Can the world afford stimulus on this scale?

The fiscal and monetary stimulus announced by major world economies in the past month is an unprecedented global political event in peacetime.

The only increase in budget spending and loans in the United States this year will reach more than 10 percent of gross domestic product, more than the increase in the federal deficit between 2008 and 2009. Although this is likely not as large as the financial stimulus implemented by China after the financial crash 12 years ago, most large economies could see public debt-to-GDP ratios increase by 10 to 20 percentage points.

The impact of central bank injections will also be enormous. For example, the US Federal Reserve can finance part of the country’s fiscal stimulus by purchasing treasury bills. In addition to this, its balance sheet will increase purchases of mortgage bonds and private loan asset sets. It would not be surprising if the Fed’s balance sheet increased by $ 2 billion to $ 3 billion this year, up from $ 4.2 billion at the end of 2019.

This is similar to the cumulative increase over the entire decade following the financial crash. Those who claimed that central banks would not be relevant to manage this crisis could not be more wrong.

However, many investors – and, privately, some policymakers – question whether this level of stimulus from the United States and most other large economies is “affordable”, and whether it will lead to public debt crises and a subsequent increase in inflation.

If the answer to any of these questions is “yes”, markets could lose confidence in the authorities’ ability to weather the coming recession. The results for asset prices would be horrible.

Fortunately, this is unlikely to be the case.

Budget stimulus can be funded in three main ways. The government can sell almost unlimited amounts of short-term treasury bills. This is normally the first recourse in the event of an unexpected spike in the budget deficit.

A little later, the Treasury could increase the sale to the public of longer-term debt issues. At the same time, the central bank can also increase its purchases of public debt from the public, which “monetizes” the deficit as long as the central bank’s balance sheet increases.

Given the current economic conditions, it is likely that part of the increase in public debt will be reflected for a long time on the balance sheets of central banks. Even if they are not formally defined as “helicopter money” – and definitions hardly matter in today’s health emergency – these actions would likely prevent any immediate rise in long-term interest rates. This would be particularly true if the major central banks followed the Bank of Japan in the formal implementation of the yield curve control.

The good news is that this combination of fiscal and monetary stimulus is likely to have greater “multiplier” effects on economic activity than if long-term interest rates were allowed to rise. In addition, interest rates on long-term debt remain well below the likely growth in nominal gross domestic product.

As a result, public debt is unlikely to increase uncontrollably, even if the central bank sells the debt to the public someday, possibly increasing bond yields and increasing the cost of financing debt.

The bad news is that this form of financing can be dangerous if inflation starts to rise. We discovered during the financial crash that the increase in central bank money did not automatically cause this. But today there is a complex mix of supply and demand effects at work, and together they could drive up inflation.

For example, if supply continues to be limited while consumers simultaneously receive large government transfers, aggregate demand could increase in an inflationary manner. In this case, it would be important for the budgetary injections to be eliminated or reversed quickly.

Fortunately, the global economy has three factors in its favor. First, this crisis comes at a time when inflation expectations are well anchored at or below central bank inflation targets.

Second, falling oil prices are helping to keep inflation down anyway. Both allow more leeway for a temporary inflationary stimulus impact – if any, which seems unlikely anyway.

And third, the massive coronavirus stimulus will not need to stay in place as long as it did after the financial crash.

For now, the most critical job is to prevent a global depression.

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