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More Stimulus and the Second Derivative Effect

Lance Roberts

 

There is currently much hope for another fiscal stimulus package to be delivered to the economy from Congress. While President Trump recently doused hopes of a quick passage, there a demand for more stimulus by both parties. While most hope more stimulus will cure the economy’s ills, it will likely disappoint due to the “second​​ derivative effect.”

 

Let me explain.

 

In March, as the economy shut down due to the pandemic, the Federal Reserve leaped into action to flood the system with liquidity. At the same time, Congress passed a massive fiscal stimulus bill that expanded Unemployment Benefits and sent checks directly to households. As shown in the chart below of the upcoming expected GDP report, it worked. (We estimated GDP to increase by 30% from the previous quarter.)

 

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

 

That expected 30% surge in the third quarter, and surging stock market to boot, directly responded to both the fiscal and monetary stimulus supplied. The chart below adds the percentage change in Federal expenditures to the chart for comparison.

 

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

 

The spike in Q2 in Federal​​ expenditure was from the initial CARES Act. In Q1-2020, the Government spent $4.9​​ trillion in total, which was up $85.3​​ billion from Q4-2019. In Q2-2020, it increased sharply, including the passage of the CARES Act. Spending for Q2 jumped to $9.1​​ trillion, which as a $4.2​​ trillion increase over Q1-2020.

 

Those are the facts as published by the Federal Reserve. From this point forward, we have to start making some estimates and assumptions.

Assuming CARES-2

 

During Q3-2020, not much happened as the Government was fighting over the next round of stimulus. As such, spending fell back to a more normal level of increase. However, if we assume that a second CARES Act is passed some time in Q4, and we apply a price tag of $2​​ trillion to the package, it would represent a roughly 25% increase in Government spending over Q3-2020.

 

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

 

Such is the “second derivative” effect we mentioned previously.

“In calculus, the second derivative, or the second-order derivative, of a function f is the derivative of the derivative of f.” – Wikipedia

 

In English, the “second derivative” measures how the rate of change of a quantity is itself changing.

 

I know, still confusing.

 

Let’s run an example:

 

As Government spending grows sequentially larger, each additional round of spending will have less and less impact on the total. Going back to 2016, not including the CARES Act, the Government increased spending by roughly $50 billion each quarter on average. If we run a hypothetical model of Government expenditures at $50 billion per quarter, you can see the issue of the “second derivative.”

 

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

 

In this case, even though Federal expenditures are increasing at $50​​ billion per quarter, the rate of change declines as the total spending increase.

More Leads​​ to​​ Less

 

The next chart shows how the “second derivative” is already undermining both fiscal and monetary stimulus. Using actual data going back to the Q1-2019, Federal​​ expenditures remained relatively stable through Q1-2020, along with real economic growth. However, in Q2-2020, with our estimates for Q3 and Q4, Federal​​ expenditures will almost double. However, the economy will not return to positive growth.

 

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

 

The chart below shows the inherent problem. While the additional fiscal stimulus may help stave off a more in-depth economic contraction, its impact becomes less over time.

 

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

However, this is ultimately the problem with all debt-supported fiscal and monetary programs.

 

Still​​ in​​ A Recession

 

As I stated above, even assuming a $2​​ trillion fiscal relief package by the end of October, which I suspect may not come, the relative impact on GDP growth will fall short of expectations.

 

Take a look at the next chart. These are our current estimates for GDP growth over the next​​ three​​ quarters. These estimates dovetail reasonably nicely with mainstream consensus.

 

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

 

At first glance, it appears that after one negative quarter of GDP, the economy is well back on track to normalcy. However, such an assumption would be incorrect. Given that we measure economic growth on an annualized basis, the three​​ quarters of positive change following such a steep decline still leaves the economy in a recession.

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

 

Yes, add a couple of more quarters of economic growth, and you will eventually be back into positive territory. However, therein lies an even bigger problem.

 

Dollars​​ of​​ Growth Deteriorate

 

As noted above, it requires increasing levels of debt to generate lower rates of economic growth. The chart below shows the previous and estimated CARES Acts and their impact on GDP growth.

 

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

 

To understand this better, we can view it from the perspective of how many dollars does it require to generate $1 of economic growth. Following the economic shutdown, when economic activity went to zero, each dollar of input had a more considerable impact as the economy restarted. However, in Q4, economic activity has already recovered and begun to stabilize at a slightly lower level than seen previously.

 

High-frequency data like credit card spending and main-street activity indicators tell us this is the case.

 

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

 

Given that stabilization of activity, it will require more dollars to generate economic growth in the future. As shown, it will require $8.80 of debt-supported expenditures to create $1 of economic growth.

 

stimulus 2nd derivative effect, #MacroView: More Stimulus And The 2nd Derivative Effect

Here is the exciting part. That is NOT a new thing. As I discussed just recently “The One-Way Trip Of American Debt:”

 

The “COVID-19″ crisis led to a debt surge to new highs. Such will result in a retardation of economic growth to 1.5% or less, as recently. Simultaneously, the stock market may rise due to massive Fed liquidity, but only the 10% of the population owning 88% of the market benefits. In the future, the economic bifurcation will deepen to the point where 5% of the population owns virtually all of it.

 

As I noted previously, it now requires $7.42 of debt to create $1 of economic growth, which will only worsen as the debt continues to expand at the expense of more robust rates of growth.