The Full Employment Limit of Broad Stimulus Effectiveness

This morning we get more non-sense from the banks yet again: they trimmed their GDP forecasts for 2022 by -100bps (-1%) because of the demise of the BBB bill. In their Keynesian thinking, if you remove stimulus spending, the economy will go down. This is wrong, it is very superficial and simplistic thinking. Here is what they get wrong:

When you have a recession, you need to stimulate the economy with broad stimulus. The decline is broad-based and affects every sector the economy and therefore the stimulus needs to be broad. You need to leave it to the Private Sector to reallocate capital to the new industries from the old industries during the recession. This is what Larry Summers screwed up in 2009: instead of giving broad stimulus in a recession, Larry Summers gave targeted stimulus. If you give targeted stimulus in recession, some parts of the economy will never recover because they aren’t stimulated by government and the private sector doesn’t have the money/savings to recover them either. That is how we got into a state of permanently lower growth after 2008. You need to give broad stimulus and give the private sector the money and ability to reallocate funds to sectors in need. In 2021, Ron Klain did it correctly by pushing through broad stimulus with the American Rescue Plan (ARP) and that is why today the economy is in top shape.

However, when the economy recovers fully and the labor market has no more workers in it (the output gap is closed), further broad based stimulus increases inflation without increasing the productive capacity of the economy. If you pour more money on an economy whose output is fixed, you simply get a higher price level. That in turn obliterates the savings that have been accumulated. When you obliterate savings, you reduce the private sector’s incentive to work and save. When people don’t want to work anymore, you reduce the aggregate capacity of the economy. Thus broad stimulus in an expanding economy is counterproductive – it reduces the productive capacity of the economy through the inflation channel.

That is why communism doesn’t work – forever broad stimulus to everybody doesn’t work in the long run. Broad stimulus only works in recessions. It doesn’t work in economies operating at their full capacity. I will use the following analogy: pouring gasoline on a fire only makes the fire bigger. You can’t do that when the fire is already big. While pouring gasoline on embers helps the embers turn into a fire that heats you in your fireplace, pouring more gasoline on an already big fire enlarges the fire beyond the fireplace and burns down the house. Long story short: you can’t overdo broad stimulus.

Therefore, once the economy gets to expansionary phase the government has to move from a policy of Broad Stimulus to a policy of Targeted Stimulus – only stimulate the parts of the economy that are hurting and be very careful not to disrupt what is already working. The inflation we are seeing today is because the government continues to apply broad stimulus (Childcare Tax Credit or CTC) to an economy that is already at full capacity by many measures (unemployment rate is 4%). Continuing that broad stimulus policy next year and beyond will further impoverish the population without achieving higher output. Broad stimulus needs to be scrapped here and that is what Manchin is doing by killing the BBB. What Manchin was trying to get the idiots in Progressive Caucus to understand for the last 6 months is that you need to start targeting stimulus once the economy has recovered. But the Progressives are ideologues, they simply don’t understand the practical limitations of broad stimulus policy. Progressives think because it worked it in 2021, it will work in 2022. That’s not how it works, comrade. And that is why we have this negotiation debacle.

Another thing that Goldman gets wrong here is a little more subtle: the labor market is at full capacity today only because of universal basic income (UBI). The CTC is UBI. If you remove UBI, there will be new entrants into the labor force because these people will need to replace their income. There is clearly 5 million people who are still out of work today. At least 50% of those (2.5 million people) can be brought back to work with the right policies – which is removing their subsidy. Thus removing UBI here actually EXPANDS the productive capacity of the economy by expanding the labor pool. If you expand the labor pool and thus the economy’s productive capacity, GDP will go up, not down. You simultaneously lower inflation and increase output. Thus killing BBB here is actually the right policy for the economy and good for GDP. I know Goldmanites aren’t really experts in MMT and they are learning it real time, but no worries, it is simply time for yet another lesson. 2021 taught Goldman one lesson (broad stimulus works in recession really well) and 2022 will teach it another (removing UBI expands GDP when economy is in expansion). Instead of lowering their 2022 GDP projection by -1%, Goldman should be raising it by +0.5%.