Covid-19, social distancing and the flood of money

We have seen an unprecedented response to manage the current health crisis. This has led to significant economic damage, as countries implement social distancing to manage the health of their populations. To provide economic support, quantitative easing has been implemented on an industrial scale, with central banks rapidly expanding the range of financial assets they are willing to buy. Also, governments have stepped up to the plate, aggressively implementing fiscal packages that will see budget deficits similar only to periods of war. As at the time of writing, policy makers around the world have provided a total of US$7tr of QE, US$6tr of fiscal policy, and US$4tr in loan loss guarantees.

In this note we will examine the strengths and weaknesses of the various policy responses, the economic impact of pandemics, and the likely medium-term consequences of the policy actions.

Monetary policy

With cash rates at or close to zero bounds, we have seen the emergence of unconventional monetary policy with quantitative easing (QE) the main pathway. While only new, we do have some understanding of its strengths and weaknesses.

For several decades, monetary policy had been conducted through price signals, manipulating cash rates, the price of money. However, recently this methodology has become unworkable. The typical cut in cash rates by the US Federal Reserve (Fed) has been around 5% in past recessions. While in Australia, the global financial crisis of 2008-2009 (GFC) saw the Reserve Bank of Australia (RBA) lower the cash rate by 4.25%. Given the low levels of cash rates in recent times, conventional monetary policy would lead to deeply negative rates, which experience has shown puts undue stress on the financial system. 

With central banks at the zero-lower bound, they have moved to a policy response dominated by quantitative easing. The established belief is that quantitative easing is transmitted through the same channels as interest rate changes. Ben Bernanke, former Chair of the US Federal Reserve has been quoted as saying about QE: “This is just monetary policy. It will work or not work in much the same way that ordinary, more conventional, familiar monetary policy works.” (cited in Krugman, 2010).

While the mechanics of QE are the same as traditional monetary policy (buying and selling assets to influence a policy target), it is the quantum of purchases during QE that is the differencing factor, and this is where a lot of criticism has been aimed. When central banks purchase financial assets, this directly pushes up the price of these assets, while the transmission mechanisms to the real economy are more indirect. While this can be argued for all monetary policy, the size of QE magnifies these distortions, and it has been said that QE increases wealth inequality. Although, this is contentious, with research by the European Central Bank (ECB) questioning this belief.

Has QE become less effective?

Probably a more important criticism is around the effectiveness of QE. While it is generally regarded that the first round of the US Federal Reserve’s QE was effective, research has suggested that subsequent rounds were much less effective. This is consistent with the research of Bech, Gambacorta and Kharroubi (2014) who found that while lower real interest rates during a “normal” recession tend to lead to a stronger recovery, post a financial crisis there was no relationship, with the recovery more related to the level of deleveraging.

Empirical evidence suggests this is not just an issue with QE, but also is an issue with conventional monetary policy, when confronted with a period of low interest rates (Borio and Hofmann, 2017). Monetary policy is generally found to be more effective than usual in the acute phase of a crisis, but less effective in the recovery phase post a crisis. In the acute phase, monetary policy can help minimise the risk of a liquidity problem becoming a solvency issue and therefore can reduce uncertainty and tail risks and negative feedback loops. Given the broader array of assets purchased during QE, central banks can be targeted in their support, and QE is most likely more effective than traditional monetary policy during the acute phase, and thus helpful in the current environment.

There are several theories on why monetary policy is less effective when interest rates are low. The traditional explanation is Keynes’ liquidity trap – where increases in money supply are offset by increased demand for money, i.e. hoarding of cash, which has a low opportunity cost where there are low interest rates. A more modern interpretation is Richard Koo’s balance sheet recession, where individuals and businesses give priority to balance sheet repair over intertemporal expenditure smoothing, i.e. they would rather pay down debt than expand their balance sheet no matter how cheap credit is.

This has been a problem for the developed world post the GFC, with balance sheet repair leading to a lack of demand. Increasing money supply has been offset by falling money multipliers (bank reserves ballooning due to a lack of lending) and velocity of money (a slower circulation of money in the economy as economic actors spend less).

Fiscal policy

While monetary policy is less effective in this environment, fiscal policy becomes more effective – interest rates are less sensitive to fiscal spending, seeing less crowding out of the private sector, leading to a greater impact on the economy. In a balance sheet recession, the government needs to step in to generate the economic demand that is not being provided by the private sector, while balance sheet repair is being undertaken. However, fiscal policy has been relatively restrained post the GFC, as governments have attempted to rein in their high debt levels.

However, with the massive economic shock that has occurred from the social distancing measures implemented in many jurisdictions, these constraints have been removed, with even conservative governments focusing on supporting their economies through aggressive fiscal spending. The pandemic is an exogenous shock, which is seen as short term in nature (until a vaccine is developed), so the policy response has been one which has attempted to minimise the economic damage and allow the economies to return to their prior state once the pandemic has passed.

