Ride or die.
Support The Bulwark.
  Join Now

The Costs of Too Much Budget Stimulus

The economy needs fiscal and monetary support—but not more than it can afford.
February 8, 2021
Featured Image
Traders work on the floor of the New York Stock Exchange during the opening bell on March 10, 2020 in New York. (Photo by TIMOTHY A. CLARY / AFP) (Photo by TIMOTHY A. CLARY/AFP via Getty Images)

Academic economists, like Nobel laureates Joseph Stiglitz and Paul Krugman, are now cheerleading the benefits of yet more massive fiscal stimulus in response to the COVID-19 pandemic. Indeed, for them it would seem that no budget support package is large enough even though they must know the economic risks entailed.

In pushing for more public spending largesse, they are doing us a great disservice by discounting the inflationary risks associated with unprecedented public spending. They also ignore the risk that such large budget deficits could cause asset and credit price bubbles all over the economy to burst spectacularly.

In the run-up to the 2008 Lehman bankruptcy, academic economists largely ignored the dangers of the large housing and credit market bubbles. Instead, they took comfort in the idea that, up until then, the United States had not experienced a generalized housing market bust. Consequently, they were blindsided by the 2008-2009 Great Recession brought on when the housing bubble burst.

That bubble was caused, at least in part, by easy monetary policy in the years after 9/11 and the earlier overgenerous public support for the housing sector. Today, most of the economic academy seems to be repeating its past mistakes by ignoring the risks associated with an even larger global financial market bubble in the wake of the Fed’s multi-trillion-dollar pandemic monetary policy response.

The academic economists’ silence is all the more surprising given the lessons that they were supposed to have been learned from the 2008 housing and credit market bust. After all, whereas in 2008 the bubbles were largely confined to the U.S. housing and credit markets, today those bubbles appear to be inflating practically every corner of the world’s asset and credit market.

Today’s U.S. equity valuations are at lofty levels last seen on the eve of the 1929 stock market crash. Risky borrowers both in the U.S. and overseas can borrow at interest rates little higher than those paid by the U.S. government. The Fed’s ultra-easy money policy has also kept large amounts of money flowing into emerging market economies when those countries’ economic fundamentals have never looked more compromised.

Some of this happy thinking can be attributed to the popularity of Modern Monetary Theory, which, like a comforting lullaby, asserts that that large budget deficits and rapidly increasing public debt levels don’t matter. That assertion is based on the mistaken belief that interest rates and inflation levels will remain low no matter how much public spending the government undertakes. No wonder they’re pushing the Biden administration and Congress to spend even more money.

Never mind that the Biden administration’s $1.9 trillion budget stimulus package comes on top of a $900 billion package last December. Never mind, too, that this unprecedented amount of peacetime fiscal pump-priming is coming on top of an unprecedented amount of monetary policy easing. Jerome Powell’s Fed has accomplished in barely six months what Ben Bernanke’s Fed took six years to do.

The academics must know that this degree of economic policy easing risks leading the U.S. economy to overheat once vaccine distribution achieves herd immunity and the economic shock of the pandemic has passed. In normal times, the monetary response to overheating would be to raise interest rates to prevent inflation. Markets anticipating this eventuality have already started to push interest rates higher, have sent the dollar lower, and have raised their medium-term inflation expectations.

But American public debt levels—which are likely only to grow with more fiscal stimulus—will complicate the Federal Reserve’s task of controlling inflation in the event that the economy does overheat. With a high public debt, the Fed will be under intense political pressure not to raise interest rates in order to keep the government’s debt payments at a tolerable level. That in turn risks causing the Fed to fall behind the inflationary curve, which could result in the United States joining the ranks of the all too many countries that have experienced inflation as a result of undisciplined budget policies.

None of this is to say that our economy now does not need substantial fiscal and monetary policy support. It is rather to emphasize that an excessive degree of monetary support can heighten financial market risk by creating asset price bubbles, and that an excessive degree of fiscal policy support risks inviting inflation and the bursting of those bubbles. The academic community, who are supposed to warn policymakers of these risks and tradeoffs, are doing a great disservice by not preaching economic policy moderation.

Desmond Lachman

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.