Laurent Ferrara, professor of international economics at SKEMA Business School, and Daniele Siena, adjunct professor of economics at the Catholic University of the Sacred Heart of Milan, explain the consequences of the American stimulus plan on the world economy.
The COVID-19 recession has drawn a robust response from American economic policy, avoiding a too-strong fall in economic activity. The latter decreased by 3.5% in 2020, compared with the figures of 6.8% for the eurozone and 9.9% for the United Kingdom. The American Federal Reserve first increased measures to ease its monetary policy by rapidly lowering its key interest rates to what it considers its effective floor (0%-0.25%), and by developing unconventional measures such as the purchase of securities in the marketplace or aid to banks in the provision of liquid assets to businesses.
The most spectacular reaction, however, came from budgetary policy. In the wake of a $900 billion plan approved at the end of December 2020, the administration of President Joe Biden initiated, in March 2021, a second stimulus amounting to $1.9 trillion, centered on households and at an increase in public spending at the federal and state levels. The budgetary stimulus thus reached, in total, 13% of GDP.
Biden then almost immediately announced an investment plan, with the objective of enhancing growth potential, and a plan for families and education. The United States seems thus to be seeing a new “Rooseveltian moment.” Economists then questioned the effects of a stimulus of such size on the American economy, wondering if it wasn’t going to overheat. They are also beginning to question the worldwide consequences of these two plans.
Consumer of Last Resort
So far, in the first quarter of 2021, the American GDP shows a growth of 1.6%, and growth anticipated by the International Monetary Fund for 2021 is on the order of 6.4%. Three percentage points seem imputable to the Biden plan. On the price side, inflation grew in April (+4.2%), especially due to base effects (this growth is calculated in relation to a weaker base than usual, the rate of inflation in April 2020 in the middle of the COVID-19 crisis not surpassing 0.3%) and to bullish pressures on energy prices (the price of oil increased nearly 50% over 12 months).
Nonetheless, expectations for inflation remain stable, permitting one to contemplate, for the moment, a temporary effect. Nothing surprising here, as empirical research generally notes such effects on the national economy of a budgetary stimulus, simultaneously on prices and business. Beyond the American frontiers, the international effects also deserve to be examined, the United States being in particular generally considered as the consumer of last resort of the world economy. In spite of attempts at relocating production and of trade war led by the Donald Trump administration, the American economy imports a large part of its consumption, especially goods. In 2020, the American trade deficit increased to $679 billion, or 3.2% of GDP, up from 2019 (2.9% of GDP).
As a result, when the American government undertakes a budgetary stimulus, a “flight of imports” falls into place that will benefit the whole of the world economy, in particular countries that export a great deal to the United States and will benefit from spiked American consumption. In its last interim economic outlook report, the OECD, using a macroeconomic model, figures on around one percentage point of gain over the growth of world GDP in 2021, which would thus be close to 5.6%. Unsurprisingly, Canada and Mexico would profit the most from this stimulus, with an anticipated increase in their output between .5 and 1% in 2021, while the Eurozone and China would realize an increase of between 0.25 and 0.5%.
Increase in Long-Term Rates
Historically, one has generally been able to observe a Fed-directed increase in interest rates following a budgetary stimulus in order to curb inflation. That, in turn, leads to an increase in long-term rates, notably the sovereign 10-year rates on which the American state runs up debts. In the current environment, the nominal American 10-year rate has gained more than 70 basis points (hundredths of a percent) between January and April 2021, before again losing slightly to settle at around 1.6% in mid-May.
Nonetheless, this phenomenon doesn’t seem today to be caused by expectations of rate increases because the Fed has insisted repeatedly that it would maintain a policy of low rates for a while longer. Notably, according to the intermediate projection of the Federal Open Market Committee, the key interest rate should remain at around 0.1% through 2023.
Nor is it linked to a monetary policy strategy that the Fed and its president, Jerome Powell, have modified since August 2020. An average inflation of 2% over time is now sought. Since price developments have been below the target over the recent period, that implies that the central bank will tolerate an increase above 2% for some time. Further, short of a very strong inflationary push and an uncoupling of inflation expectations over the long term, the Fed is unlikely to raise its key rates in the medium term.
So, what is the explanation? According to recent work of the IMF, two factors could be at the root of the increase in nominal American sovereign rates since January 2021. First, markets anticipate an increase of inflation in the medium term, driven by prospects for American growth, the increase in international prices (raw materials, transports, etc.), bottlenecks in certain sectors for lack of manpower and the Fed’s accommodating monetary policy, even if expectations remain well-entrenched over the long term (around 70 basis points), reflecting a strong uncertainty as to the economic, budgetary and monetary scenario over the next 10 years.
American government bonds are known to influence global securities on international markets. Thus, like the spread of a disease, an increase in long-term rates has been observed since the beginning of 2021 in the major economic areas, notably in the Eurozone and in emerging nations. Additionally, the increase in long-term American rates generally tends to have negative effects on certain emerging countries that finance themselves on foreign markets and thus see their financing terms become harsher.
Rebound of the Dollar
As for real exchange rates, most economic theories agree that this must increase following an increase in government spending, a prediction that the empirical literature does not, in general, confirm. It underscores that the results often depend on characteristics of countries such as the level of development or the exchange-rate regime (fixed or floating).
In a recent work on the American economy, carried out by two researchers at the Bank of Italy, we used military expenditures as an instrumental variable to seek to identify without bias the cause-and-effect relationship between the increase in budgetary expenditures and its economic effects. We show that following a budgetary stimulus, effective dollar exchange rates tend to increase relative to the currencies of the major trading partners.
As inflation is also expected to increase, the nominal exchange rate of the dollar should also increase following a budgetary shock. During the COVID-19 recession, the real effective exchange rate of the dollar decreased around 10% because of worries over the Trump administration’s management of the health crisis. That rate regained 2% between January and March 2021. Even if the exchange rate remains one of the most difficult economic variables to foresee, according to our model, it is plausible to anticipate a rebound in the real effective exchange rate of the dollar following implementation of the Biden plan.
That would contribute correspondingly to a deepening of the trade deficit while increasing the cost of American exports. On the other hand, this increase could destabilize dollar-indebted emerging countries. That could give some ideas … Other channels of international communication can be underway during a fiscal policy shock. Several research works have notably shown that the United States generates uncertainty at the global level.
Thus, the implementation of the Biden plan and its expected positive effects on growth are going to lead to a reduction in economic policy uncertainty in the short term in numerous countries. On the other hand, the increase in public debt has escalated uncertainty over the long term, with possible international implications. The channels of spread of Keynesian ideas could also become active. The fact that the largest world economy is embarking upon a policy of large-scale public expenditures might well induce other countries or monetary zones to significantly loosen their budgetary constraints in view of this unprecedented health shock.