By Dr. Rajkumar Singh
The pandemic Covid-19 has three society -related goals.The first is to fight the virus. The second is to provide disaster relief, to ensure that people do not suffer from hunger and firms do not go bankrupt. The third is to adjust aggregate demand to stay as close to potential output as possible.
However, each of these three dimensions comes with its own set of challenges and difficult decisions. It’s a difficult task for both developed and developing countries equally. In most advanced countries, interest rates are likely to remain low for a long time, so that, despite this increase in debt ratios, debt should remain sustainable. The same cannot, however, be said of several emerging-market and developing economies.
These countries should be helped so that they can spend what they need to spend to deal with the crisis. Forcing them to spend less would be wrong and dangerous for others. They will, therefore, need grants and loans, both by international institutions and individual advanced economies, which themselves have to spend to save their own economies.
There are two dimensions in which coordination across countries is essential. Help for emerging-market and developing economies is of the essence. Looking down the road, coordination in the purchase and allocation of tests and vaccines is equally so. But, beyond this, coordination of fiscal policies is not essential. In nutshell, if each country focuses only on its domestic goals, the outcome will be fine.
First priority of fiscal policy
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 and kept under control. 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 gear 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.
A large scaling up in the production of tests, to test either for the virus or for antibodies, can make a substantial difference in the speed at which confinement restrictions can be relaxed while keeping the infection rate down. 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.
Next to infection fighting is disaster relief and 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 some help.
Providing financial relief is essential to avoid extreme suffering and permanent damage to the economy. 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 going into how to do it, with different solutions in different countries. These run from suspending or canceling 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.
Challenges before the fiscal policy
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 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, 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 GDP. 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.
Hope, hard work and Covid-19
The support of aggregate demand means to make sure that the economy operates as close to potential as it can, recognizing that potential is, for the moment, profoundly impaired by the health measures needed to decrease the infection rate. 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. The decrease in potential output, based on confinement and lockdown of all nonessential firms, probably ranges between 30 and 40 percent. Governments must accept a corresponding decrease in demand. 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.
The situation will change, however, 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? The answer is that I do not know. On the one hand, there will, at least initially, be some pent-up demand from consumers who could not buy cars and other durables during lockdown.
On the other, the rate at which restrictions are removed, or the real possibility that restraints 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. Demand may go up initially and then slump again, but it is hard to be sure. This uncertainty has a straightforward implication: Governments should be ready but should not commit to a specific level of fiscal expansion before knowing where the demand goes.
Author: Dr. Rajkumar Singh, Professor and Head, University Department of Political Science, B.N.Mandal University, Madhepura, Madhepura-852113, Bihar, India.
(The opinions expressed in this article are solely those of the author and do not necessarily reflect the views of World Geostrategic Insights)