From the Desk of Christopher Thornberg

A year ago, at the outset of the COVID-19 pandemic, the U.S. economy began to contract at a pace never before seen in recorded history. When observed relative to the slow decline that occurred at the start of the Great Recession (2007-2009), it might have been natural to assume the worst—that the United States was about to suffer from a massive economic downturn. But as Beacon Economics has argued over the past year, the last recession was completely different than the one driven by the pandemic, hence those assumptions were inaccurate.

During the Great Recession the United States suffered from a demand shock generated by a collapse in wealth and credit availability, which occurred when the sub-prime housing bubble that preceded the downturn, popped. This time, the recession was characterized by a supply shock driven by the pandemic—a large part of the economy could not provide goods and services to their clients because of the risks associated with the disease, not because there was a lack of demand. This difference is why Beacon Economics called for a much more rapid “V” recovery early on.

The difference in outcomes between this recession and the last could not be more dramatic. The demand shock that started in late 2007 caused a general malaise across most of the economy, something that took nine years to fully recover from. This time, the economy began to rapidly recover even as the pandemic was still in full force (businesses and individuals figured out how to mitigate risk). By the end of 2020, the U.S. economy had regained 70% of the activity it lost in the first two months of the downturn—the first part of the “V”. Then, the enormous surge in new virus cases that hit at the end of 2020 only caused recovery to slow modestly. There was no “W”, no “L”, and clearly no “U”, as many had predicted.

One reason for the sharp rebound was because the supply shock reallocated demand within the economy. Frustrated consumers who were denied an opportunity to eat at a favorite restaurant or fly to Disney World, spent unused dollars in other parts of the economy such as buying homes, campers, and other goods. This is why worker earnings have recovered, job openings have remained remarkably high, and there was a surge in corporate profits – to their highest point ever in the second half of 2020. And this all happened despite the economic output gap and decline in payroll employment.

Of course, full economic recovery will only occur when new cases of the virus are controlled, something that is in process right now with the roll out of effective vaccines. A recent analysis by Goldman Sachs suggests close to 50% of the U.S. population is already immune to the Coronavirus through either vaccination or prior exposure, and as a result, new cases have fallen by over 75% since the start of the year. At 2 million doses per day, the United States is expected to reach herd immunity levels around July, according to the Centers for Disease Control. There will still be flare-ups of the virus as a significant portion of the population may refuse the vaccine. But overall, economic activity should be mostly returning to normal in the second half of the year. We say “mostly” inasmuch as large parts of the globe are lagging the United States in vaccinations, implying that global trade and travel will trail the broader U.S. recovery.

The weakest part of the U.S. economy remains aggregate employment, with 9 million fewer payroll jobs today than pre-pandemic. But this data looks far less scary when examined more closely.

For one thing, the U.S. unemployment rate in February of this year was already down to just 6.2%, the fastest decline ever seen. The unemployment rate was above 6% for six full years in the aftermath of the Great Recession. Moreover, one-quarter of the unemployed today are still considered to be on temporary layoff (not looking for a new job) and a far higher share are receiving unemployment benefits than during the last downturn. And aside from sectors directly impacted by the pandemic, labor markets are surprisingly tight.

Outside of the first few months of the crisis, the number of job openings in the United States has remained well above 6 million —almost where they were pre-pandemic. This has resulted in the interesting, and in recent times, unique experience of solid wage growth, despite the overall U.S. economic recession.

Earned incomes have recovered very quickly, and when combined with the generous Federal stimulus outlays, caused aggregate U.S. real disposable income to grow by an enormous 5.5% in 2020, the fastest pace since 1998 when the economy was in the midst of the tech bubble.

Coming into 2021 there is a lot of evidence that the U.S. economy is rapidly on the mend. Retail sales, excluding restaurants, were 10% higher in February than the year before. The ISM PMI (Purchasing Manager’s Index) for manufacturing was 60.8 in February, matching peaks seen over the past 30 years, as industrial production continues its record pace of recovery. Durable goods orders are at a 10-year high despite the collapse in aircraft production. Imports and exports of goods have already rebounded to pre-pandemic levels creating log jams at ports across the nation. Housing construction and consumer confidence are creeping up even as credit becomes easier to obtain. The U.S. economy is still 3% off its long-run trend, but this gap is shrinking at a record pace.

