As Biden models LBJ’s Great Society, will fiscal history repeat?

The passage of President Biden’s $1.9 trillion covid relief bill this week is being heralded as the most significant legislation in more than a generation. It provides a bridge for low-to-middle income households to cope financially until vaccines enable the U.S. economy to function normally.  

The bill is popular with the electorate for obvious reasons: Families of four earning $150,000 or less will receive checks totaling $5,600 and the unemployed will receive added weekly benefits of $300 into September. Other key provisions include funding for the rollout of vaccines and enhancing school safety, as well as $350 billion of support for state and local assistance. 

Many of the provisions will lapse after specified periods. However, Democrats are seeking to make increased child-tax-credits permanent — to $3,600 for children under age six and $3,000 for those six to 17-years-old, up from $2,000 currently. The added support is estimated to cost more than $100 billion annually and it is viewed by some as a way to provide permanent assistance to families

The main item on the Democrat’s wish list that was not included was the proposed doubling in the minimum wage to $15 per hour. However, progressives indicate they will seek separate legislation on this issue.

Beyond this, an ambitious program for the Biden administration is in the works that will include a major infrastructure program and a plan to tackle climate change. The cost could be in the vicinity of $2 trillion to $4 trillion over the coming decade.  

The main issue for investors is what the budgetary impact of increased federal spending will be. Last year, the federal deficit ballooned to a post-war high of nearly 14 percent of GDP, and it is on pace to rival that level this year. This has caused some observers including former Treasury Secretary Lawrence Summers to note the risk that the stimulus could cause the economy to overheat and generate higher inflation and interest rates.

This view is enunciated in detail by Michael Bordo and Mickey Levy, who have studied the relationship between expansionary fiscal policies and inflation for over two centuries.  

The authors note that a key difference from the 2008 global financial crisis is the money supply has surged this past year partly as a result of excess saving associated with COVID transfer payments. Meanwhile, the increase in federal debt outstanding has created a situation of “fiscal dominance” in which the Fed is compelled to keep interest rates low for the foreseeable future to keep the government’s debt service costs manageable.

For some observers, this predicament is similar to what occurred in the mid-late 1960s when President Lyndon B. Johnson proclaimed the “Great Society” while the Vietnam War was being ramped up. The initiatives included a “War on Poverty,” creation of Medicare and Medicaid, the launch of the Head Start program, urban renewal and passage of the Motor Vehicle Air and Pollution Control Act.

When these programs were unveiled in the mid-1960s, the federal budget was close to balance and interest rates and inflation were low. Thereafter, federal spending rose by 50 percent in the second half of the decade owing to the expansion in social programs and costs incurred in fighting the Vietnam War. Because tax rates then were substantially higher than today (with the top marginal tax rate for households at 70 percent) the increase in the federal budget deficit did not rise above 3 percent of GDP.

Nonetheless, consumer price inflation, which was only 1 percent at the beginning of the 1960s, rose steadily in the second half and approached 6 percent in 1970. The principal reason was the Fed was slow to raise interest rates and inflation expectations increased.  The situation culminated with the first U.S. dollar devaluation in December 1971 that was the precursor of the breakdown of the Bretton Woods system of fixed exchange rates. 

By comparison, few economists today believe the U.S. economy is headed for a repeat of the 1960s and 1970s. The primary reason is the Federal Reserve regained its credibility as an inflation fighter in the 1980s and it has kept inflation at or below its target of 2 percent for several decades now. Accordingly, proponents of fiscal stimulus contend low interest rates mean the opportunity costs are low.

However, even if inflation does not resurface quickly with unemployment still elevated, the likelihood is that Treasury bond yields will continue to climb as the economy recovers. Ten year yields have already increased by more than 50 basis this year to 1.6 percent recently and they could reach or surpass 2.0 percent as COVID vaccines become widespread and businesses resume normal operations.

Beyond the near term, the big issue is whether government programs will be rolled back sufficiently as economic conditions improve.

The main cost incurred by the “Great Society”— added healthcare expenses associated with Medicare and Medicaid — did not show up immediately but grew exponentially over time. For example, U.S. spending on healthcare was only 5 percent of GDP when these programs were launched as compared with 18 percent today and federal programs now account for nearly one third of the total. 

One thing that is clear is that the pace of increase of federal debt held by the public over the past decade is not sustainable: It has doubled to nearly 80 percent of GDP from less than 40 percent before the 2008 global financial crisis. Moreover, some forecasts call for further increases in the coming decade. 

Meanwhile, the Biden administration is expected to unveil its plans for boosting taxes on corporations and the wealthy to help to defray some of the costs of the federal programs enacted. According to Wharton’s Budget model the tally could exceed $3 trillion over the coming decade, while other forecasts call for taxes to increase between $1 trillion to $2 trillion. Once tax increases are finalized, investors will have a better idea of the sustainability of the budgetary outlook.   

Nick Sargen is an economic consultant at Fort Washington Investment Advisors and a lecturer at the University of Virginia Darden School of Business.