Macroeconomic Policy and the Coronavirus

(The post is also going to be cross-posted at Lars Christensen’s Market Monetarist blog.)

As the coronavirus spreads across the world, there is growing concern about the economic implications of the virus and what, if any, policy action is required of governments. Some have proposed traditional stimulus measures to counteract the virus while others have proposed more targeted measures. However, before one can offer policy solutions, one needs to diagnose the problem. In this post, I will outline what the potential economic consequences of the coronavirus are and the corresponding policy implications.

The Diagnosis

There are three main consequences of the coronavirus that we should be concerned about. The first is part of a flight to safety. In the face of uncertainty, people often sell risky assets, so that they can buy safe assets. People prefer to hold physical cash or put their money in an insured bank account rather than holding risky assets. What this does is create a greater demand for money. At the level of the individual, an increased demand for money is most easily accomplished by a reduction in spending. However, if money demand is rising in the aggregate (assuming there is no policy response), this reduction in spending is similar to a traffic jam. Sometimes, all it takes is for a few people to slam on the brakes and suddenly traffic is at a standstill. The widespread reduction in spending is analogous to the traffic jam in the sense that the economic activity can grind to a halt because of a significant reduction in spending.

The two other consequences of the coronavirus are related to planning and containment. Right now, in places like the United States, most people are continuing to work as usual. However, if the experience of other countries is any indication, this might not continue. Those who are infected will be expected to miss work, even if the virus is not a threat to their health. In addition, there might be forced quarantines on particular areas.

In the event of self-quarantine or forced public quarantine, consumers will need to have food and medicine since they cannot leave their home. Furthermore, firms will need to be able to pay for non-operating costs during a quarantine. This includes making debt payments. Firms who are currently cash-strapped and that are relying on cash flow to make debt payments might find themselves unable to make debt payments because of quarantines. This could result in default and bankruptcies, which exacerbate the problem through the implications on financial markets.

The Prescription

So what is to be done?

The first thing to do is for the Federal Reserve to commit to do whatever it takes to maintain stability in aggregate nominal spending. As David Beckworth and I have shown, nominal spending crashes are rare, but the common cause is monetary and such events are associated with severe recessions. The Federal Reserve should commit itself to lowering interest rates and engaging in quantitative easing to the extent necessary to prevent a decline in nominal spending. I have written about why this is important in theory and in practice. In addition, the Fed should be tracking properly measured monetary aggregates, which are released more frequently than data on nominal spending. I have shown in my own research that these monetary aggregates are useful in predicting inflation and nominal spending. The Fed is already failing at this. Inflation expectations have been plummeting and their response has been inadequate.

The Trump administration has suggested a temporary payroll tax cut. Some have criticized this idea, but these critics are missing the point. A payroll tax cut is something that would work if it is done immediately. The cut in payroll taxes would increase profits to firms and increase take-home pay of workers. This would allow firms to start retaining these additional earnings now in order to make debt payments and pay other non-operating costs in the event that they have to temporarily shut down. This would also allow workers to use this additional income to make purchases to stockpile food and medicine in the event of self-quarantine or a forced geographic quarantine. However, this needs to be done now and will not be as effective once things have started shutting down.

Another policy prescription is to do lump sum transfers of around $1000 per taxpayer. Normally, these are somewhat controversial as a consequence of Ricardian equivalence. Under Ricardian equivalence, a transfer to taxpayers that is paid for through debt creation just results in a net increase in savings which offsets the debt creation and therefore has no effect on economic activity. While there is some debate about the degree to which Ricardian equivalence holds, this debate is largely irrelevant here. These checks would allow people decide how to allocate the money for its best use in preparation for the possible consequences of the virus. For some, this might mean using it as extra savings. For others, this might be a way to purchase food and medicine in anticipation of the consequences. The objective here is not to boost real GDP per se, but rather to plug holes before they have a chance to leak.

Finally, the government should implement temporary and mandatory paid sick leave financed by the government. This will give people the peace of mind that they will not lose their income in the event that they have the virus or otherwise are unable to work because of the virus. The policy also has the added benefit of preventing the virus from spreading since people are not forced making the difficult choice between working sick or losing income.