17 March 2020

Ignore short-term GDP and avoid ‘fiscal stimulus’ – the upside-down economics of coronavirus

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Even if not a technical recession (two quarters of negative growth), a severe coronavirus-induced downturn looks certain across major economies.

Markets signal itTop economists predict it (a recent IGM poll showed 62% to 8% “agreeing” it would happen.) And many “feel it” already – from disruptions to supply chains and work arrangements, to collapsing demand for leisure, travel, and entertainment.

This, though, is no ordinary downturn. Economists and commentators who talk about it as such, pushing the same-old “fiscal stimulus” arguments for encouraging spending to “protect the economy,” are not just wrong right now, but dangerous.

The first implication of coronavirus economics is that a sharp slowdown in activity is necessary to contain the virus, because it represents the social distancing required to reduce its spread. While usually a reasonable proxy for economic health then, GDP is temporarily useless as a metric of social welfare. We should ignore it.

Second, ensuring this pause in activity does not do longer-lasting damage should be our key objective. We want this to play out like a bad agricultural season, or an extended “Christmas week” – with a Nike-tick recovery or, given some spending will never occur, a V-shaped rebound that redistributes activity over time.

Both these points mean policy success should be judged not by short-run GDP, but ability to mitigate distress among vulnerable households and businesses, preventing business failures or mass layoffs in viable firms, or severe hardship for those without significant savings or employer benefits. We can judge longer success by assessing the path of GDP over 1-2 years.

GDP must fall, and it will

The Government cannot do much about supply-chain disruption, sick workers, or necessary self-isolation. But to delay infections, containment policies, business closures, and voluntarily isolation reduces near-term demand significantly too. GDP will fall as a result.

The OBR’s initial hope that the coronavirus might shave 0.1 percentage points off UK GDP this year is hopelessly outdated. But people may be shocked when GDP numbers are next published. Goldman Sachs reckons US GDP will fall by 5% in Q2, rebounding with rapid growth in Q3 and Q4. IEA Fellow Julian Jessop thinks UK GDP could decline by 6% if a fifth of workers can’t get to work, even with “policy stimulus”.

That’s a similar downturn to the financial crisis. But this might be conservative. Simon Wren Lewis’s influenza pandemic modelling found that school closures for 13 weeks and consumers curbing entertainment and social spending could generate a one quarter GDP fall of 21%, bouncing back sharply to a one year GDP decline of 4.5%.

If this seems infeasible, consider your own spending. You might bring forward food spending and are spending more on energy at home. But many restaurant, cinema, concert, and bar trips you’ll forego, goods purchases will be put off, and journeys, for now, abandoned. Multiplied through the population, you can see why economists think the demand shock will be larger than the initial supply shock.

No time for “stimulus” 

Ordinarily, faced with recessions, Keynesians argue for tax cuts and transfers to encourage consumption, or government infrastructure projects to “stimulate the economy”. But encouraging activity today worsens the virus spread. And given isolation measures lower people’s propensity to spend anyway, encouraging consumption would be ineffective to boost the economy. The already-planned £18 billion non-coronavirus specific borrowing Rishi Sunak repackaged as “stimulus” at the Budget will be no such thing.

Does that mean nothing should be done? Not quite. Though ideally firms and households would have considered global pandemic risk, insuring against it or building precautionary savings, the majority have not. Given government containment policies will necessarily exacerbate income losses, treating this event as a normal market adjustment, seems perverse. This isn’t businesses’ fault.

As US economist John Cochrane has observed, effectively turning off segments of the economy is like winding down a nuclear power plant. It must be done with care. Otherwise viable long-term firms go to the wall, destroying capital and good labour matches, create much suffering and potentially producing a prolonged recession and financial crisis. In this case, households with workers who have been temporarily laid off or seen incomes collapse might have perverse incentives to look for other work, undermining containment efforts.

These observations are why many of us who usually oppose fiscal expansionism are less hostile to government borrowing today. Rather than “aggregate demand” though, the focus should be on liquidity for businesses and households as insurance-like cover for an unforeseen pandemic.

Stop the economic contagion

The dashboard of indicators we should care about right now is health outcomes, business failures, unemployment, and income losses for flexible workers, rather than GDP. Ideally, we’d stop demand shock “contagion” beyond industries and families obviously affected, difficult as this might be, helping them bridge to the recovery.

What might this look like? The budget took some steps – additional health resources, statutory sick pay from day 1, taxpayers stepping in to cover sick leave costs for 14 days, business rate cuts, and loans. But a lot more relief may be required for households and firms. And in this upside-down world, “paying people not to work” becomes, for the time being, a virtue. Given the speed with which the crisis is developing, existing programs – sick pay, JSA, Universal Credit – will likely need to be more generous with broadened eligibility.

Business support should have clear guiding principles. Reimburse them for any new mandates imposed on them. Support industries only where demand has collapsed and firms are credit constrained. Avoid heavy-handed and broad bailout and regulate models that entrench incumbents permanently. Make loans or tax deferral beyond this contingent on maintaining employment. The German government, hardly renowned for its fiscal abandon, loosened and broadened such programs, with no cap on the package’s size.

I can’t believe I’m writing this, but this time is different. Yes, some support will be given to firms that become unviable and others to companies that don’t really need it. Yes, the government should prioritise too if it’s going to suck in so many resources: the Chancellor should divert cash sprayed around on other projects and departments towards health, business and income relief efforts. Levelling up can wait.

And, yes, governments should not worsen the growth potential of the economy further by stamping down on so-called “price gouging”, curbing trade through protectionism, or making these labour-supply impairing programs permanent. In fact, we should consider relaxing labour-market regulations on overtime, Sunday trading, and working hours rules, and improving tax investment incentives, to give retailers and manufacturers the best chance to make up for lost activity in that rebound.

But mainly, for now, we must understand why GDP must and will fall and be clear about our fundamental economic aim: preventing this (hopefully) temporary sharp crisis spiralling out of control.

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Ryan Bourne is Chair For The Public Understanding Of Economics at the CATO Institute.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.