The potential impact of fiscal stimulus on the U.S. Economy

According to my baseline forecast from early December, the pre-crisis level of U.S. gross domestic product from the fourth quarter of 2019 will not be reached until early 2022. The fiscal stimulus package of around USD 900 billion now approved by the US Congress could help the US economy achieve a significantly higher growth rate in 2021. And most importantly, less people will suffer. Simple scenario analyses, which are intended to capture the uncertainty surrounding the economic effects, suggest that with this program the US economy could grow by 1.5 to even 4 percentage points more next year than in my baseline forecast. Even though such calculations are mainly illustrative and forecasts are currently subject to large uncertainties, the potentially significant growth effect is remarkable.

In my baseline forecast for the United States from the beginning of December, the pre-crisis level of gross domestic product in the fourth quarter of 2019 will not be reached again until early 2022. The extent of the crisis becomes even clearer if the hypothetical growth path of the US economy at the turn of 2019/2020 is considered. Compared with the forecasts made at that time, for example by the International Monetary Fund (IMF), gross domestic product in 2020 is likely to be more than five percent below the level expected before the pandemic (Figure). In fall 2019, the International Monetary Fund (IMF) had predicted growth rates of 2.0 and 1.7 percent for 2020 and 2021 (see IMF (2019): World Economic Outlook, October 2019: Global Manufacturing Downturn, Rising Trade Barriers). For the period 2022-2024, the IMF assumed growth rates of 1.6 percent each.

Compared with potential output – i.e. the theoretical production level of an economy at which the factors of production can be expected to be working at normal capacity – a significant gap also opens up for 2020. According to data from the Congressional Budget Office, this so-called output gap was still slightly positive in 2019, but in view of high unemployment and the underutilization of production capital, it has become strongly negative in the past year and is likely to amount to slightly more than four percent. Against this backdrop, there has already been an intense political and academic debate since the outbreak of the pandemic about the potential benefits of additional fiscal stimulus measures.

A new fiscal stimulus program

In the end of December, the political actors agreed on a further fiscal stimulus program after long discussions. In the following, I would like to illustrate how this stimulus package of $900 billion could affect economic development next year. It should be noted that estimating the cyclical impact of higher government spending is difficult, and academic studies sometimes publish very different effects (see, for example, Ramey and Zubairy (2018), “Government Spending Multipliers in Good Times and in Bad: Evidence from U.S. Historical Data,” Journal of Political Economy, Vol. 126(2); Whalen and Reichling (2015), “The Fiscal Multiplier and Economic Policy Analysis in the United States,” Congressional Budget Office, Working Paper 2015-02).

Uncertain level of the fiscal multiplier

The so-called fiscal multiplier, that is the change in gross domestic product triggered by a one dollar increase in government spending, cannot be observed directly. By means of empirical studies or theoretical simulations it can be tried to estimate approximately by how much the gross domestic product changes as a result of higher government spending. The results vary greatly depending on the method and the time period/country studied and range from almost 0 to about 3 – i.e. from no effect to a very strong stimulation of the economy. At least three reasons play a role in why the fiscal multiplier can vary from case to case. First, the composition of the fiscal stimulus measures often varies; but the effect on economic performance depends on whether the financial resources are allocated to roads, renewable energies, more government employees, transfer payments to households, etc. Second, there are often delays until a measure proposed by the government finds a majority in the political process and is then implemented. Such delays are particularly common in infrastructure spending and also occur when maintenance work is brought forward. This reduces their suitability as a short-term stimulus measure, even though infrastructure investments often have a positive effect on economic growth in the longer term. Third, the stimulating effect may also depend on whether an economy is in recession or in a boom phase. In a boom phase, for example, private investment could be crowded out – especially because the central bank feels compelled to pursue a more restrictive monetary policy due to the expansive fiscal policy, which increases the interest costs for financing private investment. In the current environment following a dramatic slump in economic output and low interest rates, this crowding out effect is likely to be rather small. However, it should be noted that the current crisis affects personal services to a significant extent. Residential construction, on the other hand, is booming due to very low interest rates, and corporate investments have also been developing solidly since the summer of the current year.  Capacities are therefore not underutilized to the same extent in all economic sectors.

Scenario analyses help illustrate the possible range of the fiscal multiplier

These uncertainties can be accounted for by considering different scenarios in which the level and duration of this effect are varied when estimating the multiplier effects of government spending. The following analysis examines whether the U.S. economy could converge more quickly to the growth path expected at the end of 2019 with a fiscal stimulus program than with the baseline forecast, which assumes no stimulus program. Since the composition of any program is unknown and the size of the multiplier effect can vary widely, an assumption must be made for the size and different scenarios must be shown by means of a range of possible multiplier effects. The amount of the stimulus program is $900 billion. It is assumed that this amount will reach people and businesses primarily in the first quarter of 2021. The range of assumed multiplier effects is done following the multiplier effects used by the U.S. Congressional Budget Office (CBO)-that is, the independent budget review agency of the U.S. Congress-to assess fiscal stimulus policies (see Whalen and Reichling (2015), “The Fiscal Multiplier and Economic Policy Analysis in the United States,” Congressional Budget Office, Working Paper 2015-02). In 2020, CBO adjusted the multiplier effects because the pandemic and measures to contain it are expected to constrain economic activity and thus reduce the stimulative effects. This paper assumes that the pandemic will still require various containment measures in the first quarter of next year; that is why the Congressional Budget Office’s reduced multiplier effects are used. Only in the second quarter, as a result of vaccine availability and the end of winter, are pandemic containment measures likely to be gradually relaxed. In an environment where the economy is still well below potential output and interest rates are still expected to be very low, multiplier effects are expected to range from 0.31 to 1.8 with a mean of 1.0. In the course of 2023, economic output is likely to slowly approach its potential again and interest rates are likely to slowly increase. Crowding-out effects on private investment and consumption could then play a minor role again.

Significant effects of a fiscal impulse possible

Under these assumptions, the U.S. economy would grow by around four percentage points more by 2022 under the scenario with a medium multiplier effect than without fiscal stimulus. Under a low multiplier effect, however, it would be significantly less (around one and a half percent), and under a high multiplier effect, significantly more. Stimulus measures could thus potentially close the growth gap significantly faster than under the baseline scenario without fiscal stimulus (Figure). It is clear, however, that the size of the multiplier effect as well as other economic developments is very uncertain.

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