And there is plenty of pent-up demand to propel the economy forward as vaccines bring the spread of the virus under control. The inability of consumers to spend would have caused a jump in household savings regardless, but the addition of the massive $3 trillion in Federal stimulus last year—much of it spread widely across the economy rather than focused on sectors specifically impacted by the pandemic—meant that households more than doubled their savings rate relative to 2019, from $1.23 trillion to $2.85 trillion. The U.S. banking system is now flush with almost $3 trillion in excess deposits. Households have taken advantage of this cash and low interest rates to refinance home loans and pay down debt: In 2020, the household debt service ratio dropped below 9% for the first time ever. There is little wonder why the housing market is on fire, the stock market is looking frothy with the second highest P/E ratio on record (beating 1929), and Bitcoin is sitting north of $50,000.

Amazingly, all this good news seems to have gone largely unnoticed, or perhaps ignored, in Washington DC. The national policy conversation continues to be wrapped around the broad theme of “rescuing of the nation.” In March, the U.S. Congress passed another stimulus plan costing the nation an additional $1.9 trillion. President Biden has appointed a “COVID Recovery Czar” to direct the efforts. Worse, there are already discussions of a $3 trillion spending package aimed at infrastructure and education to follow. Add it all up and it becomes almost surreal.

Typically, the nation looks to the Republican Party to be the budget hawks. Unfortunately, it’s pretty clear budget balancing is no longer an important part of their platform. We started 2020 with a $1 trillion deficit already in place, driven by the Trump administration’s tax cuts. Throw in the first round of stimulus and, in total, there was a $3 trillion deficit last Federal fiscal year— all under the Republican’s watch.

This year, deficits will be on the order of $4 trillion, between the additional stimulus and the structural gap that was already in place. In two short years, the United States has issued $7 trillion in new Federal debt—an amount equal to 30% of the nation’s GDP, or $24,000 for every person in the United States under the age of 70. And now, under the Democrat-controlled Congress and White House, there is another $3 trillion in new spending on the table.

The Federal Reserve seems to be following politicians rather than economists and similarly over-reacted when they engaged in $3 trillion in quantitative easing. This surely helped calm the market panic that was in play at the start of the pandemic, but times have changed—there have been no spikes in debt delinquencies, the stock market is on a tear, and banks are making loans easier to acquire. Yet, the Fed has made it clear they will continue to maintain their bloated balance sheet for the foreseeable future. The last time the nation saw an expansion of the money supply this rapid was in the 1970s. Some of the stimulus was certainly needed, reducing the overall economic trauma of the pandemic and playing some role in the strong earnings data for 2020. But the government cannot, and should not, be expected to fully insure the private sector against business cycle risks. Rather, as with all government programs, we need to weigh costs against benefits to find the appropriate level of stimulus.

As for the benefits, ultimately the U.S. government (in addition to providing a basic safety net) is trying soften the broader impact of the downturn by pumping up aggregate demand. This, in turn, depends critically on how the stimulus is used. Direct spending by the government to pay for things like the cost of the vaccine rollout or for schools to upgrade their ventilation systems, has a clear direct value. But most of the stimulus funds were instead transferred to businesses and individuals with no guarantee that such monies would be spent immediately on the purchase of goods or services.

A survey done by the New York Fed after the first round of stimulus, showed that 75% of the money given to families ended up in savings, or was used to pay down existing debt, or was given to charity. Surveys on the current round of stimulus suggest an even greater share will go to padding finances rather than towards current spending. This does little for the economy in the short run. If we look at the increase in deposits in the U.S. banking system – close to $3 trillion above trend in 2020 – it is clear that an enormous part of the stimulus has simply filtered straight through the economy into the financial system, doing little for the current pace of economic activity. The stimulus has largely gone to making this generation of Americans that much wealthier.

