Passing the Baton – A Keynesian Rebirth

In early January, Mark Carney, the outgoing governor of the Bank of England (BoE), voiced concerns about central banks running out of “ammunition” to combat a potential economic downturn. 5% rate cuts, which were generally required from past recessions, are no longer available with the BoE and Fed reluctant to go sub-zero and the ECB and Bank of Japan (BoJ) unlikely to push rates further negative. With the spread of coronavirus likely to hinder economic growth, it tests the ability of monetary policy to keep economies on their feet.

Movements in the markets have shown little confidence that expansionary monetary policy has the ability to counter the economic shocks of COVID-19. An emergency rate cut by the BoE, which saw the base rate fall from 0.75% to 0.25%, failed to relax panicked investors, with the FTSE 100 seeing its worst trading session since 1987 the next day. Emergency rate cuts by the Fed spelt similar stories, with sharp sell-offs and “circuit breakers” activating to halt panicky selling. 

It is clear to see why investors have such little faith in monetary policy to combat the economic consequences of the coronavirus. Although reduced reserve requirements or short-term lending operations may have some effect in supporting businesses, there is little central banks can do to tackle global aggregate supply shocks. As aggregate demand shocks begin to ripple through economies, interest rate cuts cannot give consumers the confidence to spend, cannot protect workers and, importantly, cannot alleviate the ongoing health crisis. 

Therefore, a strong fiscal response is paramount in managing the shocks of COVID-19. Although the short-term economic effects are unavoidable, as of yet the virus poses no long-term threats to the economy. Once the spread is contained, supply chains will slowly fix themselves as people return to work. As the risk of infection decreases, consumers will regain the confidence to go out and consume whilst businesses resume investment. However, the virus has potential to lead to long term economic turmoil in the case that large employers go bust due to an extended period of low consumption, inability to pay debts or failure to fulfil orders. This combines with worries over the resilience of the economy regarding historically high levels of corporate debt and the gig economy. In this scenario, millions will lose jobs and thousands of small and large businesses would fail, resulting in long term disruption to productive capacity. Hence governments around the world must coordinate a “timely and targeted” response, as chancellor Rishi Sunak puts it, that supports businesses, prevents job losses and maintains consumption whilst prioritising overcoming the health impacts of the virus.

Many key industries are at risk to the effects of the Coronavirus such as transport, hospitality and events. Reduced demand for air travel, due to travel restrictions and consumer fear, has crippled the aviation industry as they take steps to conserve cash and survive the coming months. Many airlines have forced staff to take unpaid leave whilst others take more formidable measures with Scandinavia's SAS laying off 90% of its workforce. The recent fall in oil prices may help to ease pressure on airlines, however, these benefits may arrive too late as airlines commonly lock in prices to avoid higher future prices. A report by the Centre for Aviation speculates that “by the end of May most airlines in the world will be bankrupt” and that “coordinated government and industry action is needed” to avoid “catastrophe”. Large scale lay-offs and airline collapses are certain to hinder economic recovery and government subsidies, or even government acquisitions in the case of the most established liveries, are undoubtedly necessary. It is essential that governments support businesses to navigate this turbulent period, in turn protecting long term economic prospects.

Since the global financial crisis, regulation has largely prevented households and banks directly participating in risky debts, however, COVID-19 has unearthed skyrocketing levels of corporate debt that have gone unnoticed by regulators, fuelled by over a decade of low interest rates. In America’s corporate sector, the $16 trillion of debt (75% of GDP) is above the level of 2008 and is fuelled by a new wave of “zombie” companies, over-leveraged private equity firms and loss-making “unicorns”.  Many of these highly indebted companies operate in sectors the most affected by the virus, such as hospitality (eg.airbnb) and transportation (eg. uber) and a collapse could create a spiral of debt defaults, huge losses for creditors and further turmoil in the financial markets. Despite Donald Trump's hasty reassurance that “this is not a financial crisis”, it can rapidly descend into one, and if it does, governments must be ready to step in to prevent long term damage to the economy.

So far fiscal responses around the world have ranged in nature. In late February, Hong Kong, which was already in recession due to a consumption slump, created by months of ongoing riots, announced a US$15.4 billion stimulus package, directly giving US$1200 to all permanent residents. Although measures of this kind sound attractive at first, they are unlikely to have much effect on short term consumption, if people are unable to leave their homes due to quarantine measures or risk of contracting the virus. Furthermore, reduced consumer confidence regarding job security and the future of the economy means that people are more likely to save this money reducing the magnitude of the multiplier effect, deeming the stimulus relatively ineffective. As America moves towards a similar “helicopter money” scheme, more as a form of social insurance than fiscal stimulus, it is worrying that other nations, such as Australia, may follow suit. It is vital that nations, especially developing economies, do not do this, considering their own economic needs and structures before making decisions that impact the lives of millions. 

Actions taken to maintain consumption by protecting the incomes of workers who are unable to work or at risk of being laid off may prove effective. The British government estimates that up to 20% of the country's workforce may not be working at any one time. In response it has implemented an immediate statutory sick pay (SSP) which is completely refundable for small businesses however support for gig economy workers is limited and the size of SSP is very small compared to those of other European countries and national living wage. This means that workers could be forced to work despite being ill, threatening to exacerbate the health crisis and problems in the economy. The most effective method of protecting workers may be for governments to subsidise the wages of workers that would otherwise be laid off. The Danish and Swedish governments are covering 75% of wages whilst the UK will be covering 80% of wages for employees who are furloughed rather than made redundant. Not only does this reduce job losses through this period, but additionally relieves pressure on firms by reducing labour costs. These social security measures may prove vital in protecting the economy, in addition to living standards. 

Correctly, many governments have prioritised reducing insolvencies in this period of reduced consumption, but methods of achieving this will range in effectiveness. The UK has taken a more direct stance, targeting businesses with a business rate holiday, cash grants and government loan insurance, in a £350bn stimulus package, which will help businesses cope with the oncoming pressure. These methods are too small to support large businesses in the most damaged industries, such as aviation and hospitality, which will need tailored support packages and potentially bailouts in return for equity stakes. Peter Norris, the chairman of the Virgin Group, says that the UK aviation industry alone will need up to £7.5 bn to survive. Many argue that large airlines shouldn’t be bailed out after the three largest US airlines gave shareholders $45bn in the last five years through dividends and share buybacks however, a collapse in the aviation industry would create irreversible economic damage. 

Although business support and worker protection may protect the economy, unsurprisingly, the most effective way to minimise the economic effects of the virus is by overcoming the virus itself. Governments must not lose sight of this. A fast, coordinated health care response is crucial to protect the economy. An extended period of behavioural restrictions will see more businesses fail, more unemployment and potentially irreversible damage to the economy. A shorter period of restrictions will allow people to return to their jobs, firms to resume business and the economy to recover at a reasonable pace. It is crucial that nations dedicate unlimited resources to their healthcare systems to achieve this, acknowledging that fragmented healthcare services, like those in the US, are simply inadequate to manage a crisis of this scale. 

This unprecedented situation we find ourselves in is dynamic and ever-changing. Politicians cannot postpone action, waiting for monetary policy to falter, deterred by additions to the public debt. Governments around the world must act now, the consequences of not doing so would plague future generations. In the coming months a reactive approach should be adopted catering for the specific needs of the economy. Although immediate action is required, policies should be “considered and weighted on [their] merits” as advocated by John Maynard Keynes. 

To contact the writer responsible for this piece:

Lasith Siriwardana

lasith.siriwardana@gmail.com