There has been considerable drama over the fate of another stimulus package, including pleas from Federal Reserve officials that the recovery is at risk of reverting to recession absent another boost. This from Federal Reserve Chair Jerome Powell:

 In a typical recession, there is a downward spiral in which layoffs lead to still lower demand, and subsequent additional layoffs. This dynamic was disrupted by the infusion of funds to households and businesses…

…[a] risk is that a prolonged slowing in the pace of improvement over time could trigger typical recessionary dynamics, as weakness feeds on weakness.

There is a lot going on in those sentences. I think it is important to be careful with the term “spiral” as it implies a self-perpetuating process. The implication of a spiral is that it doesn’t end or, in other words, the economy can’t find a new equilibrium. Basically, an economy characterized by one stable equilibrium and once pushed off that equilibrium it spirals into oblivion (or, if pushed the other way, into a bubble). I don’t think this is an accurate characterization of the economy.

Intuitively, one job loss leads to less than one more job loss such that each subsequent round in the dynamic becomes smaller and smaller until a new equilibrium is reached. If this wasn’t the case, you would expect every negative shock to have a very large chance of yielding a very severe recession. That’s just not what we observe in the real world.

That said, policy would still minimize the extent of those subsequent job losses and thus limit the depth of the recession. In the particular turn of events faced this year, however, I would say it is still an open question as to how much that process was reversed by policy and how much was reversed by the subsequent positive shock that hit the economy.

What positive shock? Well, if shutting down the economy was a negative shock, then re-opening the economy was a positive shock which began to shift the dynamics in the reverse direction. This too will taper off over time (one job gain will not produce more than one additional job gain).  Eventually the economy will end up in a familiar kind of equilibrium in which it is growing at such a pace that produces say 200k jobs per month.

Powell posits a theory where that slowing in the pace of improvement yields a fresh recession. That implies some endogenous double-dip recession that seems unlikely absent a fresh negative shock. More likely is that the pace of recovery slows such that the time to full recovery is more protracted than desirable. Unfortunately, I suspect this is almost a certainty given that a substantial portion of the economy remains encumbered by the pandemic.

Will we see a new negative shock? The Fed has two leading candidates. The first is a surge of Covid-19 infections that lead to a fresh nationwide lockdown. I think this is very unlikely. More likely is more of what we have been seeing, rolling policy and behavioral shifts on a local level as cases rise and fall. I don’t think another mass lockdown is politically sustainable nor economically desirable.

What about the fiscal shock of not getting another stimulus package? It sure seems like fiscal policy went off a cliff more than two months ago and yet the economy has not yet followed. And while people like to refuse to believe that the stock market has any relationship with the overall economy, note that stock prices cratered as the economy went over the pandemic cliff in the spring yet have completely ignored the fiscal cliff.

This opens up the question of why has the economy so far not retrenched with the end of the enhanced unemployment benefits? The answer seems to be this from the New York Federal Reserve:

Next, we analyze how the respondents who were on unemployment insurance (UI) in June, at the time they took the survey, used these benefits. As indicated by the table above, the average share of funds saved (23 percent) out of UI checks is much lower compared to the reported saving rate out of the stimulus checks. This difference, of course, is most likely related to the fact that those who are on UI are more likely to be credit- and cash-constrained. Similarly, we observe that the average shares of funds used to pay down debt (48 percent) and spent on essential items out of UI checks (24 percent) are significantly higher than the respective shares reported from stimulus payments. The addition of spending on non-essential items and donations brings the total MPC out of UI checks to 29 percent.

Essential and non-essential spending accounted for just 29% of UI payments, the rest was saved or used to pay down debt (which increases net wealth so it is really just saving). Results for the tax rebates:

Our analysis shows that, while economic impact payments have been acting as a significant boost to the economy, households spent a relatively small share (29 percent) of these payments by June 2020 and allocated the remaining funds equally between saving (36 percent) and paying down debt (35 percent).

The conclusion is that that vast amounts of the fiscal support was not spent but instead saved I wrote about this back in August). Which would explain why spending has not collapsed with the end of the enhanced benefits. The past benefits still exist as savings to be drawn down or were not as important for spending as initially believed (see this here).

Bottom Line: What can we conclude from this analysis?

• The Fed is probably overly pessimistic about the sustainability of the recovery. From a monetary policy perspective, I think it is appropriate to place additional emphasis on downside risks.
• From a public policy perspective, the still likely extended period of high unemployment argues strongly for additional fiscal support, but if much of the rebates and UI payments are being saved, we should be considering more targeted support or aid that we know will be entirely spent (aid to state and local governments).
• The observation that the economic recovery is both self-sustaining and the observation that more fiscal support would be optimal are not mutually exclusive. If you are a market participant, you can’t pretend that the recovery will falter simply because you believe more aid is appropriate.
• The stock of savings accumulated during since March suggests substantial upside risk to the economy.
• The possibility of a fiscal package after the election is another upside risk to the economy.
• Even the upside risks to the economy may be insufficient to shift the Fed from its zero rate policy anytime soon given the stickiness of low inflation and its propensity to emphasize the downside risks. Asset purchases remain the open policy question (in either direction!).