We have nothing to fear, but fear itself.
These famous words were spoken by Franklin D. Roosevelt upon his inauguration as US president in 1933.
Roosevelt’s subject was the Great Depression. “Our greatest primary task is to put people to work. This is no unsolvable problem if we face it wisely and courageously,” he said.
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The Great Depression, like the Great Recession after it, was a financial event. As asset values collapsed, the bold spirits that drive the economy were lost and distrust spread. The abstract events in financial markets caused widespread immiseration.
Our current financial mess began as something different; an actual enemy in our midst: a virus. For now, we have more to fear than fear itself.
We have an implacable parasite that cares nothing for our level of fear or hope. But if we let the fear of the virus turn into economic fear, our troubles will multiply. It is vital we do what we can to isolate the fear to the biological realm.
Supply and demand
Economic shocks can traditionally be divided into supply shocks and demand shocks. Supply shocks are things like droughts, where the business sector (that supplies goods) is hit hard. Output falls, prices rise.
Demand shocks are where the business sector is performing fine, but nobody is buying.
Financial crises, which destroy confidence and erode asset values, are one source of demand shocks. Output is unwanted, prices stagnate and businesses stop investing to grow.
Australia’s economy has been experiencing a slow-burning shortage of demand. That’s why unemployment and underemployment have been too high and why inflation has been so very meagre.
The coronavirus shock has hit different segments differently. If you’re a toilet paper manufacturer, or you make viral testing kits, you’re actually facing a positive demand shock. But if you run public events, you’re looking at a negative demand shock as crowds dwindle.
It could be worse. The US professional basketball league, the NBA, gives us an example of what a supply shock looks like. With players contracting coronavirus, the games are cancelled. No staff = no output at all.
Basketball courts are just the most visible example of workplaces that will have to close down because of the risk of infection between workers. We can expect similar outcomes across the economy as workers go down.
So the coronavirus represents a supply shock and a demand shock at once. Partly like a drought, and partly like a financial crisis.
The view of academic economists Luca Fornaro and Martin Wolf is that this can create “a doom loop”. But, they say, it can be solved with monetary policy:
Now, monetary expansions have a multiplier effect on demand and employment. Suppose that the central bank eases monetary policy to increase aggregate demand. Higher demand, in turn, induces firms to increase investment. This sustains consumers’ expectations of future income, leading to a further rise in demand, and so on. Monetary easing can thus reverse the supply-demand doom loop.
This is all well and good, but Australia’s monetary policy is already pretty much maxed out. We have rates at 0.5%, heading for 0.25% as soon as next month, and with quantitative easing on the way.
This, write Fornaro and Wolf, is a bad situation.
Due to the zero lower bound, the central bank cannot counteract the associated drop in demand. As a result, employment and economic activity drop. Firms react by cutting investment, which negatively affects productivity growth. Initial pessimistic expectations of weak growth thus become self-fulfilling….
The coronavirus epidemic, therefore, can open the door to expectation-driven stagnation traps precisely by weakening the growth fundamentals of the economy.
Low levels of interest rates are not unique to Australia and therefore we are not the only country with minimal capacity to respond with monetary policy. It is only on the fiscal side that there is still capacity, the authors say.
The trick is to hit hard: “a timid intervention, however, will not do the job”.
If they are right, it’s likely Morrison and Frydenberg’s fiscal boost of 1% of GDP will need to be doubled and redoubled in coming months as the extent of the crisis becomes clear.
Unlike ventilators and intensive care beds, fiscal capacity is not in short supply. The Australian government can still borrow cheaply and easily — despite a few wobbles in the bond market.
They should borrow up big and spend big, or they will end up being replaced with politicians who have the resolve of Roosevelt.