By Thomas Hoenig, courtesy of the Mercatus Center
The federal government and the Federal Reserve have implemented unprecedented spending and monetary policies to combat the economic crisis resulting from the COVID-19 pandemic. These policies, while necessary in the short term, place an ever larger mortgage against the nation’s future income; and extending them beyond the crisis period could have significant negative unintended consequences.
The recently enacted Coronavirus Aid, Relief, and Economic Security (CARES) Act authorizes federal spending to increase from approximately $5 trillion in 2019 to more than $7 trillion in 2020, and its budget deficit to increase from $1 trillion to nearly $3 trillion over this period. The federal debt, which was $23 trillion at the end of 2019, could exceed $26 trillion by the end of 2020—130 percent of GDP. The Federal Reserve, which has no constraint on its ability to create dollars, has increased its balance sheet liabilities from $4 trillion in 2019 to nearly $7 trillion today and could well increase them to $10 trillion by 2021.
These actions will provide capital and liquidity to businesses and consumers and will hold the line against a collapse in both aggregate demand and supply of goods and services. But once the worst of the crisis has passed and the economy begins to recover, these policies should be systematically wound down, or they risk compromising the economy’s long-run performance.
Learning from the 2008 crisis
To gain insight into these policies’ potential negative consequences, we can look back to the 2008 financial crisis and the highly expansionary fiscal and monetary policies that were extended for nearly a decade following it. Over the 2008–2018 period, the federal government increased spending and doubled its debt from $9 trillion to more than $20 trillion. The Federal Reserve lowered interest rates to near zero and, through quantitative easing (QE) programs, increased its balance sheet liabilities from less than $1 trillion to more than $4.5 trillion.
While such actions were judged necessary during the crisis, extending them years beyond the crisis contributed to a misallocation of resources and poor economic results. A policy of excessively low interest rates, for example, allowed consumers, businesses and government to more easily leverage their balance sheets, whereby total debt was 30 percent more in 2018 than in 2010, leaving the economy more vulnerable to shock. The series of QE programs arbitrarily changed relative yields among asset classes, distorting investment incentives. Whole industries used their cash or borrowed funds to buy back their own shares rather than invest in capacity or enhance products for which real returns had declined. Industry consolidations became more attractive and affordable because interest rates favored such combinations over other investment options.
Keeping interest rates near zero favored debtors over savers. Pension funds, which are often limited in the kinds of risk assets they can hold, became increasingly underfunded. Individuals with modest savings experienced significant reduction in income, while debtors borrowed greater sums at subsidized rates.
Although well intentioned, the highly expansionary policies that continued after the 2008 crisis culminated in disappointing economic performance for most of the following decade. Real GDP increased at an average annual rate of 2.3 percent between 2010 and 2018, in contrast to 3.8 percent between 1992 and 2000, a comparable period of stability following a recession. Gross fixed capital formation as a percentage of GDP averaged 20 percent versus the earlier period’s 22 percent, and labor productivity averaged annual increases of 1.1 percent versus 2.3 percent in the earlier period. Finally, real median weekly earnings for wage and salary workers increased an average of just over 0.26 percent per year between 2010 and 2018, compared with 0.70 percent per year between 1992 and 2000. The differences are telling. Despite all the extreme stimulus pushed into the economy for years following the Great Recession, the overall effect on real economic performance was unimpressive.
In contrast, the Dow Jones Industrial Average, boosted by the Federal Reserve’s maintenance of exceptionally low interest rates and its massive QE programs, more than doubled between 2010 and 2018. Other asset categories such as real estate celebrated similar price increases over the period. As a result, one of the more troubling effects of these policies was to increase the wealth divide between those who hold assets and the many wage earners who don’t.
The post-pandemic economy
Because of the current pandemic, the United States again faces extreme economic peril, and the federal government and Federal Reserve again are spending aggressively and creating whatever dollars it takes to mitigate this peril. These actions are understandable, but policymakers must prepare now to exit these programs and avoid exposing the economy to their unwelcome effects should they remain in place too long. The stakes are high.
Withdrawing extreme levels of stimulus at the right pace is an almost overwhelming challenge. As difficult as the policy choices have been up to this point, they will be equally difficult in the months ahead. Accelerated spending and liquidity programs will likely end, but pressure will remain to keep spending elevated. Moreover, the higher spending levels are unlikely to be funded with tax increases for fear of prematurely slowing the economy. As a result, government deficits will likely remain unusually large, and debt levels will continue to increase as a percentage of GDP.
Monetary policy also will be difficult to wind down. There is an expectation that as long as inflation remains in check, the Federal Reserve can keep interest rates near zero to stimulate the economy and keep the cost of government borrowing low. But as experience suggests, continuing with massive QE programs and low interest rates risks badly misallocating resources and undermining long-run economic growth. And despite the absence of inflation now, a policy of sustained high levels of money creation carries a real (though perhaps low) risk of future inflation.
To avoid these unwanted effects, once the crisis is under control and the recovery underway, policymakers must turn their attention from the immediate to the future. They should cautiously but deliberately unwind recent extreme actions. Government spending, for example, should slow to a pace at which its debt increases at a rate consistently lower than GDP. This rate has been achieved in the past—for example, with pay-go rules that require new spending initiatives to be paid for with savings from other programs. Such rules don’t require a balanced budget, but when they are implemented with discipline, deficit spending declines, enabling the economy to grow out of its debt burden.
As federal government spending is brought under control, the Federal Reserve can focus on its mandate to achieve maximum long-run economic growth and stable prices. It can regain control of its balance sheet and allow interest rates to reach levels consistent with the nation’s growth potential, independent of the government’s need to finance large deficits at artificially low borrowing costs. This policy will have the added benefit of reducing the adverse distributional effects that an artificially constructed low interest rate structure imposes on savers and wage earners.
National policy must address the crisis at hand, and most policymakers agree that the current economic stimulus programs are necessary. If such policies remain too long in place, however, their overall effects will be negative, including lower GDP growth and a greater disparity in wealth among US citizens. These policies portend a poorer future and greater economic uncertainty, and they will ultimately undermine economic and political stability. Implementing them with moderation and a strategy for a timely exit, however, will best avoid these unwanted outcomes and promote economic growth.
Thomas Hoenig is a Distinguished Senior Fellow at the Mercatus Center at George Mason University. His research focuses on the long-term impact of the politicization of financial services as well as the effects of government granted privileges and market performance.