Tuesday 16 February 2021

Points experts

Decoding - US economy: overheating after the freeze?

The $ 1.9 trillion spending package (or roughly 9% of GDP) that the Biden administration wants to push through causes a lot of ink to flow among economists because it may give birth to economic overheating. We review here the main stumbling blocks of the debate and the variables that have to be monitored with regard to the labor market.

Overheating: the key question of potential GDP and multiplier effects

The world of economists has been in turmoil since an op-ed written by Larry Summers, former Treasury secretary to Bill Clinton, in the Washington Post on February 4. In it, he indicates that the $ 1900 bn spending package that the Biden administration wants to pass as early as March via a budget reconciliation procedure (for which a simple majority is required in the Senate) could lead the US economy to “overheat” in the second half of 2021. Details of the package are currently being worked out in committees of the House of Representatives and of the Senate.

 Summers’s fear, even as he praises the progressive nature of the Biden plan, is that it would be oversized. According to the latest CBO projections, real GDP in the US would be $ 250 bn below its potential at the end of 2021 in the absence of this Biden plan. For Summers, the $ 1900 bn spending package would therefore push economic activity far beyond its potential, which would create two risks:

  •  “There is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation”,
  • It could hamper the ability of the Biden administration to make significant public investments afterwards (eg green investments).

Former IMF chief economist Olivier Blanchard quickly made it known that he shared Summers' fears, adding that activity in 2021 would also be stimulated by the massive excess savings accumulated by households in 2020 ($ 1600 bn more saved by households compared to 2019). For Blanchard, assuming a multiplier effect of 1 for the Biden plan and assuming that half of the 2020 excess savings is spent in 2021, GDP could be 14% above its potential. To have an idea of the scale of the matter, just consider that the output gap, that is to say the deviation of the GDP from its potential, has been at most 6% since 1950 ... For Blanchard: “It would take the unemployment rate very close to zero. This would not be overheating; it would be starting a fire.”

 Summers and Blanchard therefore argue for a more limited spending package, but they both acknowledge that there is considerable uncertainty, both on the estimate of potential GDP and on the effect the plan will have on the economy. It could be that the potential GDP is higher than what is generally estimated today but also that a significant part of the Biden plan, for example direct payments to households or the unemployment benefit supplement, would be saved. After all, a Census Bureau survey indicates that $ 600 checks paid directly to households in January 2021 (as part of the $ 900 bn plan adopted in December) would have been "mostly spent" in 26% of cases, "mostly saved” in 24% of cases (the share is higher for wealthier households) and “mainly used to repay debts” in 50% of cases. By assuming multiplier effects much lower than what Blanchard suggests and more in line with what has been observed historically, Wendy Elderberg and Louise Sheiner, two economists from the Brookings Institution, estimate that the output gap could reach at most +2.4%, which would still be the highest level for half a century. That said, their simulations do not take into account a possible use of the excess savings accumulated in 2020.

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Bastien Drut

Chief Thematic Macro Strategist at CPR AM