This desire can be seen in the nature of the fiscal response – focused primarily on attempting to avoid firm closures and labour shedding; and reducing the hit from falling incomes. UBS (2020a) analysed the nature of the fiscal response and found a focus on speed and a composition tailored to the shock. They noted several composition features of this fiscal spend: first, there is a large emphasis on job retention programs - one quarter of the global fiscal spend and a third for the developed economies. Maintaining a link to the labour market is key, while the unemployment rate rises quickly, once elevated it takes a significant period to fall. Second, the use of direct cash payments (11% of total) and loan facilities / grants for struggling business (14%). These can be made quickly, and UBS notes the lack of tax cuts and infrastructure spend of previous recessions, which take longer to implement. Lastly, and not surprisingly, an emphasis on healthcare, which represents 7% of the stimulus.

Pandemic economics

While, luckily, pandemics are rare, there have been enough for economists to study and draw some conclusions. Jorda, Singh and Taylor (2020) analysed the economic impacts of the great historical pandemics. They found they lowered the natural rate of interest for up to 4 decades and led to a smaller, but significant, increase in real wages. They hypothesised that it was due to “depressed investment opportunities, possibly due to excess capital per unit of surviving labor, and / or heightened desires to save, possibly due to an increase in precautionary saving or a rebuilding of depleted wealth.”

One area of note is that, unlike previous pandemics, the current pandemic’s fatality rate is skewed heavily toward the age cohort of over 60 years. While tragic in human terms, in economic terms, given this age bracket participates significantly less in the labour market, it will have less impact on the capital to labour ratio. Also, we have become much better in managing pandemics, with social distancing successfully reducing fatalities so far relative to the potential worst-case outcomes.

Where the economic impact will be most likely to be felt is through the “heightened desire to save” channel. While social distancing has successfully lowered the fatality rate, it has had a devastating impact on aggregate incomes. Balance sheets of households, corporates and governments will all be much worse off post the pandemic. This will have a lasting effect.

“How long?” is an interesting question. While pandemic after-effects have been found to last up to 40 years, much longer than that of financial crises of 5 to 10 years, the lack of a large change in the capital to labour ratio this time will be important. The impact of changes in the capital to labour ratio are very long lasting, as it takes a considerable period to accumulate capital or for the labour force to grow. It is likely that the balance sheet damage is less than a financial crisis, more likely equivalent to that from a recession. However, given there are still lingering impacts from the GFC, and with the overlay of the psychological trauma from the pandemic, it is possible the after-effect may be like that of a financial crisis.

How large the psychological trauma is will be related to how effective the health response is. Research into the 1918 Flu pandemic found US cities that implemented early and extensive non-pharmaceutical interventions, such as social distancing, found that not only did they yield lower mortality rates, but also better economic activity after the pandemic subsided (Comeria, Luck & Verner, 2020).

Government Deficits

Given a fiscal stimulus unpreceded in peace times, it is not surprising that we will see mind boggling fiscal deficits, with government deficits expected to reach 8% in Australia and 20% in the US. The current policy response is not cost free. However, there are some mitigating circumstances. First, the fiscal policy is counter cyclical. It is occurring during a significant contraction in the private sector. This will limit the level of crowding out of the private sector and increase the chance of the policy impact being highly effective. History suggests a negative correlation between government bond yields and budget deficits, with deficits usually rising during recessions and interest rates falling during these periods due to weak demand. Second, much of the policy response is self-correcting (the job retention programs, liquidity lines, cash transfers, and business loans are all temporary or one-offs), thus making it easier than in the past to return the deficits to more normal levels after the crisis is over. Third, any significant impact on interest rates, if markets do have issues with absorbing the large increase in government debt issuances to pay for these extremely large deficits, are expected to be managed by central bank QE programs, which will step in to buy the debt and limit its impact on interest rates. Last, with interest rates near zero, debt servicing costs are extremely low.

Will debt levels be sustainable?

UBS (2020b) estimates that global government debt will reach 101% of gross domestic product (GDP) (purchasing power parity (PPP) weighted) by the end of 2021. Much higher than the 90% threshold that Reinhart and Rogoff (2010) identified above in which they found growth fell by a full percentage point. Their seminal research has created much debate. Reinhart and Rogoff’s work captures correlation and not causality. It has been argued that there is no threshold above which growth is negatively impacted, but that high debt levels are a result of weak growth and not the other way around.

The question around a potential threshold is critically important given the high level of government debt in most advanced economies. Pescatori, Sandri and Simon (2014) delved deeply into the topic. They attempted to account for the possibility for reverse causality (from growth to debt). Their research did not find a threshold above which the medium-term growth prospects were compromised. They also found that countries with high but falling debt levels have historically grown as fast as their peers.

The Reinhart and Rogoff argument makes sense when you look at government debt in terms of the framework for a household or a corporation, where excessive debt is problematic. However, this model is not often appropriate for most governments. If a country issues debt in its own currency, has a flexible exchange rate, and controls its central bank, excessive debt is not necessarily an issue. These countries have the power to print money so their debts can be paid with its own currency. Japan is a good example of this, which passed through the so-called problematic debt levels several decades ago. While growth has been sluggish, this has been driven by weak demographics. Per capita GDP growth has been consistent with other developed nations.

