With President Biden’s proposed $1.9 trillion package looking likely to pass through budget reconciliation, it’s worth considering the macroeconomic consequences of such massive spending. This is on top of the $2.2 trillion CARES Act in the spring of 2020 and a further $900 billion of pandemic-related relief passed right at the end of 2020. The bottom line is that this new spending is unlikely to cause an inflationary event or meaningfully replace private sector investment.

Full Employment

To start, it’s helpful to understand the framework that the Federal Reserve, Congressional Budget Office, and most mainstream economists use to think about when an economy is “overheating” and when we should fear inflation.

Economists have a concept called “full employment” – the point where everyone who wants a job and is capable of working has found a job. Full employment does not mean an unemployment rate of 0% because it includes both “frictional” and “structural” unemployment: Those who are in between jobs in the natural churn of a dynamic labor market, and those whose skills do not match the needs of the economy right now (we’re not too worried, rightly or wrongly, about people whose skillset is exclusively making VCRs). When the unemployment rate is higher than full employment, economists say the labor market has “slack.” Slack is idle labor sitting around not fulfilling full potential. These are people who could be productive and want to work, but for whatever reason are not employed. During a recession or financial crisis, you can easily observe ample slack: Tons of people are out of work who only recently were very capable of working.

A recession leads to what Keynes called the “paradox of thrift” where an economic slump causes businesses and households to be risk-averse and cut back on spending and investment. This means less aggregate spending in the economy that leads to fewer people being employed, and it becomes a vicious cycle. But when there’s slack in the labor market, government spending can put these people to work. This increased spending will, in theory, get more people back to work and get the labor market back to full employment. It will also give people more confidence to spend again. The Federal Reserve can also use monetary policy to increase investment. In the simplest explanation: The Fed makes it cheaper to borrow and easier for banks to lend out to households and businesses.

But what happens if we try to go past full employment? This is the concern from skeptics of the latest $1.9 trillion fiscal package. When everyone who wants a job and is capable of working has a job, businesses need to compete with each other for workers by raising wages. In a lot of ways, this is great! When we have a “tight labor market,” bargaining power shifts to workers and they can demand higher wages. When there’s a lot of slack, workers have less bargaining power because employers have a lot of readily willing people to choose from and don’t have to compensate as well. But when we’re at full employment and there continues to be an increase in spending, the economy is then “overheating.” Businesses raise wages and then raise their prices. When both of these are going up, we have what is popularly called “inflation.”


It’s important to take a slight detour here to describe what inflation is and what it is not. Usually in the press we see inflation defined by the year-over-year increases in the Consumer Price Index, which is a price index of a basket of stuff that your typical American buys. But a big jump in CPI on its own is not inflation. Sometimes it’s because of mathematical quirks, sometimes it’s because of a relative price change. For inflation to be true inflation, it needs to be what was described above: A persistent acceleration of both wages and prices.

You might remember that in the spring of 2020, oil prices on some financial markets went below zero. This is important because when CPI is reported for March or April in 2021, it will be expressing a change compared to the same month in 2020. If energy is insanely cheap or basically free in 2020, it’s going to come across as a big spike in the 2021 numbers. Not because March 2021 has oil spiraling upward to unreasonable numbers, but because it’s being compared to such a low number. This isn’t a purposely deceptive trick anyone’s pulling, it’s just the math of it. But if oil in March 2022 is $60/barrel (roughly where it is now), the CPI in March 2022 will be unaffected by the price of oil. In this way, it’s helpful to think of a big shock like the drop in oil in the spring of 2020 as a one-time event and not true inflation.

Many economists like to look at “Core CPI” which takes out the more volatile components of food and energy. The motivation, I believe, is to get a better sense of price levels by stripping out the noisier aspects. But there can still be some elements that again are one-time events and not true inflation. For example, the CARES Act in the spring of 2020 set limits on rent evictions and moratoriums. Rent is a solid chunk of the CPI basket – after all, it’s a big portion of the cost of living for pretty much everyone. But during this time, people who were not paying rent due to whatever reason were showing up in the data as paying zero in rent. The cost of rent was not zero in any meaningful sense of how we measure prices, but it did cause downward pressure on that part of the Consumer Price Index. When the moratorium is lifted, it might appear that rent for those people goes from zero to $1000/month, or whatever they had always been charged. This could cause the appearance of rent skyrocketing, bringing up CPI and giving an impression of inflation. But it’s not! It’s just a change in policy. So a one-time oil shock or a policy initiative like rent moratoriums are two examples of things that can cause illusory spikes in the metrics we tend to use to measure inflation. Economists and many financial market participants are aware of these things, but it’s still important to acknowledge that looking at CPI purely is not a good gauge on the level/existence of inflation.

