The former Secretary of the Treasury Lawrence Summers is mistaken to caution against another large stimulus bill out of fear of overheating the economy. First things first: what does it mean for an economy to overheat? How does this happen?
Economists separate the economy into two groups of people: buyers (jargon: aggregate demand) and sellers (jargon: aggregate supply). The economy exists in some state of equilibrium, where sellers and buyers are happy to exchange goods for money. This equilibrium moves as aggregate demand and supply move.
Aggregate demand can be shifted by government policy or changes in income, for example. Aggregate supply is generally tougher to move, shifting in response to changes in productivity, the cost of input materials and labor market conditions. In the case of a recession, aggregate demand is weaker, as unemployment numbers climb, salaries are cut and individuals cut back on spending.
Keynesian economics calls on the government to push up aggregate demand through stimulus.
Overheating refers to concerns that aggregate demand is being pushed too far. Economic theory predicts that this could cause inflation to trek upwards into unhealthy levels, and this would force the government to cut back on spending and raise interest rates to restore order.
This restoration of order would cause some sort of a recession, similar to the experience of the early 1980s, and would ultimately push unemployment back up while dragging down incomes.
When was the last time the economy overheated?
The best answer would be toward the end of the 1970s, when a very different set of circumstances pushed the economy into stagflation — simultaneously high unemployment and inflation. Since then, the economy has at best only come close to even beginning to overheat.
Only at the turn of the millennium and in late-2006 through early-2007 has the economy’s output pushed against its potential. Even then, though, inflation did not take off. Not even in the wake of approximately $900 billion in federal stimulus in the midst of the Great Recession did inflation take off.
Interest rates have been at historic lows for a decade. Washington, D.C. has run large deficits incessantly for nearly two decades now. And yet, despite these facts, recovery from the Great Recession seemed to only be entering its final stages nearly a decade after it began.
If none of this could drive the economy to overheat, I think there is still plenty of operating room. This was supposed to be one of the big lessons from the experience of the Great Recession: Do not pull back on stimulus too early, to fear undershooting rather than overshooting.
Summers rightfully acknowledges that the stimulus in 2009 was too small, and yet he is still concerned about providing too much relief. We have not really done much to truly stimulate the economy yet. The bills so far were more about relief than stimulus.
Unlike traditional stimulus bills, there were no big construction plans and no big tax cuts. Instead, they were focused on pressing pause on the economy, and providing relief to those financially affected (for example, the extra unemployment payments and the Paycheck Protection Program).
The forthcoming bill is similarly more about relief than about stimulus, as the economy as we knew it before the coronavirus disease (COVID-19) is still unable to function the same as it did. People still need assistance, airlines need help, venues need grants and small businesses need funds to cover payroll.
To deny needed relief to these groups in the name of preventing an incredibly unlikely overheat of the economy is reckless. Relief is needed, as the economy cannot be fully restored until the health crisis subsides. Relief will not overheat the economy as this is not a normal demand-side recession, but a supply-side one resulting from COVID-19-related restrictions.
We should set policy to provide as much relief as possible to businesses on the supply side to prevent spillover onto the demand-side and provide benefits like child tax credits and unemployment benefits to the many who need it.
Another lesson from the Great Recession was that sometimes even the best and brightest economists are poor forecasters of the trajectory of the economy. Perhaps market-based forecasts should be trusted more, as they reflect the expectations of actual participants in the economy.
Market forecasts of inflation do not see high inflation around the corner. Indeed, they accurately did not forecast high inflation at any point during the Great Recession and its recovery, countering the predictions of high-and-mighty doctorate economists — including Summers.
It is a little foolish to worry about overheating the economy at this point. Better concerns would be about successfully negotiating a stimulus/relief package that works best for those who need it most. It would be much better to overshoot than to undershoot.
The first two bills, from March 2020 and December 2020, were a tremendous success, though of course imperfect — one can only hope this success can be replicated without needless pushback over overheating concerns.
Taylor Shiroff is a School of Arts and Sciences junior majoring in economics and minoring in mathematics and political science. His column, "Policy Matters," runs on alternate Thursdays.
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