Fiscal Policy During and Beyond the Covid Crisis

Fiscal Policy During and Beyond the Covid Crisis

The current downturns are unlike any previous recession or depression. The coronavirus itself is novel but, more to the point, so is the reason output collapsed in much of the world — not because of Covid-19 as such, but because people withdrew from normal economic activity, either by government decree or at their own initiative.

In effect, the market economy was suspended. Using conventional economic language to describe such a downturn has bred confusion about how policy should respond.

If, for reasons of public health, the government is deliberately shutting down parts of the economy, it doesn’t make sense to simply stimulate spending to fill the gap. Households would like to spend more on entertainment, hospitality and travel but they can’t. Pent-up demand will emerge when Covid-19 subsides — so long as incomes are supported during the current restrictions. What’s needed, therefore, is not a generalized stimulus to aggregate demand but support of businesses, including the self-employed, to help them weather the storm. When it resumes, the market economy will decide which firms prosper and which fail. Simple fairness also calls for this kind of temporary support. Why should restaurant owners and musicians suffer while Amazon gets a windfall?

By preventing the failure of businesses that would be costly to resurrect, such support helps protect jobs in both the short and long term. Britain’s minister for social care, Helen Whately, tried to justify ending the country’s furlough scheme in October by saying, “It doesn’t make sense to continue supporting jobs where there simply isn’t work at the moment.” She failed to understand that the reason there’s no work is the restrictions imposed by her own government. Shortly afterward, as the second wave of Covid-19 took off, U.K. Chancellor Rishi Sunak backtracked by extending the furlough scheme until March 2021. He was right.

Once restrictions are lifted, new patterns of spending will emerge, and businesses will need time to learn and adjust. Some reallocation of resources will surely be needed — but today the scale of that shift is impossible to judge. Government shouldn’t impede the process by maintaining support for too long, nor allow companies that may have a viable future to fail now by ending support too early. Easy to say, hard to do. Until it’s clear which companies can thrive in the future, the sensible course is to keep options open and withdraw support cautiously.

For now, this means very large budget deficits and rising public debt. Some argue that big tax increases will eventually be necessary to restore the public finances, and the U.K. Treasury is planning tough future measures. Whether these will in fact be necessary is not an issue of principle: It depends entirely on the circumstances.

Two factors will decide the matter — first, the budget deficit once Covid-19 has abated and the economy has returned to some semblance of normality; second, the interest rate at which the government can borrow. On both counts, things have changed since the financial crisis of a decade ago.

Prudent management of public finances meant that the major industrialized countries entered the Covid crisis with primary deficits (excluding interest payments) much lower than 10 years before. In the U.K., for example, the primary deficit in 2019 was 0.8% of output. The fiscal position was even stronger in Germany and Canada, though weaker in Japan and the U.S. If Covid causes no lasting damage to the economy’s productive capacity, and if public spending returns to its pre-Covid path, budget deficits will fall back to low levels. And if governments can borrow at interest rates below the growth rate of nominal output then the ratio of debt to output will fall slowly but steadily without further fiscal tightening. It would take time for the ratio to return to its pre-Covid level, but what matters is that the trajectory is downward. 

How realistic are those assumptions? In the U.K., the Office for Budget Responsibility has analysed three scenarios for the impact of the disease on long-run potential output, or so-called “scarring” — a reduction in potential output of zero, 3% and 6%. Press and commentators concentrated on the central case of 3%, but the OBR didn’t claim to know which of these numbers was likely to be correct and didn’t present any evidence on the point. The IMF’s latest World Economic Outlook also talked about possible lasting damage to potential output, mentioning factors such as firm closures, exit of discouraged workers from the labor force, and mismatched resources. Again, none of these factors need be permanent.

The OBR and IMF reports both show that the debt-output ratio is sensitive to assumptions about the long-run impact of the virus on potential output — something that, for the time being, can only be guessed at. Committing now to a fiscal consolidation that prejudges the issue would be an error.

What about interest rates? At the moment, they’re unprecedentedly low in real terms. In the U.K. the 30-year yield on index-linked gilts is less than minus 2%. In the U.S., the real yield on 30-year government bonds is roughly minus 0.4%. And markets are evidently expecting this to continue for a long while. Borrowing now at such rates, well below even the most pessimistic estimates of long-run growth, would be wise.

If the permanent scarring from Covid-19 is small, higher taxes won’t be needed to restore the public finances. They might be needed to finance future public spending higher than the pre-Covid path, but that’s another matter. The surge in public borrowing and debt due to Covid-19 is no immediate cause for concern. This time really is different.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mervyn King was governor of the Bank of England from 2003 to 2013. He is the Alan Greenspan Professor of Economics at NYU Stern School of Business and professor of law at NYU School of Law, and author (with John Kay) of “Radical Uncertainty: Decision-Making Beyond the Numbers.”

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