The Economics of the 2020 Stimulus Packages

A worker cleans an empty hall in Industry City, N.Y., where the shops have been closed due to the coronavirus outbreak, March 26, 2020. (Stephen Yang/Reuters)
When money pours into an economy where output is constrained, what happens?

NRPLUS MEMBER ARTICLE I t is not uncommon to look to fiscal and monetary intervention to offset the fall-off in demand in economies undergoing severe economic contraction. Even today, there is some lingering dispute about whether such actions really do much good. Generally, fiscal and monetary stimuli are thought to have little impact on price levels in the early stages of an economic recovery, as output and employment gradually begin to recover. This consensus among economists is currently being applied to the stimulus packages designed to offset an economic collapse in the U.S. and Western Europe, occasioned by mandated shutdowns of their economies, related to the fight against the spread of the COVID-19 virus.

The “Phillips Curve” rule of thumb is that inflation will be low when the economy is weak and inflation will begin to rear its head only as economies approach full capacity. The data have never supported that rule of thumb. The American economy in the 1970s experienced a decade of rising inflation and rising unemployment, a decade that came to be known as the decade of “stagflation.” In the latter half of the 19th century, the American economy grew from that of a relative backwater nation to one of the greatest economic powerhouses the world had ever seen. This period saw prices drop by over a third, the longest period of deflation in the nation’s history.

The situation is very different in the Spring of 2020 as the U.S. and Europe move forward with stimulus packages to try to put a floor under their plunging economies. What is different is that these countries are now experiencing a collapse in output. For practical purposes, it has become essentially illegal to increase output and, for most businesses, illegal to produce anything at all. This type of economic collapse will mean that the stimulus is not likely to have the effect that most economists seem to be expecting.

The Mechanics of the Stimulus Packages of Spring 2020

The government decides to provide, let’s say, $1 trillion of cash to be made available to various persons and entities within the country. This $1 trillion is to be funded by the sale of government (usually, called “sovereign”) debt. Who buys this new debt? This is a particularly interesting question when it is not only the U.S. pursuing this policy, but the euro zone as well. A flood of sovereign debt piles into the marketplace in amounts that are multiples of anything ever before seen in history.

Some of this will be purchased by private market participants. But private market participants have a much-reduced level of wealth from which they can draw to purchase this extraordinary volume of new debt offerings. Not to mention that the reward for purchasing such debt will be miniscule, as reflected in the low interest rates on sovereign debt prevailing in the Spring of 2020.

So the central bank steps in.

As a central bank turns on its digital printing presses to absorb this extraordinary level of new debt financing, cash pours from it to government and then out to the general public. The immediate effect is a huge increase in the level of demand deposits. This means that the money supply has increased by an extraordinary amount in a very short period of time.

If this kind of dramatic increase in the money supply pours into an economy in which it is a criminal act to expand output and production, where does this money go?

Where Does This Dramatic Increase in the Money Supply Go?

It is worth a pause to reflect on the views of economists on this situation. Almost all modern academic monetary models suggest that inflation will not respond to changes in the growth rate of the money supply. Think about that one for a minute. If expanding the money supply has only negligible effects on inflation, then what possible downside could there be from expanding the money supply to finance ordinary, routine government expenditures? Why do countries bother with tax collections at all? Simply issue sovereign debt, have your central bank buy it, and there will be no downside since no inflation will result.

Increasing the money supply by dramatic amounts in an economy where output is constrained by law is not likely to be benign and non-inflationary. Again, where does this money go, if not to higher prices for a declining amount of goods and services.

It is often argued that this kind of inflationary takeoff simply cannot happen in a collapsed economy. What Germany’s Weimar Republic went through in 1923 suggests otherwise. Several Latin-American countries pursued a similar strategy in the mid-20th century with results that were qualitatively similar to the experience of Germany in 1923.

So it can happen and it has happened: inflation within a collapsed economy. Stimuluses cannot increase real output in an economy where such an increase is forbidden by law. But the stimuluses of Spring 2020 can provide a boost to the prices of goods and services. Such stimuluses can also slip over into liquid-asset markets and slow the inevitable slide in global stock markets, at least for a while.

Edwin T. Burton is a visiting professor of economics at the University of Virginia.

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