The motto for fiscal policy these days is: “Whatever it takes,” and it is indeed the right motto. But what does it mean? What about the specifics? And can we really afford it? Or will we wake up in a few months with a hangover, asking ourselves, “What on earth did we do?”
The purpose of this blog is to take a pass at these issues and come to a tentative conclusion. (Spoiler alert: For advanced economies, “whatever it takes” may be less than you think. And, yes, we can almost surely afford it.) In a forthcoming blog, I shall compare my normative conclusions with what is being put in place in various countries.
I see three roles for fiscal policy in the COVID-19 crisis.
- The first is infection fighting, spending as much as needed both to deal with the infection now and to give incentives to firms to produce tests, drugs, and vaccines, so that the pandemic can be both brought down and kept under control.
- The second is disaster relief, providing funds to liquidity-constrained households and firms. Many households do not have the cash to survive the next few months without financial help. Many firms do not have the cash to avoid bankruptcy without help. Providing financial relief is essential to avoid extreme suffering and permanent damage to the economy.
- The third is support of aggregate demand, making sure that the economy operates as close to potential as it can, but recognizing that potential is, for the moment, profoundly impaired by the health measures needed to decrease the infection rate.
Let me look into each one in more detail.
Infection fighting is a no-brainer
Getting the infection rate down is an absolute priority. Apart from confinement/lockdown measures, more tests, more respirators, more masks and other vital medical supplies are essential. In the short run, the constraint is largely technological, but more funds can help attract firms and workers with the relevant skills to accelerate production. Keeping the infection rate down will be essential to the recovery, which implies giving incentives to firms to produce tests, explore drugs, and develop vaccines. The bottom line, however, is that spending on containing the infection is essential, existential, and expensive but still small in macroeconomic and budgetary terms—less than 1 percent of a country’s GDP.
Disaster relief is also a no-brainer
A large proportion of households has no cash reserves. Because of either low demand or forced lockdown, many small and medium-size enterprises, which represent 45 percent of total value added in the United States, have insufficient cash reserves to survive more than a few months. It is of the essence to provide them with enough cash to survive the crisis. The main issue is how to quickly get the funds to the people and firms in need. Much work is now going into how to do it, with different solutions in different countries. These run from suspending or cancelling tax payments, to increasing unemployment benefits, to sending checks, to asking firms to advance the funds to workers, to asking banks to advance the funds to firms in need, with the state providing the final backstop.
None of these distribution channels work perfectly; they are far from perfect. Information about who needs the money is limited; reaching those who need it the most is difficult. The implication is that, whatever combination of delivery is chosen, it is better to err on the side of giving too much rather than too little. This may, however, result in a large package. Consider the following back-of-the-envelope computation for a plausible upper bound: Assume that 40 percent of the firms and households are potentially liquidity-constrained, that the replacement rate is 80 percent, so the state replaces, say, 32 percent of lost income. Suppose that nonessential firms are on lockdown, and that output goes down by 35 percent (which is in the range of the preliminary numbers for economies on lockdown, such as France). Assume that the funds take the form of grants rather than loans, an issue to which I return below. The fiscal cost per month is 35 percent times 32 percent, thus 11 percent. If the economy is, say, on full lockdown for two months and on half lockdown for another six months, the fiscal bill will be about 5 percent of a country’s GDP.
Supporting aggregate demand is a more delicate act
In a normal recession, control of aggregate demand would be the main motivation for using fiscal policy. This, however, is a not a normal recession, and it has important implications. In the short run, so long as confinement and lockdown constraints are on, potential output will remain much lower. Based on the French number cited above, the decrease in potential output, based on confinement and lockdown of all nonessential firms, probably ranges between 25 and 40 percent. Governments must accept a corresponding decrease in demand (importing from abroad is not an option; this is a world war against the virus). Put another way, sustaining demand above potential, say, through tax cuts for firms or households, may lead to rationing and inflation rather than an increase in activity.
