The problem, he says, is that the total size of the plan reaches a scale that risks major future problems. In particular, the total money that is being proposed far exceeds most of the “output gap” estimates. (More on that next.) This implies that much of the spending will simply spread across the economy, causing prices to rise, potentially disrupting the rest of Biden’s agenda and risking another recession.
This is not a conventional argument between doctrinal hawks and pigeons, but something more subtle. In the past, Summers in particular has repeatedly called for larger budget deficits to help combat “secular stagnation”, in which the world’s major economies are mired in slow growth, and he has supported large pandemic aid packages.
But Summers says that any new spending package should pay off gradually over time and be more substantially dedicated to long-term investments.
“There is nothing wrong with targeting $ 1.9 trillion, and I could support a much larger number in total stimulus,” he wrote in a subsequent article. “But a substantial part of the program must be directed towards promoting sustainable and inclusive economic growth for the rest of the decade and beyond, not simply to support income this year and the next.”
What is the product gap?
Imagine a world in which the American economy is operating to its full potential. Almost everyone who wants to work can find a job. Each plant is at full capacity. The output gap is simply how far the economy is from this ideal state.
A traditional approach to fiscal stimulus has been to estimate the size of this gap, apply some adjustments to account for the way federal spending moves through the economy and use this arithmetic to decide how big a stimulus action should be.
In theory, if the government injects a lot of money into the economy, it is trying to generate activity beyond the potential product, which is impossible to sustain for a long time. Workers can work overtime and a factory can work overtime for a while, but eventually workers want a break and machines need to be shut down for maintenance. If there is more money floating in the economy than the supply of goods and services, the result will not be greater prosperity, but higher prices as people bid for the things they want to buy.