Why Biden’s plan will fail

US President Joe Biden, facing the challenge of stimulating the economy for a post-pandemic era and haunted by former president Barack Obama’s tepid stimulus in the face of the Great Recession a decade ago, has decided to err on the side of overshooting. He wants to “go big” with a $1.9-trillion spending plan. Prominent centrists warn that Biden’s decision may prove his undoing. They argue that too much stimulus will trigger an inflationary surge, resulting in an interest-rate spike that will force his administration to slam on the austerity brakes just before the midterm elections in 2022, costing his Democratic Party control of Congress.

The problem with this debate is that both supporters and critics of Biden’s stimulus plan assume that there is a dollar amount that is big enough, but not too big. Where they disagree is on what that figure is. In fact, no such figure exists: every possible stimulus size is simultaneously too little and too big.

To see why there can be no “Goldilocks” stimulus that gets the amount “just right”, it helps to engage those who argue that the proposal would overheat the economy and hand the Republicans the midterms. Central to their prediction is the assumption that there is also a Goldilocks interest rate and a corresponding stimulus size that will deliver it.

Just right

What would render any rate of interest “just right”? First, it would achieve the right balance between available savings and productive investment. Second, it would not unleash a cascade of corporate bankruptcies, bad loans and a fresh banking crisis. But it is not at all clear that there is a single interest rate that can do both.

Once upon a time, there was. In the 1950s and early 1960s, under the Bretton Woods system, an interest rate of about 4% did the trick of balancing savings and investment while keeping bank profitability at a level that allowed credit to reproduce itself sustainably.

Alas, we no longer live in that kind of world. The reason capitalism no longer works like that is the manner in which the Obama administration, aided by the Federal Reserve, refloated sinking Western banks in 2008.

As in 1929, bankruptcies, unemployment and falling prices meant no one was willing to borrow. Interest rates nosedived to zero and capitalism fell into what John Maynard Keynes referred to as the “liquidity trap”.

Disconnect

The great difference between 1929 and 2008 was that in 2008 the banks were not allowed to fail. One way to save them was a large-enough fiscal stimulus. Direct injections of freshly minted money to consumers and firms – to pay off debts and to increase consumption and investment – would have refloated Main Street and, indirectly, Wall Street. This was the road not taken by the Obama administration.

Instead, the Fed printed trillions of dollars, and the failing banks were refloated directly. But though the banks were saved the economy was not freed from the liquidity trap. Banks lent the new money to corporations but, because their customers were not refloated, managers were unwilling to risk ploughing the money into good jobs, buildings or machines. Instead, they took it to the stock market, causing the largest-ever disconnect between share prices and the real economy.

Corporations became hooked on (almost) interest-free credit and rising stock valuations that flew in the face of low profits. Total savings dwarfed investment, aggregate wages were at an all-time low and consumer spending remained subdued. And then Covid-19 arrived, dealing major blows to both the supply and demand sides of the economy.

A successful stimulus must bring investment closer to the level of available savings. But the moment financial markets get a whiff that this is about to happen, they will push interest rates up to a level reflecting the better balance between savings and investment. Immediately, corporations hooked on low interest rates will face ruin; so will their bankers.

In theory, this can be prevented if the stimulus simultaneously boosts incomes and consumption, so that corporations’ rising income can compensate for the rising interest rates. But, in practice, there is no time for corporations to be weaned off their dependency on low interest rates. Any stimulus takes a lot longer to stimulate incomes than it does to boost interest rates.

The combination of the liquidity trap and 12 years of dependency on near-zero interest rates has seen to it that any fiscal stimulus now, whatever its size, is bound to fail.

“Going big” might have worked in 2009, but in 2021 Biden must go beyond fiscal stimulus. Whatever quantity of money he pumps into the US economy, he will fail unless he does what is necessary to lift the spending power of those who have next to none: a decent minimum wage, compulsory collective bargaining and direct unconditional payments. Project Syndicate

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Yanis Varoufakis, a former finance minister of Greece, is leader of the MeRA25 party and professor of economics at the University of Athens.