Finding Full Employment

But back to our normal programming. It’s difficult to know exactly where full employment is. How do we know when everyone who wants a job and can work has one? It might sound obvious, but it’s not. There are endless sources of noise that can complicate “everyone who wants one” and “everyone can work.” For example, a weak labor market can make people who feel their options are sub-optimal go back to school. Or someone out of work in their early 60s may be nudged into early retirement because they give up on trying to work a few more years. Because both of these groups aren’t actively “looking for work,” they are not considered unemployed. And how do we really measure who is in school for “lack of job” reasons and who’s there despite good job opportunities. Same with early retirement – did someone do this because they’re financially healthy and are happy to retire now, or because they have no good option? In most instances, these groups have a combination of both forces. And usually the last people to get hired in a tight labor market are those that are seen for whatever reason as less desirable to employ – think of people who have been out of the labor force for a long time or the previously incarcerated. In a tight labor market, an employer will bet on hiring these groups that are seen as riskier hires. But otherwise, these groups could be discouraged from job hunting and stop looking, further complicating the goal of knowing when “everyone who wants a job can get one.”

There are a lot of signs that previous estimates of what unemployment rate constitutes “full employment” were very wrong. In December 2019 (pre-pandemic world), the Fed had thought the unemployment rate associated with full employment was 4.1%. And this was in contrast to their projection exactly two years earlier of 4.6%. The historical idea of what unemployment rate represented full employment had to be continually revised downward because we kept getting the unemployment rate lower without any spike in prices. In theory, any decrease in the unemployment rate past that should have led to overheating, and an inflationary event where businesses have no choice but to raise wages and prices in response to there being no one new to hire. But it didn’t happen. The US got its unemployment rate down to 3.5% in February 2020 with CPI and PCE (a different measure of the price level) never going above 2.5%. Furthermore, wages started to tick up (this is good!), suggesting a tightening labor market that wasn’t being accompanied by consumer price increases.

We can look at a few indicators that, in hindsight, show us that the labor market still had room to tighten at this point in time, that there was still slack. First, consider the “Employment to Population” ratio, which is a measure of what percentage of people above the age of 16 are employed.

You can see that February 2020, at 61.1%, was lower than the pre-financial crisis peak in January 2007 of 63.3%, and in fact lower than anytime between February 1987 and December 2008. Remember that underlying that trend is a steady increase since 1950 in the female participation rate – the percentage of women above 16 who have a wage-paying job or are actively looking for one. The female LFPR plateaued in 2000 more or less, and we can probably interpret that as the changing cultural forces of women working reaching somewhat of a ceiling (for now, maybe).

But the increasing participation of women means that those aggregate employment-to-population data include a huge decrease in the employment-to-population ratio for men. Take a look at these charts:

Is this because lots of men have decided to stay home and take care of the kids? Highly doubtful there’s strong data to support that explanation for such a huge drop in the last half century. Are more men deciding to attend higher education? Again, no. Any statistic will be an incomplete snapshot of whatever it is you’re trying to measure, but I think the main takeaway here is that a lot of men were not employed who wanted to be. (This fits well into the narratives suggesting lower marriage rates are in part due to a shortage of “marriageable men,” and also “deaths of despair.”)

In fact, I’d like to put forth that we haven’t been at full employment or full capacity for quite some time. Remember that in the framework of full employment we should see an acceleration of prices. And, the Federal Reserve’s target for price increases is 2% annual changes. This means that with prices increasing at sustained levels faster than that, they’d start to freak out and raise interest rates to stop the economy from overheating. Up until that point, they’re (in theory) happy to let the economy keep getting hotter. So take a look at this chart of the yearly changes of the relevant price index the Fed likes to use.

There were little momentary blips above 2% in the last few decades but nothing we’d consider an inflationary event. In fact, the last time Core PCE was at 2.5% was the first quarter of 1991. There are a number of theories on why the economy hasn’t run hot enough to get there for so long – I take a stab at it later on in this post – but the main takeaway is that we don’t have good data suggesting that the economy has been operating at full capacity for a really long time.