Is the extraordinary policy response likely to cause inflation?

In the short run, the collapse in demand will be the main driver of inflation. Given the extraordinary size of the economic shock, disruptions to demand are several multiples of the disruptions to supply. This can be seen in oil prices, which have fallen sharply, and will play a significant part in imparting a deflationary pulse across both headline and core inflation.  We have already seen core inflation post a negative month in the US and the Q2 CPI in Australia is expected to be exceptionally weak. While fiscal and monetary programs, by reducing the hit to economies, will reduce the deflationary impact, their size is not large enough to stop unemployment rates moving higher and will therefore not fully counteract the deflationary forces.

In the more medium term, energy prices will stop being a drag and will likely add to inflation. The labour market will stabilise, and the unemployment rate will fall. The focus will move to how much the surge in liquidity, driven by fiscal and monetary policy, will impact on inflation. The ability to print money is not unlimited. At some stage the extra money will overwhelm the productive capacity of the economy, or foreign investors will lose faith in the currency, seeing it fall, leading to an inflationary problem.

There are several factors that suggest a major break out in inflation is not on the cards for the major advanced economies and Australia. First, while the fiscal response is aggressive, unemployment is expected to be higher post the pandemic, suggesting it is not pushing demand above supply. Also, given much of the policy response is temporary and self-correcting, this is expected to remain the case. Second, independent central banks reduce the risk. While it could be argued that central banks are currently monetarising the government spending, the lack of direct payments is important. Central banks are generally purchasing government bonds on the secondary market, rather than direct transfers of cash. This leaves a measure of the extent of the government spending via the amount of government debt outstanding and places some discipline on governments. Third, many economies are still suffering from the aftermath of the GFC, with balance repair still ongoing as seen by cash rates near the zero bound, and this has weakened the power of monetary policy. With balance sheets worse off post the pandemic, this is likely to continue to be the case, and monetary policy will have less impact on the economy and inflation.

Conclusion

The current pandemic will have a profound impact on the global economy, possibly for decades. With economies still suffering from the after-effects of the GFC, the pandemic, which will have a similar suppressing impact, will see a continuation of the structural malaise in growth and keep interest rates near to the zero bound. In this environment monetary policy will be relatively ineffective, but fiscal policy will be a powerful antidote. Our analysis suggests fears around ‘debt and deficits’ are misplaced, as the forces of balance sheet repair will make it difficult for policy to pass the threshold where inflationary pressures become a restraint.

We expect a large variation in how much different economies recover on the other side. Two factors will be key: first, how successful fiscal policy is in keeping a link between employees and their employers. More successful economies will have much lower unemployment once the pandemic passes and the key to this will be effective fiscal spending. Second, successful management of the pandemic, an early and strong response, will not only see a lower mortality rate, but will see less structural economic damage, and more robust economic recovery.

Theoretically, the best approach is to monetarise the fiscal spending, to take away the debt overhang. However, in the real-world giving governments such a free ride has usually led to major inflationary headache. The next best strategy would be to issue long dated debt – 50-year, 100-year or even perpetuals. If this is a one in a hundred-year shock, then the cost should be spread out over this period, especially given interest rates are so low and therefore servicing the debt will be minimal. Inflation will also work its magic over this extended period making this a very manageable approach. The risk would be problems with the market digesting a large issuance of long dated securities, but this could be managed by central banks which could warehouse any issuance that is problematic and feed it into the market over time.  

References

Bech, M., Gambacorta, L., and E, Kharroubi, (2014), “Monetary Policy in a Downturn: Are Financial Crises Special?” International Finance, 17(1), pp99-119.

Borio, C., and B. Hofmann, (2017) “Is Monetary Policy Less Effective When Interest Rates are Persistently Low?”, Reserve Bank of Australia Conference Volume.

Correia, S., Luck, S., and E. Verner, (2020), “Pandemics Depress the Economy, Public Health Interventions Do Not: Evidence from the 1918 Flu”, March 30.

Jorda, O., Singh, S., and A. Taylor, (2020) “Longer-Run Economic Consequences of Pandemics”, Federal Reserve Bank of San Francisco Working Paper 2020-09.

Krugman, P., (2010), “Doing It Again”, The New York Times, November 7.

Pescatori, A., Sandri, D., and J. Simon, (2014), “Debt and Growth: Is There a Magic Threshold?” IMF Working Paper No. 14/34.

Reinhart, C., and K. Rogoff, (2010), “Growth in a Time of Debt”, American Economic Review: Papers & Proceedings 100, May, pp573-578.

UBS, (2020a), “Bubble, Bubble, Toil, and Trouble: Which Fiscal Mix Will Work Against Covid-19”, Global Economic Perspectives, April 21.

UBS, (2020b), “What if Virus Containment Fails? Scenarios for Markets”, Global Economic Perspectives, April 27.