How the COVID-19 economic feedback loop amplified the crisis

By William Longbrake

SMITH BRAIN TRUST – The COVID-19 pandemic precipitated an abrupt and extraordinarily severe global recession. Social distancing and lockdowns which were intended to slow the spread of contagion threw millions out of work and crushed economic activity instantaneously.

Unemployed workers faced the prospect of reduced or no income. Loss of income leads to reduced spending. And, reduced spending, which crimps another individual’s income, precipitates further reductions in spending. This feedback loop, like the virus itself, can spread and amplify economic contagion.

Absent a vaccine, the only way to contain a pandemic is implementation of policies to limit human contact. But while containment policies reduce infections and save lives, they force the shutdown of economic activity involving direct human interaction, such as dining out and sporting events. As businesses directly impacted fight for survival, they cut costs and let go employees, and in so doing ignite economic contagion.

The current global recession differs from past recessions because the disruption of economic activity occurred literally overnight on a massive scale, but the consequences of this recession are like those of past recessions, namely rising unemployment and falling spending.

Macroeconomic policy tools to treat economic contagion, prevent its spread, and hasten recovery are the same today as those used to combat the consequences of past recessions. The primary tools are fiscal policy and monetary policy.

Policy Objective – Full Employment

Deployment of macroeconomic policy tools is intended to support income and boost spending. Fiscal policy does this by reducing taxes and by spending money on programs that replace lost income (stimulus checks and unemployment insurance benefits) and support job retention (paycheck protection program) and job creation. Meanwhile, monetary policy does this by reducing the cost of borrowing and encouraging investment, which leads over time to increases in employment. Historically, low interest rates have spurred car and home buying – two economic sectors that have traditionally led economic recovery.

Policy Objective – Price Stability

While the purpose of macroeconomic policy tools is to promote full employment and full utilization of resources, there is a second policy objective – and that is price stability. Price stability is important because individuals’ and businesses’ economic decisions are impacted by their expectations about future prices. Expectations for negligible changes in future prices have little impact on today’s decisions, but expectations of significant changes – either inflation or deflation – will influence today’s decisions in ways that destabilize economic activity.

For example, if inflation is expected, demand will escalate and hoarding will occur. Such activity will reinforce inflationary pressures. Or, if deflation is expected, purchases will be delayed to take advantage of expected lower prices in the future and this will depress economic activity today – again reinforcing the expected decline in prices. Price stability expectations also impact decisions about the use of credit. When inflation is expected, demand for credit escalates because borrowers expect to repay debt in cheaper dollars. Conversely, when prices are deflating debt taken on today becomes more difficult to repay in the future as incomes and revenues decline.

Mainstream Macroeconomic Policy and Modern Monetary Theory (MMT)

Both mainstream macroeconomic policy and modern monetary theory focus on achieving the dual objectives of full employment and price stability. The intent of both is to achieve and sustain employment and output (gross domestic product) at its full noninflationary potential.

While there is debate about what constitutes noninflationary full potential, there is general agreement that the “non-accelerating inflation rate of unemployment – NAIRU” is in a narrow range of 4.1% to 4.5%, potential real GDP growth is in a range of 1.7% to 2.2% and price stability is consistent with 2% inflation (personal consumption expenditures price index).

So, if the policy objectives of the two economic theories are the same, what is the difference between them?

Arjun Jayadev and J.W. Mason in a September 6, 2018 article, “Mainstream Macroeconomics and Modern Monetary Theory: What Really Divides Them?” provided an answer: “The different conclusions drawn by MMT and the mainstream in policy do not come from a different understanding of the economy, but from a different view of the capacities of policymakers, and in particular, of what kinds of policy errors are likely to be most costly,” they wrote.

Key to the potential for policy errors is the accumulated federal debt- to-nominal-GDP ratio. There is concern among mainstream macroeconomic policymakers that the size of this ratio matters and it is the responsibility of Congress (the budgetary policymakers) to manage this ratio to a prudent level. MMT adherents argue budgetary policymakers should be concerned only with adjusting fiscal policy to achieve maximum employment consistent with price stability and should not concern themselves with the level of the debt ratio. Rather, it is the responsibility of the monetary authority (Federal Reserve Bank) to make sure the size of the debt to GDP ratio has no impact. The Federal Reserve can achieve this outcome through the management of interest rates. Thus, the principal difference between the two schools of thought has to do with whether Congress or the Federal Reserve Bank should be responsible for making sure the debt-to-GDP ratio does not cause problems in the long run.

MMT emphasizes that budgetary policymakers should manage tax and spending policy to maximize full employment but should raise taxes and reduce spending whenever the price stability objective is threatened by an outbreak in inflation caused by an overheated economy which has exceeded its non-accelerating inflation full potential.

Potential for Policy Errors

An obvious potential policy error is that politicians have a bias to spend and are slow to apply the brakes when the economy is overheating. A recent rather apt case in point was the so-called Trump tax cuts when the economy was already at full employment. This spending bias imparts a systematic upward bias to the debt-to-GDP ratio.

