Analysis: Coronavirus Crisis Blows Away Economic Policy Dogmas

RIO DE JANEIRO, BRAZIL – Mario Draghi, the great craftsman of the European rebound after the past decade’s eternal crisis (first the global one, then that of sovereign debt), resurfaced last week after months behind the scenes.

It was in his native Italy, with a powerful double message – young people come first, and the avalanche of public debt that will take Europe and the world out of this coronavirus crisis must, without exception, be destined for productive spending – adding a quote from John Maynard Keynes that comes in handy these days: “When the facts change, I change my mind. And what do you do?”

The question was answered in record time by governments and central banks worldwide, which tailored the menu of potential options to the radical circumstances that took place: a global pandemic, strict confinements, the highest GDP slump in nearly a century. If the 2008 Great Recession shook the tree of economic studies, this crisis is on its way to changing paradigms carved in stone for decades.

The first match point has already been saved: the recession will be huge, but the economic depression that many feared in the early days of the pandemic can be ruled out. At least for now.

The crisis is still far from reaching its epilogue: despite a fast improvement of the health situation – suffice it to observe the deceleration of card spending – most Western countries will only recover their GDP level, at best, in 2022 or 2023.

The scars will be deep, but by now the picture has left some lessons learned from earlier events, particularly in Europe. “On the brink of the abyss you make decisions you never thought you would,” says Xosé Carlos Arias, professor at the University of Vigo (Spain).

“This will leave a long-term legacy of economic policy: the paradigm is changing, and it’s seriously changing. Everything that has worked and is working is the opposite of what we, professors of Economic Policy, have spent decades telling students,” he adds.

“A profound change is taking place in the economy, one that we only see once a generation (…). The pandemic marks the beginning of a new era,” said The Economist newspaper in a July editorial. The twist is drastic: the crisis has stretched the limits of what is possible (or what was believed possible until now).

On the fiscal aspect, a European plan greatly resembles a debt mutualization; and on the monetary front, central banks enable their most activist version to sustain the financing costs of states when they need it most.

“The so-called limits were not so. The world has learned that there are other tools that work,” points out Ángel Talavera, of the Oxford Economics consultancy. “A Great Depression is being averted: the economic policy response was surprisingly good, far above expectations, and it was clearly understood that the dangerous thing would be a [funding] lack, rather than an excess.”

Alicia García Herrero, of the Bruegel think tank, adds that “it was the fastest fiscal and monetary response in history. Several dogmas were broken, and the idea that fiscal expansion may be less costly than we thought, thanks to monetary financing, helped to test the limits.”

After the 2008 and 2009 Great Recession, Europe reacted late in monetary policy and badly in fiscal policy: always fearing inflation – his mistake would soon be obvious – Jean-Claude Trichet raised the price of money in April and July 2011, when the sovereign debt crisis that left the euro on the ropes was already fermenting in southern EU states.

It took Draghi to fix the flaw, months later, in great style: with his now-famous “I will do everything that needs to be done to save the euro.” The European Central Bank waited until 2015 to launch a massive debt purchase in the markets (the famous QE – quantitative easing); at that time, the Federal Reserve was already doing its third program of this kind.

On the fiscal front, German and Dutch domination prevented something that resembled a truly countercyclical policy: those years added “expansive austerity” and other similar paradoxes to the economic dictionary.

Nowadays, that is all water under the bridge. Christine Lagarde, current president of the European Central Bank, took a few hours to recant her blunder at the start of confinement – “We’re not here to reduce risk rates” – and has since followed in the footsteps of her predecessor with conviction.

His steadfastness -more debt purchases, high liquidity – has paid off: despite the double-digit GDP collapse, Spain and Italy now manage to finance themselves the same as they did before the virus.

“This time, both the fiscal and monetary authorities soon realized that this is, in fact, a global shock, that moral risk is not something to worry about and that everything must be done,” says Ugo Panizza of the Graduate Institute.

On the other side of the Atlantic, Fed (US central bank) president Jerome Powell last week used his address in Jackson Hole to make his inflation target more flexible – which, he said, is already a distant concern – and put employment one step above the institution’s double mandate: a turnaround unimaginable only a decade ago, but which in practice has been applied for years.

