The problem, he says, is that the overall size of the plan is reaching a level that poses major problems in the future. In particular, the proposed total money far exceeds most “output gap” estimates. (More on that below.) This implies that much of that spending will just slosh in the economy, causing price hikes, potentially hindering the rest of Mr Biden’s agenda, and risking another recession.
This is not a conventional argument between doctrinal deficit hawks and doves, but something more subtle. In the past, Mr Summers in particular has repeatedly called for larger budget deficits to help tackle “secular stagnation” in which large world economies are stuck in slow growth, and he has supported major pandemic relief packages.
However, Mr Summers says that any new package of spending should gradually pay off over time and be more focused on long-term investments.
“There is nothing wrong with targeting $ 1.9 trillion, and I could support a much larger number of overall incentives,” he wrote in a follow-up article. “However, a significant part of the program should be aimed at promoting sustainable and inclusive economic growth for the rest of the decade and beyond, rather than just supporting incomes this year and next.”
What is the output gap?
Imagine a world where the American economy can reach its full potential. Pretty much anyone who wants to work can find a job. Every factory is running at full capacity. The output gap is simply how far the economy is from this ideal state.
A traditional approach to fiscal incentives has been to estimate the size of this gap, make some adjustments to account for the way federal spending circulates through the economy, and use that arithmetic to decide how big an incentive measure is should be.
In theory, when the government pumps too much money into the economy, it tries to generate activities beyond potential production that cannot be sustained for long. Workers could work overtime and a factory could run extra hours for a while, but eventually workers want a breather and the machines need to be shut down for maintenance. When there is more money circulating in the economy than goods and services, it does not lead to more wealth, but to higher prices when people sell the things they want to buy.
