Written by Paul Sheard




This article appeared in Briefing for Britain, and we republish here with kind permission.



In reviewing the global economic response to the Covid pandemic Paul Sheard of the Harvard Kennedy School makes the important, indeed vital, point that concerns about printing money reflect outdated thinking and that debt does not need to be repaid.

The coronavirus is a classic negative “exogenous shock,” an unforeseen event that hits the economy from outside and pushes it into recession. On closer inspection, many such shocks turn out to be “endogenous,” that is, arising from the internal workings of the system. The Global Financial Crisis felt like an exogenous shock, but it was really a complicated endogenous one. Economists talk of “policy shocks” and “technology shocks,” but these too arise from within the economic system. Next to a solar flare or an asteroid hitting the earth, COVID-19 feels like the closest thing to a genuine exogenous shock.

The distinction matters because the more “exogenous” the shock the easier it should be for the economy to return to its prior course or condition once the shock dissipates. This is the relative good news about the COVID-19 recession: if the virus runs its course or is quashed by an effective vaccine being developed, the economy should be able to return to some semblance of normalcy, without too many lingering negative effects (like the headwinds of secular debt deleveraging in the wake of an asset-bubble-fueled financial crisis).

But there are some more sobering counterpoints to that optimism. The unique feature of this recession is that it is happening as an integral by-product of the public policy response to the health crisis. This turns the usual logic of recessions and macroeconomic policy responses on their head. In a usual recession, aggregate demand falls for some reason and the government (including importantly the central bank) tries to restore the lost demand as quickly as possible by easing monetary and fiscal policies. In the COVID-19 recession, governments have suppressed economic activity so as to stem the spread of the pandemic. It is not so much the pandemic, as the responses of governments to it, that has caused economic activity to contract as much as it has. Recession has been part of the pandemic cure.

The fall in economic activity in such a short span of time is unprecedented. The IMF downgraded its global (real GDP) growth forecast by 8.2 percentage points (pp) between January and June (from 3.3% to -4.9%). Even in the Great Depression, GDP did not fall, and unemployment rise, so fast. The unemployment/underemployment (U6) rate in the US rose by 15.8 pp in just two months, from 7.0% in February to 22.8% in April (by June it was down to 16.5%); in the Great Recession it rose from 10.8% (in August 2008) to an initial peak of 17.1% (in October 2009), but this 6.3pp increase took 14 months. In the 20 weeks since mid-March the cumulative total of initial unemployment claims in the US is equivalent to one-third of February’s workforce. Even after three months of “record” increases in non-farm payrolls, all of the jobs growth since September 2014 stands wiped out.

This last observation highlights a key point about interpreting economic data in such volatile times. After a sharp fall in activity, it is important to look at both levels and rates of change in taking the pulse of the economy: if a variable drops by 50% and then rises by 50%, it is still 25% below where it started.

Governments have responded to the sharp fall in economic activity, much of which they imposed, with aggressive monetary and fiscal policy easing. Usually the aim of such measures is to stimulate economic activity and restore the shortfall in demand as quickly as possible, but this time is uniquely different. Governments do not want consumers to go on an across-the-board spending spree (at least not just yet), because this would defeat much of the purpose of the “social distancing” and “lockdowns” imposed to fight the virus. Rather, macroeconomic policies are aimed more at keeping the economy in a state of “suspended animation,” so that it is ready to recover strongly when the pandemic coast is clear. Thus fiscal policy responses have been centered on income transfers and loans and loan guarantees (rather than government spending on GDP), and monetary policy responses have focused on central banks providing “liquidity” to the real economy and easing fiscal constraints by buying bucket loads of government bonds (this “quantitative easing” or QE just restores the central bank reserves and part or all of the bank deposit money that the government creates by running a budget deficit but “sterilizes” by issuing bonds).

Most of the widespread concern that is expressed about governments running up so much debt and central banks “printing” too much money is misplaced and reflects academic and policy thinking that is held hostage to twentieth century paradigms. The “functional finance” perspective of Abba Lerner, a brilliant but younger contemporary of John Maynard Keynes, is more useful. The judgement on when and how to pull fiscal and monetary policy levers should be based on what is needed to keep the economy at full employment with price stability (and with financial stability), rather than being driven by arbitrary fiscal targets and monetary probity.

A rising stock of government debt does not impose a “burden” on our grandchildren. For one thing, government debt never has to be repaid in the way that households or companies are on the hook for their debts. As the recent experience with QE should make clear, one arm of the government – the central bank – at will can convert government bonds into central bank money (reserves), which no more has to be repaid than a twenty dollar bill does. Government bonds are better viewed as a means by which people can transfer purchasing power through time. The simplest way to see this is to note what the national accounting identity for the world as a whole says: the private sector can save more than it invests only if the government runs a budget deficit.

As was learned in the twentieth century and codified in the contemporary macroeconomic policy framework, governments printing too much money can lead to high inflation, if too much purchasing power ends up chasing too few goods. The well-known remedy then is for governments to modulate that purchasing power by tightening monetary and fiscal policy. Governments can find it useful to raise taxes in order to keep inflation in check (and to redistribute income and ameliorate negative and positive externalities), but they don’t need to do so to repay their debts or to avoid imposing a burden on future generations.

The real burden of a recession falls on the people today who lose their jobs and suffer associated hardship and on future generations who will likely inherit a slightly smaller stock of productive capital than they otherwise would; the longer and deeper the recession the bigger that burden. What goes by the moniker of “austerity” gets this all wrong.


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