Part of a series of proposals for the G20's* agenda on the COVID-19 pandemic. The fiscal policy response to the pandemic has been unprecedented. Urgent measures are being taken, which are likely to lead very large fiscal deficits. The response will have to be refined and adjusted over time, as a function of both the pandemic dynamics and our improving understanding of the issues. The purpose of this blog is to think about the best design of fiscal policy, both now and in the near future. The conclusions can be stated as follows: In this crisis, fiscal policy should have three goals. The first is to fight the virus. The second is to provide disaster relief, to ensure that people do not suffer from hunger and firms do not go bankrupt. The third is to adjust aggregate demand to stay as
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Part of a series of proposals for the G20's* agenda on the COVID-19 pandemic.
The fiscal policy response to the pandemic has been unprecedented. Urgent measures are being taken, which are likely to lead very large fiscal deficits. The response will have to be refined and adjusted over time, as a function of both the pandemic dynamics and our improving understanding of the issues.
The purpose of this blog is to think about the best design of fiscal policy, both now and in the near future. The conclusions can be stated as follows:
In this crisis, fiscal policy should have three goals. The first is to fight the virus. The second is to provide disaster relief, to ensure that people do not suffer from hunger and firms do not go bankrupt. The third is to adjust aggregate demand to stay as close to potential output as possible. Each of these three dimensions comes with its own set of challenges and difficult decisions.
Such policies will result in a large increase in debt relative to GDP. In most advanced countries, interest rates are likely to remain low for a long time, so that, despite this increase in debt ratios, debt should remain sustainable. The same cannot, however, be said of several emerging-market and developing economies. These countries should be helped so that they can spend what they need to spend to deal with the crisis. Forcing them to spend less would be wrong and dangerous for others. They will, therefore, need grants and loans, both by international institutions and individual advanced economies, which themselves have to spend to save their own economies.
There are two dimensions in which coordination across countries is essential. Help for emerging-market and developing economies is of the essence. Looking down the road, coordination in the purchase and allocation of tests and vaccines is equally so. But, beyond this, coordination of fiscal policies is not essential. Put another way, if each country focuses only on its domestic goals, the outcome will be fine.
The three roles of fiscal policy in the COVID-19 crisis
- The first is infection fighting, spending as much as needed both to deal with the infection now and to give incentives to firms to produce tests, drugs, and vaccines, so that the pandemic can be both brought and kept under control.
- The second is disaster relief, providing funds to liquidity-constrained households and firms. Many households do not have the cash to survive the next few months without financial help. Many firms do not have the cash to avoid bankruptcy without some help. Providing financial relief is essential to avoid extreme suffering and permanent damage to the economy.
- The third is support of aggregate demand, to make sure that the economy operates as close to potential as it can, recognizing that potential is, for the moment, profoundly impaired by the health measures needed to decrease the infection rate.
Infection fighting is a no-brainer. Getting the infection rate down is an absolute priority. Apart from confinement/lockdown measures, more tests, more respirators, more masks and other vital medical gear are essential. In the short run, the constraint is largely technological, but more funds can help attract firms and workers with the relevant skills to accelerate production. Keeping the infection rate down will be essential to the recovery, which implies giving incentives to firms to produce tests, explore drugs, and develop vaccines. A large scaling up in the production of tests, to test either for the virus or for antibodies, can make a substantial difference in the speed at which confinement restrictions can be relaxed while keeping the infection rate down. The bottom line, however, is that spending on containing the infection is essential, existential, and expensive but still small in macroeconomic and budgetary terms—less than 1 percent of a country’s GDP.
Disaster relief is also a no-brainer. A large proportion of households has no cash reserves. Because of either low demand or forced lockdown, many small and medium size enterprises, which represent 45 percent of total value added in the United States, have insufficient cash reserves to survive more than a few months. It is of the essence to provide them with enough cash to survive the crisis.
The main issue is how to quickly get the funds to the people and firms in need. Much work is going into how to do it, with different solutions in different countries. These run from suspending or canceling tax payments, to increasing unemployment benefits, to sending checks, to asking firms to advance the funds to workers, to asking banks to advance the funds to firms in need, with the state providing the final backstop.
None of these distribution channels work perfectly. Information about who needs the money is limited; reaching those who need it the most is difficult. The implication is that, whatever combination of delivery is chosen, it is better to err on the side of giving too much rather than too little. This may, however, result in a large package. Consider the following back-of-the-envelope computation for a plausible upper bound: Assume that 40 percent of the firms and households are liquidity-constrained, that the replacement rate is 80 percent, so the state replaces, say, 32 percent of lost income. Suppose that nonessential firms are on lockdown, that output goes down by 35 percent (which is in the range of the preliminary numbers for economies on lockdown, such as France). Assume that the funds take the form of grants rather than loans, an issue to which I return below. The fiscal cost per month is 35 percent times 32 percent, thus 11 percent. If the economy is, say, on full lockdown for two months and on half lockdown for another six months, the fiscal bill will be about 5 percent of GDP.
Supporting aggregate demand
In a normal recession, control of aggregate demand would be the main motivation for using fiscal policy. This, however, is a not a normal recession, and it has important implications. In the short run, so long as confinement and lockdown constraints are on, potential output will remain much lower. Based on the French number cited above, the decrease in potential output, based on confinement and lockdown of all nonessential firms, probably ranges between 30 and 40 percent. Governments must accept a corresponding decrease in demand (importing from abroad is not an option; this is a world war against the virus). Put another way, sustaining demand above potential, say through tax cuts for firms or households, may lead to rationing and inflation rather than an increase in activity.
