Ricardo Reis is A.W. Philips Professor of Economics at the London School of Economics and is an academic consultant to the Bank of England and the Richmond Fed. He is an expert on both monetary and fiscal policy and is one of the leading macro economists of his generation. He also was a professor at Columbia and Princeton University.
How can fiscal policy keep the economy alive while it is effectively put on ice?
During the lockdown period, the priority of economics policy should be three fold.
First, to fight the health emergency by devoting resources to:
(i) staffing the health care sector
(ii) buying the equipment (like ventilators) that will soon be needed,
(iii) mobilizing the resources to quickly expand hospital capacity, and
(iv) directing all researchers and industry in the health field to quickly develop faster, cheaper, more reliable tests, as well as a potential vaccine. Fiscal policy can provide financial incentives and exemption of regulations to allow the wartime-type mobilization that we need in the health sector right now. The returns to preventing the spread of infection and reducing the fatality rate make it worth every dollar that is spent right now.
The second priority is to prevent the economic scars formed in this period from persisting for a long time post the lockdown. The main risk is that many firms, whose revenues will collapse in the coming weeks, are unable to pay their creditors and workers, even though in the absence of a lockdown they would be solvent. These firms would fire workers and default on loans in the next few weeks or months, triggering a cascade of other layoffs and defaults.
After the crisis, it will take time for these businesses to get off the ground again, and time for these workers to find new jobs, time during which we will have depressed national income and endure painfully high unemployment. We will have long-lasting effects from the crisis, even if the lockdown period is short. Fiscal policy can mitigate this by supporting firms and people, providing them the funds to make it through the lockdown times without layoffs and defaults. This can be done by providing liquidity and credit, as their private supply will be scarce. Some ways to do this are through delaying tax payments, extending furloughs where the wage is partially paid by the government, and maybe even small direct cash transfers.
Third, during the crisis, policy must try to make sure that the most vulnerable in society have their needs met. The safety net, with unemployment insurance and poverty alleviation programs, will be seriously put to test by such a sudden shock to the economy. Economies regularly go through recessions, but a sudden stop that is this sharp is not usual, and will put serious stress on the welfare system. This is especially worrying in the US. Moreover, insofar as people become afraid that they will be next to lose their jobs, they will hold back from spending, even after the lockdown has been lifted, which will make the recovery harder still.
You suggested policy should think inter-temporally, what do you mean by that?
The health experts tell us that we have to stay home for the next few weeks. People at home can't produce and can't consume (or if they can, its much less than usual). Therefore, we are told that for health reasons we have to freeze the economy, or reduce GDP for a short period of time. In turn, as soon as the lockdown ends we want to get back to business as strongly and intensively as possible to make up for the lost output. This is an intertemporal goal: freeze now to unfreeze (and even heat up) in a quarter or two. Intertemporal goals requires intertemporal thinking and intertemporal policies.
One policy example comes from sales taxes. Right now, governments are struggling to keep people at home. Post-lockdown we want them to get out to work and shop as much as possible. Well, raising sales taxes now, and lowering them later is a way to achieve this goal. Likewise, and going back to the need to prevent mass layoffs and defaults, we need to borrow large amounts now, and generate large revenues post lockdown to pay for it. Again, the key is intertemporal.
Do you think the loans to businesses as part of a stimulus package should be paid back? What is the advantage of loans over transfers?
That is a very hard question. If the government gives people money now, it will have to tax its citizens in the future to pay for this. Of course, taxing people right after the lockdown, when we want to maximize production and bounce back, would be self-defeating. So, any intervention now will have to be financed by the government borrowing from a medium-run future. Who should pay for that?
If we give firms and people loans now, then we are saying that those same people that are being helped now will be the ones paying back. Of course some of them will be unable to pay, and that is fine, but still they will pay the majority of it. Moreover, if we tie repayment to tax collection, we create an “equity-like” claim so that those that emerge from the crisis healthy and solvent will pay back over time, and those that do not will stop their economic activity and stop paying taxes and so stop making payments. If instead we give them transfers, then we say that its the future generations, people working in the future, that will pay for the help some get now.
Now, in times of war, we tend to opt for the latter, and an argument for that approach is that the future generations should pay for the peace they inherit. With the current health crisis, that argument does not really apply as neatly (although one could make it).
Are central banks out of ammunition? If not what can they do? If the goal is not just reducing unemployment, what else is it?
The first priority for central banks right now is to be lenders of last resort: keep the financial system standing and make sure there is enough liquidity. In these times of great uncertainty and some panic, there will be market dysfunctions and it is a key job of the central bank to ensure that those financial firms that are illiquid but solvent can survive. On the second point about liquidity, the financial sector is especially prone to the cascade of defaults I was talking about in an earlier answer, so it is especially important to provide credit that prevents a meltdown. Lastly, people will rush for safety, and deposits at the central bank and cash are the safest there is, so there will be a great increase in the demand for liquidity. The Fed was created in the early 20th century to provide “an elastic currency,” that is, to accommodate these rushes.