This raises a question about the size of the disaster relief package I discussed earlier. It could indeed be that the increase in consumption, which is likely to be substantial if the funds really go to liquidity-constrained households, runs into supply constraints. This concern may not be a major issue, as much of the spending is likely to go toward making mortgage payments and buying food—a sector where supply constraints may not be binding. And, even if the outcome is in part some rationing and some inflation, the distribution effects—namely that poorer households have enough to eat—are such that the outcome is still desirable. But the point remains that, so long as potential output remains much lower, boosting aggregate demand beyond what is needed for disaster relief is probably unwise.
The situation will change, however, if and when the infection rate is under control, restrictions are slowly relaxed, and potential output returns, if not to its old level, at least close to it. Will there be a need then to boost aggregate demand and help the economy recover faster? On the one hand, there will be pent-up demand from consumers who could not buy cars and other durables during the lockdown. On the other, the rate at which restrictions are removed, or the real possibility that restrictions have to be reinstated if the infection rate starts increasing again, is likely to lead to precautionary saving by consumers and low investment by firms. I genuinely do not know which way it will go, and this has a straightforward implication: Governments should be ready to act but should not commit to a specific level of fiscal expansion before they know which way demand will go.
To sum up, infection fighting and disaster relief are the highest priorities. Unless the fight against the virus turns out to be much tougher and longer than expected, they imply large but not gigantic deficits. Doing more to increase aggregate demand may be unwise in the short run, and a boost may or may not be needed later. Flexibility here is of the essence.
Should governments worry about the increase in debt?
Will there be a “what on earth did we do?” moment? This happened in Europe during the financial crisis, when, after embarking on a major fiscal expansion, governments got worried about the large increase in debt and shifted to fiscal austerity, which probably slowed the recovery.
Suppose that, as a result of not only the deficits but also the decrease in output, debt-to-GDP ratios increase this time by, say, 30 percent of GDP (the computation above suggests smaller numbers). Should governments worry? And, if so, should they design smaller fiscal packages today, perhaps relying more on loans than on grants to households and firms? I believe the answer depends on whether we are looking at advanced or emerging-market and developing economies.
In advanced economies, the answer must be that, short of a defeat in the fight against the virus, debt will remain sustainable. (And if we lose that battle, debt sustainability will be the least of our problems.) Before the COVID-19 crisis I had argued that low safe interest rates implied not only that higher levels of debt were sustainable but also that the welfare cost of higher debt for future generations was small. The implication was that advanced-country governments should not hesitate to run deficits if, given constraints on monetary policy, running deficits is required to maintain output at potential. The need to maintain output at potential is most definitely here. And, if anything, safe interest rates are likely to be even lower in the future than they were expected to be before the COVID-19 crisis. Precautionary saving is likely to be higher, and uncertainty is likely to hamper private investment; both imply a lower neutral rate for a long time to come.
Having argued that advanced economies have substantial fiscal space, I am much less sanguine about emerging-market and developing economies. Many of them were already struggling before the COVID-19 crisis and have been hit not only by the virus but also by the fall in commodity prices (if they are exporters) and large capital outflows by investors who need liquidity at home. Some of these economies do not have the fiscal space to react to these combined shocks and will need help, in the form of grants to fight the virus, and adjustment programs to adapt to the other shocks. Helping emerging-market and developing economies is a major and urgent issue, not only for their own sake but also for the evolution of the pandemic and thus for the rest of the world. It is tough for advanced economies, confronted with the crisis at home, to be generous. But it is essential that they be.
The bottom line: In my view, “whatever it takes” means spending as much as needed to fight the virus and to avoid hunger and bankruptcies. Being ready and committed to spend more if demand does not pick up, but keeping options open. And, at least for advanced economies, not worrying about the resulting increase in debt.
2. According to a US Federal Reserve survey conducted in 2018, only 61 percent of those surveyed would have enough liquidity to pay for an unexpected expense of $400. According to a September 2019 study by the JPMorgan Chase Institute, half of US small businesses have less than 15 days’ worth of cash on hand.
4. Large public investment programs, as needed as they are, are not the right instrument to deal with the challenge at hand.
5. As I argued in another piece on Italian debt, sovereign bond markets are exposed to multiple equilibria: At the safe rate, debt is safe. But if investors start worrying and increase spreads, debt can indeed become unsafe, and the worries of investors become self-fulfilling. In advanced economies, the bad equilibrium can be eliminated by the central bank’s commitment to keep the rate low.