This is all important because when economists try to consider what level of increased government spending will lead to inflation, they try to look at the “output gap” – the difference between what our economy is producing and what the economy is capable of producing. The Congressional Budget Office, the Fed, and others have an estimate for what “full capacity” GDP is, now typically off a benchmark of where we were in February 2020. The problem is that if we weren’t at full employment or full capacity at February 2020 or perhaps the last couple decades, trying to get back to February 2020 levels of employment/GDP will still be short of what we want. February 2020 and the summer of 2007 may have been peaks in their relative cycles, but that doesn’t mean we were at full capacity then. So trying to fill the output gap of where our economy would be on trend after February 2020 without the pandemic is still going to be an undershoot of full capacity.

How to Know It’s Too Much

The financial markets now are expecting inflation in 5 years to be just over 2%.

This might look like a sign to sound the alarm, but it’s just above 2%. And this is likely pricing in the $1.9 trillion package passing, which means that almost $5 trillion in extra government spending from the pandemic – about 25% of the annual output of the United States – has made a pretty minor blip in the inflation expectations rate.

Another cause for concern from spending trillions of dollars from government borrowing is the potential for “crowding out.” The idea here is that government spending through borrowing is using resources that would otherwise be spent on private investment or consumption. If the government is taking money saved by households or businesses, money to invest will become more scarce and so the cost of borrowing for everyone else will become more expensive – interest rates will go up. But in the case of a slack labor market, where the “paradox of thrift” rules, people have made resources idle to save for a rainy day. Government spending gets those resources active.

The political discourse has always been mindful of this crowding out, so we’ve always felt like we’ve gotten to the brink of it without really getting there. The Obama stimulus in 2008 was less than $800 billion and it was enough to give rise to the Tea Party. The dire circumstances of the pandemic have given us an experiment to see just how far we can go. Not since World War II has there been such urgency to get money out the door in such a big way. What’s then amazing is how small $800 billion is compared to what the Federal Government has done already even without the newest potential $1.9 trillion package. And yet…the world hasn’t ended! Interest rates budged up a little when you look at this chart showing the interest rate on 10-year bonds in the last two years:

Whoa there! That’s a turn up for sure. But then zoom out for the longer run picture and that blip up is…not much.

I think the takeaway here is that there has always been a huge amount of excess saving in the world and we never knew how much room there was for the government to borrow because we never wanted to test where the edge was. Turns out there was a lot more money that was willing to go to the US government than we expected. But admittedly, looking purely at nominal interest rates is an oversimplified way of gauging the level of crowding out or pressure on the public fiscal situation. A discussion for another day too is that government spending is not an apples to apples comparison to private spending: The discretion of the different actors can change the quality/value of what that money is being spent on. But to me it very likely that wherever the “edge” is for when government borrowing will lead to crowding out or inflation, we are not at that point right now.

This Time is Different: Capacity Constraints And Household Balance Sheets

What’s indeed very different about our economy right now compared to 2008, 2001, or the vast majority of economic downturns is that our capacity is being restricted by the pandemic. Businesses and households are fully capable of doing things they aren’t doing, not because anything in the economic machinery is broken, but because they or the government have deemed the public health risk is too great for them to operate as they would otherwise. And this is the most legitimate concern for those worried about inflation: Our capacity to produce is limited by the pandemic, so previous levels of income chasing less production will lead to a spiral upward in prices. But this is overstated for a number of reasons.

There’s been a lot of suffering – economic, mental, and of course in terms of public health – in the last year. But it’s important to consider the national aggregates for things like savings and income. Because the suffering has not fallen on everyone equally, the national picture can look quite surprising, namely because those in the top quintile have more or less kept their jobs while saving a lot more money. Take a look at this chart from tracktherecovery.org about the employment picture for top earners versus the lowest earners.

The number of jobs has actually gone up for the highest earners. And then take a look at the national savings data:

Wow, that’s wild! This national number shows that a) people who maintained pre-pandemic income were left to save a lot of money because they weren’t able to spend on vacations, eat at restaurants, and spend on a number of expensive things they’d otherwise enjoy; b) the fiscal packages so far have in part given money to a decent number of people who don’t have an immediate need to spend; c) it’s a once-in-a-century pandemic with a huge recession and so people are going to save in the event that they may lose their job sometime soon.

