How will the pandemic affect the US short- and long-term economic outlook? The US economy is set to shrink 2.5% in 2020. This decline is very similar to the US economy's 2009 post-GFC performance. Only in the aftermath of post-WWII demobilization in 1946 did the US economy suffer a greater loss of output. The US will fare relatively well compared to its advanced economy peers where real GDP will contract 5-10% in 2020 (IMF 2021). China is virtually the only major economy not to suffer an output decline last year. The CBO now projects US GDP to reach its pre-pandemic level by mid-2021 and for unemployment to fall to pre-pandemic levels by the middle of the decade (CBO 2021).
A hyper-accommodative monetary policy and a massive fiscal stimulus worth USD 4 tr (and counting) have helped put a floor under the US economy. If the current stimulus bill worth an additional USD 1.9 tr (or slightly less than 10% of GDP) is passed, the economic recovery will accelerate this year and beyond. Not only will an expansionary fiscal policy add to domestic demand. Households are also in pretty good financial shape (in aggregate!). Household savings have actually increased by USD 1.5 last year on the back of a stimulus-induced increase in income and a pandemic-driven fall in consumption. And this is not counting the wealth effect stemming from higher asset prices (Furman 2021). How quickly the economy rebounds and returns to its pre-pandemic growth trajectory will also depend on how much productive capacity was destroyed during the past 12 months. Economists disagree over the degree of fiscal stimulus that is needed to revive the economy without overstimulating it and triggering higher inflation (Yellen vs Summers).
The Democrats are firmly committed to adding another USD 1.9 tr of extra spending to the economy. This is why, instead of seeking bipartisan support, they have initiated budget reconciliation. This allows them to pass the fiscal package without Republican support. As the adage goes, generals are prone to fighting the last war. The same is true for economic policymakers. The lesson learnt from the 2009 crisis was that too little fiscal support is worse than too much. After all, the post-GFC economic recovery was very slow in terms of growth, employment creation and wage increase.
It is worth asking though whether the current economic crisis is sufficiently similar to the aftermath of the GFC to warrant such a conclusion. The 2008 crisis was a classic example of what is called a “balance sheet recession” (Koo 2009). Balance sheet recessions are more severe and are followed by weaker recoveries than normal business cycle recessions. Typically, a debt overhang leads to excess savings, insufficient investment and demand and therefore translates into anemic economic growth. Simply relying on an accommodative monetary policy is suboptimal in such a situation. The government should stimulate demand through an expansionary fiscal policy to guide the economy back to full capacity.
Not surprisingly, the Democrats aree loath to run the risk of adding too little rather than too much stimulus to the economy. The post-GFC recovery, they believe, has taught them several lessons: (1) Don’t rely solely on monetary policy to stimulate economic growth – not least because it leads to increasing inequality through financial asset appreciation. (2) Go big fiscal-policy-wise, as insufficient stimulus only leads to a slow recovery of the economy and labour markets. (3) Don’t count on the Republicans to the support necessary policy measures, as they blocked and undermined Obama administration stimulus policies, especially after their takeover of the House in 2011.
In reality, fiscal stimulus policies are often tricky to devise and and even more difficult to implement successfully. Ideally, they should be timely, targeted and temporary – the so-called three T’s (Brookings 2008). This can be a challenge if the political conditions are not right. Then there is also the question of how large the stimulus should be. Estimating fiscal multipliers with any degree of accuracy is a fool’s errand, as the GFC and euro area crisis demonstrated (IMF 2012). Future economic conditions are often difficult to predict, particularly after large, unprecedented exogenous shocks like the pandemic, making it very difficult to get the timing and the size of stimulus measures right.
Politically, however, the appeal of going fast and going big is easy to understand. A majority of Americans support further fiscal stimulus (Pew 2021). Poor households are in dire straits and need financial support. Accelerating the economic recovery should help boost the Democrats’ electoral prospects in the 2022 midterm elections where they will be forced to defend extremely slim majorities in both houses of congress. A combination of economic concerns and political interests help explain why the Democrats are so reluctant to seek bipartisan consensus with respect to economic stimulus.
