By Scott Sumner
The second quarter of this year saw what is probably the biggest fiscal stimulus in American history, in terms of increase in the budget deficit. And today we see the results: nominal GDP fell by 34.3% at an annual rate. That means the fiscal stimulus prevented a much bigger fall in GDP—right?
Well, that might be true, but how would we know? We have models, but these models certainly don’t predict that NGDP would fall at a 34.3% rate in a quarter where disposable income is actually rising. And not just rising, but (according to the BEA) rising at an almost insane annual rate of 42.1%. In real terms it was even higher, due to deflation:
Real disposable personal income (DPI)—personal income adjusted for taxes and inflation—increased 44.9 percent in the second quarter after increasing 2.6 percent in the first quarter.
Why do I mention disposable income? Because the models that predict fiscal stimulus will boost the economy are based on a transmission mechanism that runs from more fiscal stimulus to more disposable income to more spending. Thus our (Keynesian) models don’t really explain why NGDP fell so sharply in Q2. Indeed, if anything these models predict an extraordinary boom.
You might respond that our common sense does provide an answer—people were afraid to go out shopping due to the virus. I accept that theory. But as far as I know there are no models that predict fiscal stimulus will be effective when people are afraid to go out shopping. And with the new Q2 GDP data there is also no empirical evidence that fiscal stimulus boosted GDP.
Before discussing the policy implications of all this, a few caveats:
1. Yes, I understand “ceteris paribus”. It’s plausible that the fiscal stimulus had some positive effect. After all, even during periods where the virus is the dominant factor, disposable income does matter at the margin.
2. A very large budget deficit in Q2 was appropriate, as standard public finance theory says you should take in less tax revenue during a severe slump, and spend more on unemployment compensation. Then there’s spending on the virus itself. I accept all of that. A big deficit was inevitable and appropriate.
What I question is the part of the deficit that was motivated solely by the desire to boost disposable income. For instance, why give $1200 to middle class people with stable jobs who were actually benefiting from a decline in the cost of living? That seems like wasted ammunition. What were they expected to do with the money? Why not just do enough stimulus to keep disposable income stable, if the problem is that people are afraid of spending? Why a 44% (annualized) real increase?
In fairness to the other side, the fiscal stimulus this time around was larger and timelier than I expected. I would have expected gridlock in DC to slow the process. Nonetheless, it seems plausible to me that the massive fiscal stimulus was mostly wasted, due to the reluctance of people to spend. Ironically, this might be the one recession where it would have been better to delay the fiscal stimulus until 2021. If we get a vaccine this winter (which experts seem to think increasingly likely) then perhaps people will become more willing to shop in 2021. That’s when the fiscal stimulus might have been effective, at least if you buy the underlying Keynesian model.
For myself, I believe monetary stimulus would be more effective in boosting the economy in 2021, at a much lower cost. Monetary and fiscal policy are very different. Monetary stimulus does not exhaust ammunition; rather it actually creates ammunition by raising the natural rate of interest. Fiscal stimulus really does exhaust ammunition.
Despite the preceding comments, I actually believe the economy received too little stimulus in Q2 of this year. I would have preferred to see monetary policy be expansionary enough to prevent disinflation. It wasn’t. So I’m not one of those conservatives who argue that “stimulus” doesn’t help in a slump. Rather, I favor monetary stimulus (which is basically costless) over fiscal stimulus that imposes a heavy burden on future taxpayers. If there’s a vaccine this winter, then I believe that monetary stimulus alone (done properly) could give us a V-shaped recovery.
In the past, I argued that fiscal stimulus did boost GDP in Q2 of 2008, but did not boost GDP for 2008 as a whole. That’s because the Fed responded to Bush’s spring of 2008 tax rebate by tightening money to slow inflation (CPI inflation peaked at 5.5% in mid-2008.) The rest is history.
In my view the recent fiscal stimulus did slightly boost NGDP in Q2, but the gains are likely to be taken away in 2021. We’ll do a bit less monetary stimulus in 2021 because of all of the fiscal stimulus done in 2020, money that was basically wasted.
PS. Yes, the unannualized drop in NGDP was much smaller than 34.3%, but still pretty horrific by historical standards.