The COVID-19 Pandemic of 2020-2022 (C): Fiscal and Monetary Stimulus

The circumstances of the COVID-19 pandemic as outlined in part (A) of this case study prompted dramatic responses in government policy. In early March, credit markets in the U.S. and internationally nearly froze, reflecting a massive “dash for cash”: most investors sought to sell assets and few sought to buy. The trading imbalance meant that businesses, governments, and individuals found it impossible to meet their credit needs. The U.S. Federal Government responded with innovations in fiscal and monetary policy. This massive program dwarfed many previous responses to economic crises and was the most comprehensive stimulus program enacted in a short time in U.S. history (see Exhibit C1).

Monetary policy. The U.S. Federal Reserve System flooded financial markets with liquidity. From March 11 2020, to 2022, the U.S. Federal Reserve (“Fed”) purchased $4.06 trillion in Treasury securities and mortgage-backed securities; it added $447 billion in liquidity through repurchase facilities and central bank dollar swap lines; it extended $110 billion to small businesses through the Paycheck Protection Program; and it loaned $54.6 billion through various lending facilities to municipalities, medium-size businesses, money market mutual funds, and to primary dealers in government securities. Finally, the Fed cut the benchmark Federal Funds Rate to near zero and reduced reserve requirements to banks to zero. In all, the change in the Fed’s monetary policy, committing $4.67 trillion in funds, was the fastest and largest in central banking history (see Exhibit C2).

Fiscal policy. In 10 acts of law,¹ the U.S. Congress disbursed $5.47 trillion to offset the impact of nationwide lockdowns, which when combined with $814 billion disbursed through presidential executive orders and other administrative orders, amounted to a total of $6.28 trillion. In absolute size, the spending dwarfed all previous responses to economic and financial crises. According to national income accounting, increases in government spending (net of increased tax revenues) would increase the output of an economy, or Gross Domestic Product (GDP):

GDP = C + I + G + NX

Where C is private consumption, I is private investment, G is net government spending, and NX is net exports. As the equation shows, an increase (decrease) in G will expand (contract) output.

Funding. The fiscal stimulus entailed virtually no tax increases and several tax decreases and deferments. Therefore, the stimulus relied upon issuance of debt by the U.S. Treasury (see Exhibit C3). Of the $6.28 trillion in stimulus spending, the Federal Reserve purchased $2.7 trillion in Treasury securities, which in combination with the Fed’s reduction in interest rates, implied a partial monetization of the stimulus program. Monetization was not without precedent, having been practiced by the U.S. Treasury and other governments during wars and other national emergencies.

The COVID pandemic prompted some policy analysts and public officials to advocate a broader program of fiscal spending and debt monetization. They argued that the country faced limitless calls for spending to address priorities such as climate change, aging infrastructure, national security, and economic inequality. At the same time, prevailing interest rates in the market were at all-time lows. The causes of low interest rates were the focus of active debate, yet they stimulated the view that at low interest rates, government deficits do not matter, particularly for countries that borrow in their own currencies.²

Writing before the pandemic, MIT economist Olivier Blanchard (2019) held that when the interest rate (R) on safe government debt fell below the nominal growth rate of the economy (G), governments no longer face an intertemporal budget constraint—that is, they can borrow freely from future generations to finance current projects. Economist Stephanie Kelton (2021) extended this reasoning to propose that the U.S. government should issue and monetize debt without limit. In other words, the U.S. government should finance itself from the Fed—and embark on a program of policy activism not seen since the 1930s. Kelton’s “Modern Monetary Theory” played an important role in helping to justify the $1.2 trillion infrastructure bill of late 2021, and the proposed but not enacted $2 trillion Green New Deal bill. As Ruchir Sharma, chief global strategist at Morgan Stanley Investment Management wrote, “They believe that they can easily borrow to pay for it all because the last four decades of easy money have brought interest rates to near or less than zero: Money is free.”³

On the other hand, “debt hawks” strongly opposed large fiscal deficits and debt monetization. First, they argued that over time, interest rates have tended to be lower (not higher) than the growth rate of the economy. Thus, historically, interest rates that fell below the growth rate of the economy were brief and infrequent. Second, if the country issued a lot of new debt when interest rates were low, it would face a crushing financial burden when interest rates rose. Third, critics worried that too much government borrowing would “crowd out” private sector borrowers in the credit markets, and thus constrain economic growth. Fourth, reliance on excessive debt finance was associated with financial instability. A study by economists Carmen Reinhart and Kenneth Rogoff (2010) found that countries were more prone to slow growth and even financial instability if their debt exceeded 90 percent of GDP.⁴ And finally, debt hawks said that aggressive fiscal and monetary policies prompted inflation in prices.

Milton Friedman, a champion of Monetary Economics, had famously said that “Inflation is always and everywhere a monetary phenomenon,” meaning that inflation tended to follow material increases in the money supply. Other economists, such as Nouriel Roubini, argued that fiscal, not monetary, policy was the source of inflation.⁵ Thomas Sargent, another Nobel Laureate in Economics, argued that “Persistent inflation is always and everywhere a fiscal phenomenon.” Sargent’s assertion was part of a larger movement among economists toward the Fiscal Theory of the Price Level (FTPL). This theory asserted that fiscal and monetary policy are linked and that the central bank will tend to respond to fiscal deficits by printing more money.

Yet from 2008 to 2019, massive increases in the money supply by the Fed had yielded scant increases in inflation. The Fed’s policy of “quantitative easing” from 2008 to 2015 had added $3 trillion to the money supply of the U.S., though consumer price inflation in the U.S. had remained relatively low (an average of 1.8% per year from 2010 to 2019⁶)—this prompted many observers to conclude that the link between money supply and inflation had ended. However, economist Greg Mankiw (2020) said that analysts needed to look at the association between money supply and inflation over the long term, not short term—from 1870 to 2022, he found a 79% correlation between the two.

By early 2022, prices began to rise more sharply at annual rates of 7.5%, 7.9% and 8.5% in January, February and March, respectively. Inflation expectations appeared to be forming. Prices for gasoline, food, and transportation rose even faster.

Optimists argued that inflation had waxed and waned since the end of World War II and that the current inflation rates were only temporarily high. They believed that rising inflation was due to supply shocks associated with broken global supply chains and that when supply chains were repaired, inflation would subside. Modern Monetary Theory adherents dismissed inflation as a problem for American society.
Pessimists feared the onset of serious inflationary forces that would take years to quell owing to inflationary expectations among the American public: if individuals believed that prices would increase rapidly, they tended to behave in ways that created a self-fulfilling prophecy, for instance, through hoarding or heightened demand for increased wages. The pessimists argued that inflation distorted decision-making about resource allocation, market pricing, and employment, and that it triggered wealth transfers from creditors to debtors and from the wealthy to the poor. Also important was that voters tended to penalize elected officials following rising inflation.