The operative words here are ‘this generation’, since all this new private wealth is being generated by running up the public national debt. We are getting richer at the expense of our children and grandchildren. Justified? Consider that despite the economic chaos of the last year, per person real net worth in the United States hit an all time high at the end of 2020. If we consider net worth as share of current incomes, even proportionate to our level of income, we have exceeded all past generations. Indeed, the debt service ratio in the United States has dropped to its lowest level ever.

One reaction to these figures is that this is stilted by the enormous income and wealth inequality that indeed does exist in the United States. Perhaps, but there is little evidence that the stimulus overall is very progressive (the PPP loans were the exact opposite) and even more to the point, such inequality is dealt with through transfers within a generation, not taken from future generations. History will not look kindly upon these policy decisions and the legacy of debt it’s leaving for our children and grandchildren to clean up.

That the U.S. economy is going to take off like a rocket in the second half of this year is obvious. Even the Federal Reserve has started to revise its outlook up as the weight of positive data in recent months makes their pessimistic stance unsupportable. The U.S. economy will see a higher-than-normal pace of growth for at least two years and perhaps more. Unemployment will be back into the low 4’s in 2022. While the COVID pandemic will be remembered for decades, the economic ramifications will disappear more quickly than the legacy of the tech bubble collapse in the late 1990s.

Unfortunately, all the good news will be tempered by problems that will arise from the Federal government’s excessive monetary and fiscal intervention. We’re already seeing some effects, such as a stock market driven to extreme valuations, and a housing market that is experiencing record price increases and incredibly low inventories. At this point, however, Beacon Economics doesn’t see financial volatility offsetting the growth momentum of the real economy. The fundamentals of the debt markets and real estate are still very good. Even a sizable stock market crash will not create systemic problems. The peril of financial market bubbles will become manifest if the huge new supply of wealth starts to overheat the economy and create the types of distortions that made recovery from the Great Recession so long and painful. However, this won’t be an issue for years.

A more critical and immediate issue is the potential for inflation. The massive increase in the money supply has created an inflation risk unlike any seen since the 1970s. Too many economists have been lulled into a sense of false security—after all, inflation has continued to sit below Fed targets despite years of relatively fast money supply growth, suggesting structural changes in the economy have reduced inflation risks. But the current surge in money expansion is far beyond anything experienced in the past, so this confidence is misplaced. This isn’t to say inflation is an immediate threat. Recent trends in interest rates and consumer prices are a function of the recovery—not the excess supply of liquidity. For inflation to kick in, the economy has to be running at close to full capacity and typically experience some external demand shock—such as a large expansion in Federal spending. These conditions will all be in place in 2023. There is time to reduce that loose money supply, but will those efforts begin soon enough? We don’t know.

Lastly, there is the explosion in Federal borrowing. In the short run, as the economy begins to fully heal, Beacon Economics anticipates that the private sector will again go back to spending and borrowing—and saving less. The Federal Reserve should be on track to absorb excess liquidity by starting to shrink their balance sheet. But all this removes the funds that have been available for the Federal government to borrow. Hence, future deficits are more likely to cause real interest rates to go up. And ultimately, with the Federal government likely to add $10 billion to its outstanding debt in four short years, the nation will find itself more challenged in its future choices regarding how to balance the competing needs of discretionary spending and entitlement programs. And if, as feared, inflation does creep into the system, look for the cost of carrying this debt (currently quite low due to record low interest rates), to rise very sharply, very quickly.

There has been a tendency by many prominent economists to be quite forgiving of these deficits. They are less worried about the potential for a fiscal crisis, even at the high debt-to-GDP levels. But history is clear on two points. First, when making unprecedented moves in deficits and debt expansions, lessons of the recent past are no longer relevant; ergo we should not be so pollyannish about the situation. And second, bond markets also seem unconcerned about Federal borrowing. But history shows us that bond markets are very placid—until they aren’t. That is when we will have serious political and economic problems on our hands.