In fact, nationally, income is looking pretty good!

Pent-Up Demand

So back to the matter at hand: With 2 trillion dollars in personal savings, will there be a mad rush of spending once the economy opens back up later this year, once government restrictions ease up, vaccinations get to a critical point, and (hopefully) most of the pandemic is in the rear view mirror? Well let’s consider where this “pent-up demand” will go. To the extent that people will spend their saved money, where could it go? The industries most impacted by the pandemic aren’t going to be back to where they are in February 2020. Restaurants won’t all reopen, lots of places have gone out of business, supply chains have been decimated. So if people all try to spend like they used to on industries that exist at 50% of their previous levels, those industries can’t keep up with the demand and they’ll have to raise prices. This is what the inflation-hawks are worried about.

While people may splurge on going out to eat a bit more, going on a vacation, or going to a concert, they’re not going to make up for a year’s worth of lost time entirely. They’re not going to the bar to get 10 drinks instead of 2 or get 4 haircuts to make up for the only one they got in 2020. They’re not going to go on every vacation they would have otherwise between March 2020 and August 2021. Or see a year’s worth of movies in one month. And if they did, think about what this would mean: movie tickets that are usually $15 would now be $50. Restaurants with $7 beers will now be $15. But: Most of the places with remaining capacity issues have goods and services with what economists call elastic demand. You’re not going to spend $50 on a movie ticket. Personally, I’ll probably be willing to spend more on some travel just to get the hell out of New York. But for an inflation event to occur, you’d need to see these industries have a huge run-up in prices. More likely, people will shift to spending more on a new streaming service rather than pay $50 on a movie ticket. They’ll have a backyard bbq with some grocery store beers instead of having a $15 beer at a bar. Or they’ll get a Peloton instead of a more expensive gym membership. So the bottom line is that we’d see people shifting their consumption to industries that do not have the supply constraints of the damaged industries. When oil prices surged in the 1970s, people weren’t going to stop heating their homes or driving to work. They probably cut back on gas consumption a little, but their demand was “inelastic,” and thus their consumption was not as sensitive to price changes.

Another element is that, just like every other economic downturn, people will be skittish about spending all their savings. There’s real psychological scarring from a recession and I would think that, more than previous recessions, this one was really in your face in terms of lifestyle and news, no matter what your income situation has been.

What’s the deal with all these inflation worries?!

If you look back at the charts showing the year-over-year changes in price levels, you might wonder why policymakers have been so worried about inflation. It’s true that the typical framework suggests that once inflation happens, stopping that process can be pretty painful. So getting to the edge and then realizing it’s already happening means… it’s too late. But I think that too many of the powers that be have been scarred by the stagflation of the 1970s, where low growth and high inflation wreaked really bad havoc on the economy. (As far as I can tell, not nearly as painful as a financial crisis recession, or the aggregate misery from having an economy with millions of underemployed people.) The Federal Reserve hiked rates tremendously, causing a really bad recession – though seeming to choke off inflation – in the early 1980s and making central bankers vow to never relive the episode again. And many of the people who lived through that were the PhD advisers to people who are now our philosopher-kings of economics. But for the current generation of economists, there’s just no livable experience that justifies being scarred by a painful inflationary episode. A 40-year old person would have been a newborn the last time core PCE year-over-year changes were at 3%. In a sense, this older generation of economists is too busy fighting the last war, and the younger one is much more concerned with inequality, student debt, and sluggish growth. To this extent, one should be optimistic about the future in terms of recalibrating inflation fears.

And there’s further evidence that The Federal Reserve has made it clear it will tolerate above 2% inflation, so don’t expect interest rate hikes any time soon. Jerome Powell, the current Fed Chair, has testified that he acknowledges the Fed has been wrong about their estimate for full employment. Lael Brainard, who is on the Federal Reserve Board of Governors, has also stated that the Fed is baking into its projections a revised estimate for what full employment is. On the monetary policy front, we can be hopeful that we’ll be closer to running the economy as hot as it can get without inflation fears.

On the fiscal front, this $1.9 trillion may not be perfect in its composition – nor an exact filler for any output gap – but we shouldn’t fear the package leading to harmful inflation or meaningful crowding out of private investment.