Of course, the Federal Reserve can mitigate the potential explosion in the debt-to-GDP ratio by holding down interest rates, but there is disagreement about the long-run consequences of low interest rates. Nonetheless, right now that is exactly what the Federal Reserve is doing and is promising to continue doing for quite some time.

Policymaking in Response to the Covid-19 Recession

Policymaking responses to the damage done to the global economy by the Covid-19 pandemic is mostly following the MMT playbook. Congress moved quickly and aggressively to replace income lost by individuals and businesses through stimulus checks, enhanced unemployment insurance benefits for individuals, and generous loan and grant terms of the payment protection program for businesses. Given the depth of the recession, Congress is expected to pass additional income supporting measures. Even Federal Reserve Chairman Jay Powell is encouraging Congress to do more. The debt-to-GDP ratio is skyrocketing, but that has not been a consideration.

Monetary policymakers quickly slashed interest rates to zero and increased purchases of Treasury debt and mortgage-backed securities substantially. Although the Fed is not legally permitted to buy newly issued debt directly from the U.S. Treasury, in effect it is scooping up a substantial portion of the new issuance of Treasury securities which is financing the fiscal policy response to the recession. Near zero interest rates and substantial purchases of Treasury debt are likely to continue for a long time.

Printing Money and 'Monetization' of Treasury Debt

There is concern in some quarters that the Federal Reserve’s purchase of large amounts of newly issued Treasury securities is akin to printing copious amounts of money and this will eventually lead to an explosion in demand and runaway inflation – too many dollars chasing too few goods and services. Some even characterize this as “monetization” of the federal debt. Technically, debt monetization results only if the debt obligation is eliminated. However, when the Federal Reserve purchases Treasury securities for its portfolio, the debt is not retired but remains an obligation of the U.S. government and taxpayers. But, putting this technicality aside, the Federal Reserve’s purchases of securities are financed by the creation of bank reserves.

Is it possible that the expansion of the Federal Reserve’s balance sheet will stimulate a massive increase in bank lending, which in time will result in an overheated economy and uncontrolled inflation? The answer to this question is that such an outcome is not at all likely. While individual banks can transform reserves held at the Federal Reserve into loans, all banks collectively cannot. That is because in the aggregate only the Federal Reserve can change the level of bank reserves. And because the Federal Reserve pays interest on reserves, the incentive for banks to try to convert reserves into loans is limited. Bank regulatory liquidity requirements also limit incentives for banks to convert reserves into loans.

Impacts of Monetary and Fiscal Policies in the Current Economic Crisis

Monetary and fiscal policies of developed economies appear to be having the intended effect of stopping economic contagion and establishing a base for recovery.

Nonetheless, the question remains whether any set of policy responses can fully offset the damage that new waves of Covid-19 contagion might inflict. And, even if the worst of the pandemic is now past, secondary negative impacts on economic activity stemming from the initial enormous disruptive economic shock are still possible. However, it does seem likely if worse comes to worse that policymakers will continue to use available policy tools aggressively.

And, if the proponents of MMT are right, exploding debt-to-GDP ratios will not matter.

Are There Risks to the ‘Go for Broke’ MMT-Inspired Policy Response to the Covid-19 Recession?

In the short run, TINA – there is no alternative – prevails. Indeed, more may be necessary. But, in the longer run there are two impacts of today’s macroeconomic policies that may prove troublesome.

Low interest rates have been a feature of developed economies since the global financial crisis a decade ago. Low interest rates inflate the value of assets and disproportionately favor owners of assets relative to the rest of the population. Low interest rates are driving the divide between rich and poor ever wider.

Stock prices during past recessions have taken years to recover. But, in this recession, which is worse by far than others, stock prices have recovered dramatically and are higher in aggregate than just a year ago. What gives? Are traders irrational? The most likely answer is that the promise of near zero interest rates for years to come, Federal Reserve credit facilities for many asset classes, and copious amounts of liquidity are behind the stock market’s breathtaking recovery. In other words, what is happening to asset prices is probably not an aberrant fluke.

But, in addition to exacerbating wealth inequality, it appears that only limited amounts of monetary policy liquidity are going into investments in new business endeavors and infrastructure – most is going into inflating the values of existing assets. This dearth of new investment in time will weigh upon productivity and drive down the potential rate of growth in output.

A second given outcome of current macroeconomic policies is that the growth in the size of the debt-to-GDP ratio will accelerate. We already know that the demographics of an aging population will combine with entitlement programs in coming years to drive the debt-to-GDP ratio even higher. While MMT advocates argue that the size of the debt won’t matter as long as the Federal Reserve keeps interest rates low, no substantive proof has been offered. Many professional economists, including the Congressional Budget Office, believe that there is an inverse correlation between the size of the debt-to-GDP ratio and potential output growth.

While this risk may not materialize in the long run, if it does, the damage could be considerable and not easily reversed.

–William Longbrake is executive-in-residence in finance at the University of Maryland's Robert H. Smith School of Business, and is the author of the monthly economics report, the Longbrake Letter.