Beware The ‘Post-War Hangover’ From Misguided Government Belt Tightening

What’s the biggest risk to the macroeconomic outlook in 2021 and beyond?

To answer that question, one really has to assume that vaccine rollout goes according to plan and that no biological black swan (e.g., a mutation in the virus) splashes down, derailing the best-laid plans of mice, men, and modern science.

That may not be a safe assumption, but if you don’t start from that, everything else is, at best, trivial. At worst, unexpected developments on the public health front would render forecasts totally irrelevant.

Outside of a bungled vaccination push or another intervention from Mother Nature, the biggest risk from here is that developed economies fall victim to misguided efforts to “correct” for the government spending associated with the pandemic.

There’s no shortage of warnings about this. Economists generally recognize (with the benefit of hindsight) that a lackluster fiscal impulse following the initial response to the financial crisis was in part responsible for a sub-par recovery and also served to put too much of the onus for sustaining growth on central banks, with predictable results in terms of asset prices bubbles and inequality.

Lawmakers in the US are quite obviously predisposed to making the same mistake again. Just ask Mitch McConnell and some hardline Senate Republicans, who seem to believe that going forward, the only “good” stimulus is money for businesses and liability protection for employers, with the latter not really being “stimulus,” but rather a legal shield that could conceivably reduce the incentive to ensure workplaces are safe.

Public sector belt-tightening on the excuse that developed economies must immediately “get their fiscal house in order,” will invariably mean central banks double-down in their efforts to support the recovery, assuming growth doesn’t magically explode higher and stay there (an outcome that seems exceptionally unlikely). In that scenario, the results will just be more asset bubbles and wider inequality.

Politicians have variously described a “war” on the pandemic and the associated government spending as akin to “wartime” outlays. There’s more than a little irony in that, considering, as Rabobank’s Michael Every and Christian Lawrence point out, “despite often being dubbed ‘a war’, the quandary of battling COVID-19 is that it requires restraint in economic activity, albeit mostly in services rather than the goods sector.”

But let’s assume the war analogy is valid for some purposes. Every and Lawrence note that “after World War I, the US did not see a boom but a bust… as the government rolled back spending and the private sector failed to fill that gap.” They flag “a similar pattern” after World War II. “Initially there was a sharp slump as huge public spending into war industries was reversed,” they wrote, in a note dated Monday. “Indeed, GDP did not start to pick up strongly until around 1950.”

On the bright side, thanks to the unique nature of the “war” against the pandemic, economies head into the new year without an overhang. That is: Rather than being juiced, supply and demand have been depressed.

Every and Lawrence (with an emphasis on Every, because this sounds like his cadence) somewhat darkly note that “the starting base is good in that we don’t have excess wartime production, except perhaps of ventilators or office space.”

Then, they get right to the heart of the problem. After observing that monetary policy is at or near its limits (or at least at or near the point of diminishing returns for everything other than financial asset prices), they ask whether fiscal policy will “help or hurt” from here. The answer, they suggest, is that it will hurt.

“The traditional economic advisors around governments are not embracing” the notion that expansion of central bank balance sheets to accommodate government spending will likely never be unwound, they said, adding that “as after every war, there are already signs that more traditional fiscal and economic thinking is going to try to reassert itself.”

That is a mistake on the part of policymakers, something I emphasize nearly every, single day.

“‘Belt tightening,’ ‘dealing with the debt,’ or ‘balancing the books’ is the message — not that most extraordinary state spending due to the virus has been de facto covered by central bank debt monetization, just as it is during a real war!,” Every and Lawrence went on to exclaim, before asking the only questions that really matter. To wit, from the same note:

Almost certainly, fiscal deficits as a % of GDP will be much smaller in 2021 than they were in 2020. And as the government pulls money out of the economy on a net basis, is the private sector ready to put more than that *in*? Will they have confidence and output automatically ‘bounce back’ as neoclassical economic theory assumes? Or will a lower net flow of public spending, or even just public spending lower than is required to boost confidence, prevent that bounce from happening?

Although it’s not possible to answer those questions definitively ahead of time, history suggests the answers may be, in order, “No,” “No,” and “Yes.”

The likelihood that those answers will prove to be correct isn’t lost on Every and Lawrence. “Both WW1 and WW2, as well as the 2008 crisis, show the risks of reducing fiscal stimulus too soon,” they cautioned. “Doing so would mean a post-war hangover, not a post-war party awaits.”