Last but not least, the Democrats are understandably suspicious of Republicans' professed concerns about fiscal sustainability – and rightfully so. Over the past forty years, the Republicans only proved financially virtuous when the Democrats were in power. The Republicans are typically keen on lower taxes and lower (non-military) spending. If in doubt, they opt for lower taxes only regardless of what happens to the deficit (e.g. Trump tax cuts). The Democrats have a preference for higher spending and, if it cant be helped, accept the need for higher taxes to finance higher government expenditure. Financial prudence has been at best a secondary concern for Republican majorities since Reagan. The Democrats have proven somewhat more responsible financially, at least until now. The Republican approach makes good sense, politically. Running outsized fiscal deficits limits the Democrats’ ability to increase expenditure when they come to power. In the academic literature, this is also known as “war of attrition” (Alesina 1989).
In spite of having just suffered the sharpest economic downturn since the end of WWII, the US economy is projected reach its pre-pandemic level by mid-2021 (CBO 2021) The downturn was less than initially feared due to various fiscal stimulus packages – worth a massive 25% of GDP. The fiscal rescue measures have led to a sizeable increase in public debt. The IMF now projects US gross government debt to reach close to 140% of GDP by 2025, up from 109% in 2019. Net government debt will rise to 107% of GDP, up from 107% during the same period.
To what extent the worsening financial outlook will constrain US medium- to long-term foreign policy strategy is difficult to say. Resource mobilisation is primarily a political decision, even if economic and financial conditions do influence these political decisions and ultimately de-limit what is economically feasible. Political constraints on making resources available typically “bite” first – at least during peace time. Nonetheless, as George Washington put it: “A very important source of strength and security, cherish public debt”. A high debt burden has the potential to constraint resource mobilisation.
US government debt is now projected to increase more rapidly, low interest rates notwithstanding. Although debt will continue to increase, the US is unlikely to run into any financing constraints. Federal Reserve policy is supportive in terms of interest rate rates and government debt purchases. Demand for government remains strong, not least because the dollar remains solidly the world’s dominant reserve currency (Jaeger 2012). Besides, advanced economies are quite capable of sustaining high public debt burdens at a relatively low cost (e.g. Italy, Japan). Nonetheless, US government debt is set to grow to 200% of GDP by the middle of the century given slow real GDP growth and low-ish inflation. Furthermore, implicit government liabilities related to pension and health care spending amount to 28% and 162% of GDP (until 2050), respectively, in net present value terms (or a total of 190% of GDP). While there is no hard and fast limit to US government debt accumulation, the higher the level of debt, the more difficult it is to mobilise additional resources.
The long-term trajectory of US debt brings back memories of the 1980s with respect to resource scarcity and hegemonic decline. Increasing indebtedness, including foreign indebtedness, was seen as limiting the resources available to the US to fight the Cold War. The US was facing a “guns vs butter” (or savings vs consumption) trade-off. Back then adversary was the USSR, whose economic outlook the CIA famously more than overestimated, however (GAO 1991). Today the adversary is not a planned market economy, but China whose state-led capitalist system continues to perform well. At the moment, China is well-positioned to overtake the US economically, not least because of its much higher savings/ investment rates compared to the US. In the ten year till 2019, Chinese real GDP averaged 7.5% compared to only 2.3% in the US. For 2020-25, the IMF projects Chinese real GDP growth at 5.5% compared to US growth of 1.3%.