What about interest rates? Well, they are particularly important to fight inflation, which usually is the big priority of the central bank. But right now, the priorities are the ones above, and for those set of concerns, interest rates are not the main ammunition. Rather, the crucial tools will be the liquidity and credit programs that we see central banks adopting.
Should Fed start swap lines with emerging country central banks? What would this do?
In principle yes, but not in the way they are currently designed. The swap lines are important because financial firms all over the world invest in US markets and get dollar funding. During these crisis times, they suffer shortfalls of funding, much like US firms do, but they do not have direct access to the Fed. Without a lender of last resort, they would be forced to sell dollar assets, potentially leading to fire sales and market crashes in the US. The swap lines are a smart way to lend dollars to these firms, but using the foreign central bank as an intermediary so that it bears all the credit risk. In research with Saleem Bahaj, we found that they have been very effective in the last decade in keeping these funding pressures from developing. The cut in the interest rate charged in the existing 5 swap lines last week, together with the creation of new ones with 9 other countries, also had a visible effect on market prices right away.
At the same time, this instrument has three clear limits. First, it is bilateral, so we end up with a patch of different swap lines interweaved across currencies, with gaps and fragilities. Second, while they are destined to address funding problems in the financial sector of the recipient countries, if these funding problems get serious, they can quickly become financial crises with solvency implications for those countries. In that case, the |MF would be called in, but the interaction between the IMF and a central bank swap line would be uncomfortable. Third, the Fed should not be taking credit risk with these swap lines, but if they are extended to EM countries with volatile exchange rates, this may become unavoidable, and in trying to prevent it, the Fed could make things worse.
So, while I think EMs should have dollar swap lines, and ultimately only the dollar-issuing Fed can provide them at the source, I would prefer to see the IMF stand in between as an intermediary that coordinates actions in a multilateral way and that takes on the associated credit risk and articulates it with its own programs.
Should Central banks start buying untraditional assets like corporate bonds?
There are clear legal obstacles written into the Federal Reserve Act which make supporting firms directly hard for the Fed to do. At the same time, the evidence on the effectiveness of corporate bond purchases from when they were used in the UK or the Eurozone is still mixed. But, as the crisis gets worse, and the needed liquidity to keep businesses afloat gets worse with banks not being able to step in because of their own problems, then this would probably be necessary. It may also have to be complemented with credit to SMEs (Small and mid-size enterprises) which do not issue corporate bonds. This should all be done in close coordination with the Treasury though, since these are very close to being fiscal measures, and the central bank cannot take them without some explicit fiscal backing.
Will the recovery be V or U shaped?
I don't know. First, it depends on health policy. Right now, I would think that almost every health scientist and company in the world are working on producing better and faster tests, effective treatments, and a vaccine. If they come up with a solution in just a few weeks, it could be a V; if we need to be in lockdown for months, then it will be a U.
Second, it depends on economic policy. If we swiftly implement the right policies to prevent the permanent scars I spoke about above, and we are lucky that the productive capacity of the economy does not suffer a big dent, then we could have a swift, V-shaped recovery right after the lockdown. But if not, it could be a very drawn out U-shaped depression.
Third, it depends on the policies we have right after the lockdown is lifted. There will likely be bottlenecks in both supply and demand, as well as the debt inherited from this crisis to manage. If we can address these issues deftly (and get some luck), like the US did in 1918-19 post Spanish flu and post-World War I, we could see a quick bounce back like we saw then. But many, many things could instead go wrong, leaving us with a painful U-shaped recovery.
Do you see risks of overreaction to the crisis (in the near or long-term) that do lasting economic damage?
This is a serious crisis. It is right for economists and policymakers to panic even if that leads to over-reactions. What would surely do lasting economic damage is to do nothing.
I would be paying more attention to the lasting economic impact that comes from people taking advantage of the crisis to quickly get policies that they ideologically favor, but which have little to do with the acute crises we’re facing. For instance, right at the start of this crisis, this was very visible in an unashamed way. Some people that have for years defended cuts in payroll taxes to increase incentives to work (and lower the size of the government), said we should do this right now to prevent a crisis. People that have for years defended big increases in government spending to stimulate aggregate demand (and increase the size of the government), jumped to say we should do this right now to stop a recession. But, right now, during lockdown, providing incentives to work or stimulating demand is the opposite of what “freezing” the economy is: you can’t incentivize of stimulate a person that is locked at home.
More subtly, you see people that start from the legitimate premise that we need to keep businesses go on to make proposals that would imply large transfers to shareholders, or that bail out failed businesses. On the other end of the spectrum, you see people using the uncontroversial need for government intervention in a crisis, propose schemes that would make the government all-powerful central planner, buying everything made in the economy and choosing who should be given what. For these people, these are not lasting damages, but lasting “revolutions” to the way our society runs, which they believe will be better. But when I have read people say “the window of opportunity is now” in the last week, often that did not refer to the urgency of taking measures to salvage the economy; rather the urgency was to push through long-lasting changes to the role of the government in society that they knew would not be approved by our democratic institutions outside of crises times.
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