Biden’s ‘go big’ stimulus has kicked off a huge debate about just how big a hole the pandemic punched in the economy

President Joe Biden

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Congressional Democrats and President Joe Biden are betting there’s a bigger hole in the US economy than some government models suggest.

The main conflict around Biden’s $1.9 trillion stimulus plan has to do with a fairly simple concept: the output gap. That gauge measures the difference between actual output and the maximum potential output generated by an economy. During a recession, it’s a popular metric for judging how much more an economy can rebound before overheating.

Positive output gaps — in which actual GDP exceeds the estimated maximum — tend to fuel inflation due to strong demand for goods and services. Conversely, a negative output gap drags inflation even further below the Federal Reserve’s target. Weak inflation can be a sign of slowing economic growth and stifled wage improvement.

Lawmakers largely agree more stimulus is necessary to fill the hole in the economy created by the pandemic. But debate over a new relief bill places fresh focus on the output gap and its true size.

Democrats have repeatedly warned that passing too little stimulus would fail to close the gap and, in turn, leave the US economy languishing in a weakened state. Lawmakers should “go big” on stimulus and stray from passing an inadequate deal, Biden said in private comments to lawmakers earlier in February, the AP reported.

Republicans and even some moderate Democrats countered with arguments that overfilling the hole with stimulus could drive outsize inflation.

Two major left-leaning economists further fueled the debate: Larry Summers, director of the National Economic Council under President Barack Obama, wrote in a recent Washington Post column that Biden’s plan handily exceeds the amount of support needed for a full recovery. Olivier Blanchard, former chief economist at the International Monetary Fund, backed Summers’ thesis, tweeting the $1.9 trillion plan could accelerate growth so much “as to be counterproductive,” later defending his concerns in an article for the Petersen Institute, a nonpartisan think tank.

But what if the Summers and Blanchard camp is wrong about the output gap? Biden’s team is betting they are. 

The debate is putting the White House at odds with the government’s official budgetkeeper, the Congressional Budget Office (CBO). Wall Street is emerging in Biden’s corner.

Mind the gap

The CBO currently sees real GDP exceeding projected output by a wide margin, according to an economic outlook report published earlier this month. The output gap is already expected to quickly rise and turn positive in 2025, all without additional stimulus.

Yet some experts wonder whether the model is dependable. The CBO tends to underestimate the output gap and, in turn, provide an incorrect reading of slack in the economy, Goldman Sachs economists led by Jan Hatzius said Wednesday.

Following the financial crisis, the office repeatedly revised potential GDP estimates lower as actual output lagged its full capability. Revisions then turned positive in 2018 and 2019, once actual output exceeded its estimated potential. The model interpreted what first looked like an overheating as a catch-up, suggesting the forecasts are biased by real GDP readings, Goldman said.

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Source:: Business Insider


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