The popular narrative amongst pundits is that Republicans face existential questions about whether theirs is the party of Trump or Lincoln. Yet by the end of last week, the outcome seemed clear. Only a handful of Congressional Republicans voted alongside Democrats to bar Representative Marjorie Taylor Greene from House committees. The party of Trump remains, for now, the party of Trump.
Instead, it is among Democrats that divisions are opening, ones that are much more important for economic, financial and political outcomes. Confronted with razor-thin majorities in the House of Representatives and US Senate, Democrats are beginning to debate among themselves how to best allocate scarce political and financial capital in the first two years of the Biden Administration. Their choices could have profound impacts on a cyclical recovery, inflation, financial markets and longer-term economic growth outcomes.
With Republicans abandoning the center, Democrats have acres of political pasture beneath their feet. The question is whether they will cultivate the landscape or feud over it.
Last week, President Biden set out his fiscal priorities. He stated categorically that compromise on a smaller Covid-19 relief package, along the lines recently proposed by 10 Senate Republicans—a number just large enough to be filibuster-proof—was not acceptable. Arguing that he would not break a campaign pledge to provide eligible Americans with $2,000 relief checks and sensitive to a decade-old criticism that the Obama-Biden 2009 Recovery Act was too small, the 46th President drew his line in the sand.
Biden’s $1.9 trillion stimulus package, coming on the heels of a $900 billion measure legislated late last year, will provide an overall fiscal boost to the US economy in 2021 worth nearly 13% of US GDP, more than double the uplift from the 2009 Recovery Act, which amounted to about 5.7% of GDP.
The overwhelming majority of House and Senate Democrats have pledged their support for the Biden plan. But not all economists agree, including prominent former policy makers such as Larry Summers, Treasury Secretary under Clinton and director of Obama’s National Economic Council, or Olivier Blanchard, former Chief Economist of the International Monetary Fund. Summers and Blanchard carry additional intellectual heft as two of the most widely cited academic economists of their generation.
Importantly, Summers, Blanchard and others are not questioning the wisdom of the Biden package on public debt grounds. In a recent paper, Larry Summers and Jason Furman noted that real (inflation-adjusted) interest rates have fallen as government indebtedness has increased, dispelling concerns that government borrowing risks ‘crowding out’ private investment, particularly when considerable slack exists in the economy. They argue forcefully that fiscal policy must play a larger role in counter-cyclical demand management, given that monetary policy easing today is akin to ‘pushing on a string’.
One might think, therefore, that their views would be wholly aligned with those of the Biden Administration. However, there are clear points of departure, spanning growth, inflation and politics.
To begin, Summers and Furman argue that fiscal policy ought to be used both as a shorter-term stimulus lever to restore full employment and as a means to promote public investment in order to boost long-term growth. In the parlance, they argue that fiscal policy can shift demand and supply curves in the long run, yielding higher living standards for all.
In political terms, Summers is concerned that the Biden Administration will use up too much of its political capital on short-term fiscal stimulus, potentially eroding the chance to lift investment in productivity-enhancing public goods, such as education, transportation or research and development. Other goals, such as hike in the minimum wage may also be at risk.
The argument warrants scrutiny. In order to legislate the Biden Covid-19 relief package, for example, Democrats in Congress will have to pass the bill via reconciliation to avoid a blocking filibuster by Senate Republicans. Yet only one reconciliation bill can be passed per fiscal year, which means a future infrastructure bill may fail unless it garners Republican support. In today’s polarized US political landscape, however, that may be asking for too much political flexibility. Moreover, due to arcane provisions in reconciliation bills (Byrd amendment), non-fiscal measures, such as a proposed hike in the Federal minimum wage to $15/hour could be removed at Republican insistence.
In short, Biden’s Democratic critics argue that the cost of a large fiscal package today may be forgone public investment and even greater social equality. But they have another concern, tool, namely that fiscal stimulus worth nearly 14% of US GDP may risk inflation. If so, market participants should take note.
Accelerating inflation may not be as far-fetched as some think, a point we’ve made here before. After all, the pandemic induced adverse demand and supply shocks. Few argue that stimulus checks and spending on public health are not required. But a very large fiscal boost could prove inflationary if it coincides with broad-based successful vaccination and a re-opening of the economy in 2021.
The primary reason is that the demand response may initially outpace the supply response. US household savings has soared during the pandemic. And while savings are hardly equally distributed, pent-up demand for many basic goods and services—dining away from home, travel, or retailing come to mind—is likely to be very large. Meanwhile, swathes of small businesses have folded or dismissed staff, and may not be able to remobilize quickly. Global supply chains have been impaired by the pandemic and trade wars.
The US labor market may also be tightening. Proponents of very large fiscal stimulus point to a 6.3% unemployment rate and a plunging 61.4% labor force participation rate as signs of excess slack and a social imperative to put Americans back to work. Yet there are concerns that an erosion of job skills, shifting demographics and pandemic-induced changes in production may be altering the level of non-inflationary full employment in the economy. Importantly, the debate is not whether fiscal stimulus is appropriate today—there is near unanimity on that point—but whether the Biden plan risks overdoing it.
Financial markets are taking note. US ten-year inflation expectations, as measured by inflation-protected Treasury notes, have risen to 2.21%, their highest level since 2014 and just a half percentage point below their 2005 all-time highs. Industrial and energy commodity prices have soared in recent months.
Thus far, Fed Chairman Jerome Powell has endorsed the use of fiscal policy to promote economic recovery, and there are few reasons to believe that the Fed will risk unsettling markets by taking issue with the new Administration. But if markets fear that the combination of economic re-opening, accompanied by unprecedented monetary and fiscal stimulus, will boost inflation, stocks and bonds could get hammered. Both markets owe their current stretched valuations, above all, to a supported Federal Reserve. Remove that underpinning, and the market’s edifice could collapse.
President Biden and his advisors do not wish to repeat the mistake of 2009, when fiscal stimulus was too small to address the Great Recession. But just as generals can be criticized for preparing for the wrong war, so too can politicians and economists.
Unlike the unedifying recent debates among Republicans, those among Democrats are healthy. After all, they are based on logic, fact and reason. The best policies arise from a clash of ideas, nurtured by well-intentioned participants and grounded in sound analysis. Democrats should welcome the debate and let the best ideas triumph.