Coronavirus requires swift but targeted economic policy reaction
The new coronavirus is primarily a health crisis, but it also causes an unprecedented economic shock. The fact that economic policy is reacting quickly to it is encouraging and contrasts with the hesitation that caused the euro crisis ten years ago. If there is a fire, it needs to be extinguished, preferably as soon as possible, but with the right means. In order to absorb this economic shock, fiscal policy is particularly appropriate. Monetary policy can make little direct contribution, especially in the euro area, where policy rates have been negative for some time. Central banks must now prevent financial markets from exacerbating the coronavirus shock. This risk exists because the inevitable rise in budget deficits in many countries takes place in the context of already precarious public finances.
Virus affects supply and demand
The advance of the new coronavirus is holding the world in its grip. The measures taken to contain it are drastic, because human lives are at stake. The economic cost is of secondary importance. That does not alter the fact that it is gigantic. The decline and, a fortiori, the stoppage of production because people fall ill or cannot do their job as a precaution, affects supply. Where that happens, economic growth immediately falls. With internationally integrated production processes, this also hampers production elsewhere. For example, the initial quarantine measures in China have reduced traffic to and from European ports, including Belgian ports, and disrupted production processes worldwide. Today, production in China is getting back on track, but measures in Europe and the US are now affecting supply. As a result of their strong integration, the European economies are also quickly experiencing the impact of measures taken in neighbouring countries.
Nor is demand being spared. Preventive measures often restrict freedom of movement with immediate consequences for services such as transport, tourism, catering and the organisation of all kinds of events. ‘Voluntary’ consumption restrictions out of fear increase the impact. The further protective measures have to go, the more they affect all non-life-essential consumption. Some of these expenditures are probably definitively lost, others only postponed. This also applies to goods that cannot be bought because they are unavailable due to barriers to production or transport. Investments have also been affected. The negative demand shock will be all the greater and last longer the longer prevention has to be maintained or fear has a greater impact on confidence. This could trigger a self-sustaining negative spiral, with people permanently losing their jobs and incomes and more companies going bankrupt. Fast and well thought-through macro-economic policies should help prevent this.
Swift policy response...
Chinese authorities reacted quickly to the coronavirus crisis with economic stimulus measures, and Europe and the US are also reacting quickly. As far as monetary policy is concerned, the US central bank reacted with drastic interest rate cuts and extra liquidity for the economy and financial markets. Other central banks, including the European ones, followed suit. Macro-prudential policy allows banks to reduce the capital and liquidity buffers that were built up after the previous financial crisis. In this way, they can help cushion the financial impact of the economic shock by maintaining lending levels. Indeed, a major economic danger of the coronavirus malaise is that companies will be in need of liquidity as a result of a fall in turnover. Last but not least, governments are using fiscal policy to alleviate the impact on businesses. By deferring payment of taxes and social security contributions, they help prevent temporary liquidity problems in healthy companies from leading to bankruptcy. Widening systems of temporary unemployment helps prevent outright redundancies. These would further erode confidence and purchasing power and exacerbate the economic downturn. Outright redundancies would also further disrupt production processes and make a quick rebound after the crisis very difficult.
If there is a fire, it needs to be extinguished, preferably as soon as possible. The speed of the policy response is encouraging. In the euro area, it contrasts with the often hesitant action of authorities during the European debt crisis, which allowed the euro crisis to sink in. This will probably be avoided now.
... must also be well thought through
However, if there is a fire, it needs to be extinguished, but not always with the same extinguishing agent. Likewise, not every economic policy measure is equally adequate to combat the economic consequences of the corona crisis.
As the central bankers themselves point out, in the current circumstances monetary policy is not best suited to deal with the consequences for the real economy. It does not remedy the supply disruption. If production comes to a standstill due to quarantine, a cut in interest rates cannot do anything about it. And whether a lower interest rate will support demand is questionable, as long as there is no room for manoeuvre or fear undermines consumer and investor confidence.
In principle, however, monetary policy can make an effective contribution by easing the financial pressure on businesses and households through lower interest rates. In this context, however, the euro area is in a special situation. The ECB’s policy rate has been negative for some time. An even lower interest rate will then have little effect. The macroprudential policy measures mentioned above and those operating via the government budget will then be much more effective.
The Fed’s drastic action was mainly intended to reassure financial markets. It also had ‘technical’ reasons. Risk aversion on the part of market participants prevented normal functioning and price formation in some markets. In that case, central banks can help with extra liquidity.
Fiscal policy must be relied upon to cushion this shock to the real economy. The so-called ‘automatic stabilisers’ must be allowed to fully operate. It is no problem that the budget deficits are now temporarily increasing as the economic malaise is reducing government revenue and pushing up expenditure. The high government deficits and debt in many countries should not act as a brake on this, nor should it prevent necessary public health spending.
However, the euro area is again at risk of facing its institutional weaknesses. In order to absorb economic shocks effectively, monetary unions need a central budget. But in this respect, the euro zone is paralysed (KBC Economic Opinion of 21 February 2017). It has to cope with a complex fiscal framework for national budgets. It is right to make full use of its flexibility to enable it to combat crises with larger deficits in the short term. In principle, there are sufficient savings in the economy to finance those deficits. But there is a risk that financial markets will only want to channel that money at much higher risk premiums to governments with too precarious public finances. In order to prevent a new euro crisis, a ‘backstop’ is needed. Either the ECB can play that role, which, after some uncertainty, it intends to do with the Pandemic Emergency Purchase Programme, or there will be sufficient European budgetary solidarity. Unfortunately, there is still too little political appetite for this in the short or medium term.
Of a different order is the call for discretionary stimulation of demand through, for example, tax cuts or increased public investment. This call was already heard before the coronavirus struck. However, as long as the supply problems are not solved, such stimulation will not be very effective. Once the crisis has been averted, many European countries - in particular Italy, which is being hit hard by the coronavirus - will once again quickly run into their budgetary limits. Whether the euro area will be able to move up a gear in fiscal terms will depend on the countries with the policy scope to do so. Let it be a ray of hope that the coronavirus is also curing Germany’s obsession with the ‘Schwarze Null’ (KBC Economic Opinion of 5 May 2019 and of 11 September 2019).