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When Stimulus Works, and When it Does Not: COVID-19, GFC and Japan

Updated: Dec 29, 2022


As prices soar, the faith in the economics profession falls – indeed, sometimes, the effect of a policy is not clear to experts until after it has already happened. For instance, to cushion the impact of the 2007-2009 global financial crisis (GFC), extensive stimulus packages and monetary accommodations were implemented – and yet, little inflation occurred. But now, following the 2020-2021 COVID-19 crisis, similar measures have led to prices rising at the fastest pace in decades. What changed?

For any additional liquidity to have an effect, it must reach and be spent within the real economy first – though this does not always occur. The behaviour of economic agents is crucial to understanding when policies do or do not work as intended.

It should be noted that fiscal and monetary policies are not the only drivers behind current inflation in western economies – the Russian invasion of Ukraine perpetuates cost-push inflation, while lingering supply chain disruptions due to the Omicron wave and China’s zero-COVID policy creates demand-pull inflation. For the purposes of this column, we shall focus on government and central bank policies as possible causes of inflation, bearing in mind that they may not always be the only cause.

When Policies Cause Inflation – Fiscal policy in the US in 2020-2021

The current inflation levels in the US are no accident – the policies implemented during and after the COVID-19 pandemic worked as intended, and economic agents behaved in a way that furthered inflation: when authorities pumped money into the economy, banks lent, households consumed and firms increased their prices.

Throughout the 2020-2021 pandemic, the United States (US) government spent an accumulated $5 trillion on stimulus for the economy – by the end of 2021, Americans faced a CPI rate of 7%, 3% of which can be directly attributed to the effects of the pandemic relief packages, according to the Federal Reserve Bank of San Francisco.

Such packages include the $1 trillion American Rescue Plan, providing the vulnerable with loans, grants, tax credits and even direct cheques worth $1400. While the US may have achieved “one of the strongest periods of economic growth in a century” (U.S. Department of Treasury), it did so through a profoundly demand-driven recovery. Consumers had more disposable personal income available to them, which, in turn, lead to greater demand and consumption. Additionally, supply chain disruptions did not subside alongside economic recovery, as authorities believed when they first implemented such stimulus policies, so supply could not satisfy the post-lockdown explosion of demand. Demand-pull inflation is the logical end result.

When Policies do not Cause Inflation – Unconventional Monetary Policy in 2013-2019

Average consumer prices recorded in 2013-2019 read 0.87% for the eurozone, 1.54% for the US and 1.68% for the UK. Surprisingly, this was also a period in which western central banks carried out extensive quantitative easing (QE) programs, which increase the money supply of the economy and stimulate demand by incentivising banks to lend. So, why did QE not cause high inflation?

It is worth bearing in mind that global availability of credit tightened as banks faced stricter regulation, and – most notably – may have become more risk-averse. One may connect the latter development with a theory proposed by Benn Steil and Benjamin Della Rocca, economists at the Council on Foreign Relations.

Despite no obvious liquidity risks, banks seem to have hoarded the credit available to them, so the money had no way of reaching the real economy. Steil and Della Rocca were even able to predict inflation in the US by observing the gap between central bank bond holdings (used to generate liquidity for commercial banks) and excess bank reserves (reserves in excess of the reserve asset ratio) – it was only in 2022 that banks started to use up their excess reserves, pumping money into the economy. Only then, QE worked as intended.