It is difficult to see how the US will grow more than 2% per year over the next ten years and beyond. Barring a productivity revolution, the demographic headwinds are strong and investment is too low. By comparison, Chinese growth is more likely to be in the 4-6% range, barring major accidents. Rapid economic growth increases the availability of resources for the pursuit of foreign policy objectives. Moreover, Chinese debt metrics are more favourable than the US metrics. China currently also spends far less than the US on defence (2% of GDP vs 3.5% of GDP in the US). Not only is China less resource constrained. Its available resources will continue to increase rapidly on the back of continued high economic growth. It can also concentrate its policies and particularly its defence policy on Asia and particularly the maritime sphere, while the US continues to be burdened by global commitments.
Chinese government debt will increase from 53% of GDP in 2019 to just below 80% of GDP in 2025, compared to nearly 140% of GDP in the US (IMF 2020). Admittedly, Chinese government debt figures need to be consumed with caution given a large state-economy sector and potentially significant contingent liabilities related to an ailing financial system. Health- and pension-related implicit liabilities also amount to a significant 105% and 25% of GDP, respectively. China is nonetheless in better shape, not least thanks to stronger medium-term economic growth and the concomitant financial flexibility and ability to mobilise resources that come with it.
As for external debt, the US is the world’s largest debtor, while China is among the largest creditors. The US is the world’s largest debtor by a wide margin with its net international investment position amounting to a negative USD 14 tr (or -66% of GDP)! China is the world’s third largest (net) creditor in dollar terms and its net creditor position exceeds USD 2 tr (or 15% of GDP). By comparison, Japan and Germany are the largest and second largest international creditors in dollar terms with claims equivalent to USD 3.7 tr and USD 2.9 tr (or 67% and 70% of GDP), respectively. In purely financial terms, China is in a far superior position to the US. (Ultimately, of course, the ability to mobilise external resources depends on more than the level of financial assets and liabilities, but on the willingness of foreigners to provide these resources.)
Projecting long-term growth is risky business. After all, Japan was meant to emerge as “number one” once (Vogel 1989), just before it entered its lost decade of the nineties. China does face a number of significant challenges in terms of future economic growth. First, it is staring down the middle-income trap (Eichengreen et al. 2013). Doubling down on state-driven investment may lead to serious financial stability problems down the road. Second, demographic challenges will generate headwinds, not least in terms of labour supply. Third, political risk, while difficult to estimate, could weigh on the economic outlook in the medium- to long-term. Fourth, in spite of a commitment to allow markets to play a “decisive role”, the government has substantially backtracked on productivity-enhancing, market-oriented reform. Even so, while China faces economic challenges, it continues to benefit from significant catch-up potential given that its per capita income is only about ¼ the level of the US.
Finance and credit are important factors affecting the ability of a state to mobilise resources - particularly during peace time. National resource availability is not destiny, however. First, greater quantity does not necessarily translate into greater quality (aka influence and power). A large defence budget, for example, does not necessarily translate military effectiveness. In fact, resource constraints often represent an opportunity to evaluate the cost-effectiveness and quality of expenditure, leading to strategic adjustment rather than retrenchment (Leffler 1992). Second, emerging and foundational technologies (in US government speak) may offer the prospect of lasting strategic advantage. While technological breakthroughs are made more likely if arge amounts of resources is thrown at them, the relationship is not linear. Third, states can seek to mobilise additional resources by forming coalition with like-minded states (aka coalitions) that often translate into resource transfer or at least into greater collective resource mobilisation.
Nonetheless, resources do matter in view of US grand strategy. China has greater room for financial manouevre – in terms of both government and external credit – and domestic resource mobilisation thanks to a rapidly expanding economy. A high savings rate provides China with significant flexibility, as does a strong international creditor position. On the current trajectory, the US will not be able to match China’s ability to mobilise additional financial, economic and military resources one-for-one. While the level of potential resource mobilisation in the US is not set in stone, neither politically or economically, the US will need to improve the quality of its spending or mobilise additional “external” resources in the guise of alliance strategy if it wants to avoid falling behind China in terms of its ability to generate the resources necessary to engage in strategic competition.