-estate bubble. When that popped in 2007, the U.S. economy also fell into a liquidity trap.

Millions of workers did not suddenly become unemployable in the Great Recession, nor did the march of technological progress somehow stop. The slow recovery of the U.S. economy after 2009 was due to the failure of businesses to invest in the workforce and technology at the levels they had in the past.

Rather than recognize this persistent gap between the potential of the U.S. economy and its continuing weak performance, the CBO steadily downgraded its estimates of the economy’s potential. This was not an act of incompetence or political gamesmanship. The CBO, ever striving to be impartial, arrives at its estimate by letting the data largely speak for itself.

The CBO assumed that years of slow productivity growth and a shrunken workforce meant that these conditions were natural. They weren’t. GDP rose above the CBO estimate of its maximum potential in late 2017 — and stayed above it right up until the pandemic hit.

If the economy had truly been operating above potential — a state that economists sometimes refer to as “overheated” — then the economy should have seen rising inflation, as well as flat or (eventually) rising unemployment. This is the type of stagflation that resulted from overheating during the 1970s.

Instead, inflation remained stubbornly below the U.S. Federal Reserve’s target, while unemployment continued to fall to record lows. This strongly implies that the economy didn’t come close to its maximum potential even then.

Thus, the CBO’s current estimate of maximum potential — which is essentially an extrapolation of its pre-pandemic estimate — is too low. The output gap is larger than it than it supposes, and it will take more stimulus to close it.

And then there is the matter of escaping the liquidity trap. For that to happen, the economy needs to exceed its potential for some time. When inflation rises to the Fed’s target, businesses will start to run short of workers and will be forced to put in place the many technological improvements that have occurred over the last decade. And when wages start rising 4% to 5% a year, it will provide employees with a sense of underlying security that promotes an entrepreneurial economy; workers are more likely to strike out on their own when good jobs are plentiful.

How much more stimulus will it take to reach this level? Anyone who says they know for sure is lying. In recognition of this reality, Fed Vice Chair Richard Clarida has suggested that policymakers take a “whites of their eyes” approach: Wait until there is rising inflation and an obvious shortage of workers. There is little to suggest that, even with another major stimulus, the U.S. economy will be there anytime soon.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a Bloomberg Opinion columnist. He was formerly vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina. He is also co-founder of the economics blog Modeled Behavior.

©2021 Bloomberg L.P.

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