Even some central banks of emerging countries, historically fearful -and rightly so- of hyperinflation, have gone out to purchase debt on a large scale this time around. It is another indication that times have changed and some maxims no longer apply: few guardians of orthodoxy at any price have raised their voices.

But perhaps the great turning point in the script was in terms of fiscal policy. With a Republican in the White House, the almost free money has turned the US into an advocate of Keynesianism: with a trillion-dollar stimulus, equal to very few countries, it was able to sustain available income for families during the quarantine.

Debts exceeding GDP are already the new normal in the West. And Kristalina Georgieva, managing director of the International Monetary Fund (IMF), has not refrained from making it clear that new winds are blowing and that austerity measures are a thing of the past. At least for now: the goal must be to emerge from this crisis with minimal scarring.

“You will not hear the IMF say this often: spend. But that’s what we’re telling governments: spend as much as you can, but keep your receipts, make sure you account for how the money is used,” she said in June.

In Europe, the pandemic earthquake also rattled fiscal foundations that were believed to be firmly in place. The stability and growth pact soon became worthless. With the rescue fund, the Old Continent crossed the Rubicon of bonus issuance.

Angela Merkel, today one of the sponsors and strongest advocates of change in the script, once said “there will be no mutualization of debt as long as I live” – it seems like a century ago. If in the last decade it was Germany that led the group of debt hawks, nowadays it is Holland – an important country, but of much less specific gravity – that tried to torpedo any advance. With limited success, because it was soft: it managed to cut the volume of subsidies, but failed to torpedo them, as intended.

“This explosion in fiscal policy is justified, but not always the way the money is spent,” says French economist Charles Wyplosz. “When a government announces that it will increase its spending by billions of euros, all interest groups use their tremendous influence to get their share of the cake. There must be a focus on the quality of spending.”

In parallel, and based on bailouts – observing what happened with the largest European airlines is enough – the point of balance between the public and private spheres has changed:

“We have learned that when the market system is dealt a strong blow, like that of the coronavirus, it can implode, and only an external force, like the State, can stabilize it. This will affect our perspective on the balance of power between markets and governments,” says Paul de Grauwe of the London School of Economics.

Some dogmas have been blown away, also with regard to the labor market: faced with the US’ adherence to pure and simple creative destruction, most European countries, led by Denmark, have launched ambitious – and costly – job retention programs to avoid a break in the nexus between workers and employees that will make things even worse in the medium term.

Whether called ERTE, furloughs, ‘Kurzarbeit’, or ‘chômage partiel’, the use of these instruments has prevented a sharp rise in unemployment. “This could not be done until it could be done,” Talavera points out. “It is remarkable how quickly countries have adapted to this kind of policy. There is no neutral policy, they all have their negative side, but the alternative for the market to choose the winners was worse.”

Germany, and Spain to a lesser extent, have already shown their willingness to extend these schemes, but the most complex issue will arise within a few months when this artificial ventilator will need to be disconnected and prevent the necessary transfer of workers between sectors.

Western economists came out of the 1970s with a clear maxim: inflation was the greatest risk they faced, and virtually the whole machinery of economic policy focused on mitigating it. “But the message that emerged from the global financial crisis, and even more so today, is that in very adverse contexts we need greater coordination between fiscal policy and monetary policy,” Panizza stresses.

“This does not mean that everything is worthwhile, that there are no budget restrictions and that public spending can always be financed by printing money, as advocates of the modern monetary theory say. But in the short term, monetary policy can create fiscal elbowroom by keeping financing costs low and offering support.”

Unless central banks hesitate, the risk of a financial crisis will not spread. And as former chief economist of the IMF Olivier Blanchard recently noted, “as long as interest rates remain manageable, there will be no need for cuts or foolish tax raises, and we will be able to cope with our debt from now until the end of the crisis without having to do anything crazy afterwards.”

With zero interest rates – the Fed has recently made it clear that they will be long-lasting – and safe liquidity, the tide will continue to ebb more or less calmly. The great unknown is what will happen afterwards – what are the consequences of stretching the rope of economic policy beyond the limits that we once believed immovable?

“Beware of uncritical acceptance of radically heterodox approaches, because the economy cannot move indefinitely over a bag of debt,” Arias concludes. “Now should not be the priority, but rather the medium-term.”

Source: El País