This article is part of an FT series on the economic cures for the coronavirus crisis, in which leading commentators and policymakers give their advice on how to alleviate a devastating global slowdown.
As the enormity of Covid-19’s probable economic fallout dawns, governments should prepare themselves for equally yawning gaps in public finances. That should not be a cause for alarm. On the contrary, unless government deficits widen to a scale unprecedented even in the global financial crisis then policy may well be seen to have failed to do its job.
Between 2008 and 2010 the public debt of the Group of 7 large economies rose by 10 to 25 percentage points as a share of gross domestic product. Government deficits worsened by four to 10 percentage points. Most of that was because of the collapse in GDP, which reduced tax revenues and increased spending on things such as unemployment benefits — the “automatic stabilisers” of government budgets in action. A smaller part was due to the discretionary fiscal stimulus packages deployed in 2009.
It now looks like the current downturn will be at least as deep as that caused by the global financial crisis. Economists think Chinese GDP fell by 13 per cent in the first two months of the year. Dramatic contractions are likely in the US and European economies too, with cross-border travel all but shut down and much retail, service and manufacturing activity reduced by isolation and social-distancing measures.
As economics professor Pierre-Olivier Gourinchas points out, if the measures to contain the virus reduce economic activity to half its normal level for just one month, and then to three-quarters for two more months, year-on-year growth will come in at about minus 10 per cent.
If the downturn this year is deeper than in 2008-9, we should expect bigger government deficits than then. But even that will not be enough. The discretionary fiscal stimulus needed today is much bigger than the 1.5 per cent of GDP delivered in the EU a decade ago.
That is because the right fiscal response today, beyond obviously spending as much on health measures as needed, is to sustain the income that people had expected to receive were it not for the virus. While the disease and the containment measures constitute a temporary (we hope) supply shock, the demand repercussions will make the recession deeper and longer. Disappearing orders, jobs and pay cheques — and the uncertainty that this creates — make people curtail their purchases by far more than the direct effect of the disruption.
That is why it is a mistake to argue that a big demand stimulus cannot do any good because demand is constrained by disrupted supplies and people’s constrained ability to spend if they are self-isolating. The point of a fiscal programme, scaled to sustain everyone’s income through the downturn, is to ensure that demand falls no further than this. The dramatic slide in inflation expectations suggests that markets expect demand to contract much more than is necessary.
What do naysayers think are the risks of a massive fiscal transfer programme? Is it that people do not spend it because they are physically unable to? At least they will not cut back because they are afraid for their futures, which is what can cause harmful downward spirals in demand. Or is it that the additional debt is unsustainable? Yet central banks have ensured that ultra-low interest rates can be locked in for the long term.
Or is it that they do try to spend it, but because of supply shutdowns this causes an inflationary spike? Yet that would be a sign of success: it would prove that a deeper demand contraction has been contained. As soon as capacity is back on stream, increased production will bring inflation down. There may even be an added bonus if pent-up demand creates pressure for greater production and productivity improvements, just when people may be eager to get back to work and make up for lost time.
The upshot of all this is twofold.
First, governments should throw caution to the wind and spend massively. Luis Garicano, an economics professor and EU parliamentarian, proposes a programme of €500bn, or some 4 per cent of EU GDP. Even that may be too modest. Prof Gourinchas suggests the size of the fiscal stimulus should be as big as the drop in GDP. If governments end the year with budget deficits in the single digits, they will most probably have done too little.
Second, speed is of the essence when the goal is to reassure people they will not be poorer. This puts on the table policy ideas that just yesterday seemed radical. Universal transfers to all Americans are being discussed seriously in the US (following Hong Kong’s example) as the quickest way to achieve traction on the real economy. The push by many economists to sustain incomes, regardless of the supply contraction and possible inflation, amounts to a tacit endorsement of targeting nominal GDP.
As for the eurozone, mutualising some of the new debt to ensure that flighty bond markets do not derail government spending to combat the virus has become conceivable, whether that is through common bonds or central bank money.
The containment of the virus is already turning our everyday life upside down. The necessary fiscal remedy may well do the same to many received economic ideas.
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