By Gavyn Davies
The political agreement reached in the Senate on Tuesday night will probably result in a fiscal injection into the US economy worth $2 trillion, which would represent 9% of American GDP in 2020. This is slightly larger than the rise in the federal government deficit introduced in 2008-09 over two years. In fact, it is not far below the gigantic fiscal stimulus implemented by China after the financial crash, previously the largest in recent history.
The impact of central bank injections will be equally enormous. For example, the Federal Reserve will probably finance, over a period ahead, much of this fiscal stimulus by buying treasuries, and on top of that its balance sheet will be increased further as a result of purchases of mortgage bonds, and packages of private loan assets. It would not be at all surprising if the Fed’s balance sheet increased by $3 trillion this US year.
That is an increase of about 75 per cent, roughly equal to the cumulative increase over the entire decade that followed the financial crash. Those who claimed that central banks would not be relevant in handling this crisis could not have been more wrong.
Many investors (and, privately, some policy makers) are asking whether this degree of stimulus in the US and most other major economies can be “afforded”, or whether it will cause government debt crises and, later, rising inflation. If the answer to either of these questions is positive, markets could lose confidence in the ability of the authorities to cope with the coming recession and the results for asset prices could be gruesome.
Fortunately, this is unlikely to be the case.
A fiscal stimulus can be financed in three main ways. The government can sell almost unlimited quantities of treasury bills, and this is normally the first recourse in the case of an unexpected surge in the budget deficit. Slightly later, the treasury is likely to increase longer term debt issues, purchased by the public. Alongside that, the central bank may increase its purchases of government debt from the public, in effect “monetising” the deficit for as long as the central bank balance sheet is increased.
It is likely, in present economic conditions, that most of the rise in public debt will end up in the central bank balance sheet for a very long period. Even if not formally defined as “helicopter money” – and definitions scarcely matter in today’s health emergency – these actions would be likely to prevent any significant rise in long term interest rates. This would especially be the case if the major central banks follow the Bank of Japan in formally implementing yield curve control.
The good news is that this combination of fiscal and monetary stimulus is likely to result in larger ‘multiplier’ effects on economic activity than would be the case if long term interest rates were allowed to rise. Furthermore, with interest rates on long term debt now well below the probable growth in nominal GDP, government debt is unlikely to rise in an uncontrollable way, even if the central bank sells the debt back to the public one day.
The real reason why this form of financing could be dangerous is that inflation could start to rise. We discovered during the financial crash that increases in central bank money will not automatically cause this to happen, but this time there is a complex mix of supply and demand effects in the economy which could conceivably cause higher inflation.
For example, if supply continues to be constrained for a lengthy period, while consumers are enjoying a large increase in monetary transfers from governments, it is possible that aggregate demand could rise in an inflationary manner. In that case, it would be important for fiscal injections to be eliminated or reversed very quickly.
The world economy is fortunate that this crisis is coming at a time when inflation expectations are very well anchored at or below the central banks’ targets, and when lower oil prices will anyway be holding inflation down. This allows more leeway for allowing a temporary inflationary impact from the stimulus – should that occur, which is improbable anyway.
Today’s massive policy stimulus will not need to remain in place for as long as it did after the financial crash. For now, however, it is critical to prevent a global depression.