Covid-19 is a supply shock. Huge amounts of capacity are being taken out of the economy. It would not be surprising to see a 10 per cent fall in national income. It has been suggested that there is a demand shock too: there isn’t. The shock is to supply and the reduction in demand only arises because the supply of certain goods and services is effectively prohibited.
Alex Tabarrok and Nobel Prize Winner Paul Romer (writing separately) have argued that more government interventions should be used to get back to business as normal – especially through testing for the virus. That may be wise, but there would still be an over-hanging problem.
This event is different from the oil price supply shock of the 1970s. That led to a rise in costs and a change in industrial structure as relative prices changed. Covid-19 is more like a major war – though still with a difference. During World War II, huge numbers of people were drafted into the war effort. The equivalent today would be if those who were made unemployed were drafted into hospitals or other areas of work to deal with the effects of the virus. In World War II, therefore, national income numbers held up, but the normal goods and services that we like to consume were not being produced or consumed so living standards fell dramatically. In those situations, national income numbers are meaningless.
So we have large numbers of people with no work and who are producing nothing. Even greater numbers of people are able to spend less on goods and services than they normally would. This is a genuine loss of output and consumption. Company shareholders will bear some of this cost if they keep paying their employees. Otherwise, the shock will be felt by employees unless, of course, the government intervenes.
There are two reasons why the government should intervene – but only temporarily.
Firstly, there are transactions costs of sound good businesses going bankrupt because of a government edict to close temporarily. It is extremely inefficient if perfectly good businesses go bust and then have to re-enter the market or have their places in the market taken by other businesses when the crisis is over. From an economic point of view, government support for businesses can be justified, though it will be difficult for the government to determine which businesses would have gone under anyway. Temporary subsidies to employees, business rates and rents are reasonable ways to do this.
Secondly, for similar reasons, it is reasonable to support those who have lost employment or who are laid off. You could argue that Covid-19 is an insurable event and that government assistance creates moral hazard, but the fact that the government decided to close businesses undermines that argument.
The Institute for Fiscal Studies (IFS) reckons that the total increase in government borrowing as a result of the crisis will be about £120 billion. Over half of that arises from reduced tax revenues whilst government spending on health, education and welfare continues at normal levels. The rest arises from direct government support. In the long term, of course, if national income continues to fall, government spending would have to be reduced. In the short term, that is clearly not in the government plans. How, then, should we finance the increased direct interventions (estimated at £50 billion by the IFS)?
Transfers financed by taxes
If this spending is financed by extra taxes levied this year and next, real resources will be transferred from those who are earning but unable to spend to those who are unable to earn. To simplify somewhat, if there were only two goods, food from supermarkets and meals out, and the latter are banned thus putting all their providers out of work, the government could tax supermarket workers the amount they would have spent on meals out and give the money to restaurant owners and workers so that they can still buy food from supermarkets. This could be regarded as a transfer of “forced saving” from those of us on fixed incomes who cannot spend because of the crisis to restaurant workers and owners. In theory, taxpayers just go back to normal in a few months after having missed out on luxuries for a while.
Transfers financed by borrowing
It is often thought that borrowing leads to stimulus – a proposition that is debatable in itself. But we don’t need stimulus. People who are not working are effectively banned from working and people who are not consuming are effectively banned from consuming. Stimulus will not solve that problem. Borrowing to fund government support does, though, change the profile of gains and losses. Here the government issues bonds and people buy those bonds. Over the long term, the bond buyers receive their capital back with (very low) interest financed by the taxpayers of the future. Bond-buyers are forced to consume less today, but their consumption can be increased beyond its expected level in the future. This will be paid for by future taxpayers. Some would justify this on the grounds that the cost of this one-off event should be amortised over future generations as we have done with the cost of wars. We should not assume that is an easy option given current levels of debt, however (that will be the subject of a later article).
Transfers financed by printing money
Finally, imagine if governments simply created bank deposits to give to people who had lost their jobs or who needed liquidity to keep their businesses going. The impact of that might be inflation assuming that all other aspects of monetary policy are unchanged. Those receiving the income transfers will try to spend the money and the rest of us are also trying to spend whilst the supply capacity of the economy has fallen. This would lead to inflation and all sorts of redistributional consequences. The real value of business and household debt would fall, for example, as would the real value of people’s savings. In moderation, this would not necessarily be a bad thing.
In war time and at the time of other supply shocks, of course, governments have taxed, printed money and borrowed. But Covid-19 is not like an all-out war with the survival of the nation at stake. Experiences of countries printing money during shorter and partial supply shocks have not been good. In particular, it has become difficult to wean countries off the drug. In deciding the best policy, there are advantages of visibility over opacity and advantages of policies that do not have long-lasting effects. There is a strong case for emergency tax increases passed by primary legislation with a strict time limit, levied on incomes above £25,000 and strictly proportional to income designed to fund the direct cost of the government’s decisions.
As supporters of free markets, we are rightly allergic to taxes (and even temporary taxes have a habit of becoming permanent). However, we should be even more allergic to the narrative of fiscal stimulus with its subliminal message that we are getting something for nothing. There is no free lunch here. This crisis has a big cost. We can argue about whether the government has taken the right decisions, but, given the decisions it has taken, it is a myth to suppose that the costs can be brushed under the carpet. The US tried that in the Vietnam War; we tried it in the 1970s oil crisis. It ended badly both times.
A shorter version of this article was originally published on CapX.