The Goldilocks stimulus mythNo right figure exists: every possible stimulus size is simultaneously too little and too big.
US President Joe Biden, facing the great challenge of stimulating his country’s economy for the post-pandemic era, and haunted by then-President Barack Obama’s tepid stimulus in the face of the Great Recession a decade ago, has decided to err on the side of overshooting. He wants to 'go big' with a $1.9 trillion spending plan.
Prominent centrists like Larry Summers and Olivier Blanchard warn that Biden’s decision may prove his undoing. Their argument is that too much stimulus will trigger an inflationary surge, resulting in an interest-rate spike that will force his administration to slam on the austerity brakes just before the midterm elections in 2022, costing his Democratic Party control of Congress—just as too little stimulus cost Obama control of Congress in the 2010 midterms.
The problem with this debate is that both supporters and critics of Biden’s stimulus plan assume that there is a dollar amount that is big enough, but not too big. Where they disagree is on what that figure is. In fact, no such figure exists: every possible stimulus size is simultaneously too little and too big.
To see why there can be no 'Goldilocks' stimulus that gets the amount 'just right,' it helps to engage the critics who argue that the administration’s proposal would overheat the economy and hand the Republicans the midterms. Central to their prediction is their tacit assumption that there is also a Goldilocks interest rate and a corresponding stimulus size that will deliver it.
What would render any rate of interest 'just right'? First, it would achieve the right balance between available savings and productive investment. Second, it would not unleash a cascade of corporate bankruptcies, bad loans, and a fresh banking crisis. And there’s the rub: It is not at all clear that there is a single interest rate that can do both.
Once upon a time, there was. In the 1950s and early 1960s, under the Bretton Woods system, an interest rate of around 4% did the trick of balancing savings and investment while keeping bank profitability at a level that allowed credit to reproduce itself sustainably.
Back then, if investment fell below available savings for too long, and failed to recover despite a reduction in the interest rate, a well-designed government stimulus raised investment back to the level of savings, the rate of interest picked up, and balance was restored. Alas, we no longer live in that kind of world.
The reason capitalism no longer works like that is the manner in which the Obama administration, aided and abetted by the Federal Reserve, re-floated the sinking Western banks. The 2008 crisis was as deep and terrible as that of 1929.
As in 1929, sequential bankruptcies, unemployment, and falling prices meant no one was willing to borrow. Interest rates nosedived to zero and capitalism fell into what John Maynard Keynes referred to as the 'liquidity trap.' Once at zero, the interest rate could not go much lower without destroying what was left of the banking sector, insurance companies, pension funds, and other financial institutions.
The great difference between 1929 and 2008 was that in 2008 the banks were not allowed to fail. One way to save them was a large enough fiscal stimulus. Direct injections of freshly minted money to consumers and firms—to pay off debts and to increase consumption and investment—would have re-floated Main Street and, indirectly, Wall Street. This was the road not taken by the Obama administration.
Instead, the Fed printed trillions of dollars, and the failing banks were re-floated directly. But while the banks were saved, the economy was not freed from the liquidity trap. The banks lent the new money to corporations, but, because their customers were not re-floated, managers were unwilling to risk ploughing the money into good jobs, buildings, or machines. Instead, they took it to the stock market, causing the largest-ever disconnect between share prices and the real economy.
Following Wall Street’s near-death experience in 2008, corporations became hooked on (almost) interest-free credit and rising stock valuations that flew in the face of low profits. Total savings dwarfed investment, aggregate wages were at an all-time low, and consumer spending remained subdued. And then, suddenly, COVID-19 arrived, with the ensuing lockdowns dealing major blows on both the supply and the demand side of the economy.
The 12 years before the pandemic arrived explain why a sizeable stimulus today may not achieve what it could have achieved in 2009. A successful stimulus must bring investment closer to the level of available savings. But the moment financial markets get a whiff that this is about to happen, they will push interest rates up to a level reflecting the better balance between savings and investment. Immediately, corporations hooked on low interest rates will face ruin; so will their bankers.
In theory, this can be prevented if the stimulus simultaneously boosts incomes and consumption, so that corporations’ rising income can compensate for the rising interest rates. But, in practice, there is no time for corporations to be weaned off their dependency on low interest rates, because any stimulus takes a lot longer to stimulate incomes than it does to boost interest rates.
The combination of the liquidity trap and 12 years of corporate dependency on near-zero interest rates has, therefore, seen to it that any fiscal stimulus now, whatever its size, is bound to fail in one or both of its crucial aims: To boost investment and to prevent a chain reaction of corporate failures.
'Going big' might have worked in 2009, but in 2021 Biden must go beyond fiscal stimulus. Whatever quantity of money he pumps into the US economy, he will fail unless he does what is necessary to lift the spending power of those who have next to none: a decent minimum wage, compulsory collective bargaining, and direct unconditional payments.