This raises a question about the size of the disaster relief package discussed earlier. It could indeed be that the increase in consumption, which is likely to be substantial if the funds really go to liquidity-constrained households, runs into supply constraints. This concern may not be a major issue as much of the spending is likely to go toward making mortgage payments and buying food—a sector where supply constraints may not be binding. And, even if the outcome is in part some rationing and some inflation, temporary inflation may actually be helpful in decreasing real interest rates, and the distribution effects—namely that poorer households have enough to eat—are such that the outcome is still desirable. But the point remains that, so long as potential output remains much lower, boosting aggregate demand beyond what is needed for disaster relief is probably unwise.
The situation will change, however, when the infection rate is under control, restrictions are slowly relaxed, and potential output returns, if not to its old level, at least close to it. Will there be a need then to boost aggregate demand and help the economy recover faster? The answer is that I do not know. On the one hand, there will, at least initially, be some pent-up demand from consumers who could not buy cars and other durables during lockdown. On the other, the rate at which restrictions are removed, or the real possibility that restraints have to be reinstated if the infection rate starts increasing again, is likely to lead to precautionary saving by consumers and low investment by firms. Demand may go up initially and then slump again, but it is hard to be sure. This uncertainty has a straightforward implication: Governments should be ready but should not commit to a specific level of fiscal expansion before we know which way demand goes.
To sum up, infection fighting and disaster relief are the highest priorities. Unless the fight against the virus turns out to be much tougher and longer than expected, they imply large but not gigantic deficits. Doing more to increase aggregate demand may be unwise in the short run and a boost may or may not be needed later. Flexibility here is of the essence.
Can countries afford it?
Can countries afford the resulting increase in debt? Will investors start to worry and ask for spreads? And even if they do not react, will there be a “What on earth did we do?” phase on the part of policymakers? It is a familiar phase from the last financial crisis when, after having embarked on a major fiscal expansion, European governments got worried about the large increase in debt and shifted to fiscal austerity, probably excessively slowing the recovery.
Suppose that, as a result of not only the deficits but also the decrease in output, debt-to-GDP ratios increase this time by, say, 30 percent of GDP (the computation above suggests smaller numbers). Should governments worry? And, if so, should they design smaller fiscal packages today, perhaps relying more on loans than on grants to households and firms? I believe the answer depends on whether we are looking at advanced or emerging-market and developing economies.
In advanced economies, the answer must be that, short of a defeat in the fight against the virus, debt will remain sustainable. (And if we lose that battle, debt sustainability will be the least of our problems). Before the COVID-19 crisis I had argued that low safe interest rates implied not only that higher levels of debt were sustainable but also that the welfare cost of higher debt for future generations was small. The implication was that advanced-country governments should not hesitate to run deficits if they had urgent needs. There is no question that they have urgent needs today. And, if anything, safe interest rates are likely to be even lower in the future than they were expected to be before the virus crisis. Precautionary saving is likely to be higher, uncertainty is likely to hamper private investment; both imply a lower neutral rate for a long time to come.
An important footnote about the role of central banks is needed at this point. As I discussed in a piece on Italian debt, sovereign bond markets are exposed to multiple equilibria. I have argued above that, at the safe rate, the sovereign debt of most advanced countries is likely to be safe. But if investors start worrying and require spreads on government bonds, the burden of debt payments will increase, and debt can indeed become unsafe; the worries of investors can become self-fulfilling. In advanced economies, central banks have the means to eliminate this bad equilibrium by committing to purchase whatever amount of bonds it takes to maintain the low rate. The best example of such a policy is the commitment of the Bank of Japan to maintain a rate close to zero on long-term bonds, the so-called yield curve control. Such a commitment may not be costly: With the knowledge that the central bank will intervene to maintain the rate, investors will not want to sell, and the central bank may not have to intervene at all. Other central banks may want to follow this policy. 
Having argued that advanced economies have substantial fiscal space, I am less sanguine about emerging market and developing economies. Many of them were already struggling before the COVID-19 crisis and have now been hit not only by the virus but also by the fall in commodity prices (if they are exporters) and large capital outflows by investors who need liquidity at home. Some of them do not have the fiscal space to react to these combined shocks and will need help, in the form of grants to fight the virus and adjustment programs to adapt to the other shocks. Helping these economies is a major and urgent issue, not only for their own sake but also for the evolution of the pandemic and thus for the rest of the world.
The role for fiscal coordination
Nearly ritually, G20 communiqués refer to the need for fiscal and monetary coordination. What does it mean in this context? Both more and less than it suggests.
If coordination means providing financial help to those countries that do not have the means to fight the virus and its economic ills, then coordination is indeed essential. The war must be won on all fronts. If Africa, for example, is unable to fight the pandemic, not only will it be a human tragedy but also it implies that either Africa becomes cut off from the rest of the world, an additional economic and human tragedy, or the pandemic continues in the rest of the world.
If coordination means sharing information about the characteristics of the pandemic, about the efficiency of tests, drugs, and vaccines, sharing medical resources as the heterogeneity and the moving nature of the pandemic allow, then yes, such coordination is also essential. So is sharing of information about the efficiency of fiscal measures never tried before, about the best ways of getting funds to those who need them, about the best ways to share risk between the private and the public sector.
While not strictly about fiscal policy, coordination is also needed both to produce the high amounts of tests and vaccines needed to maintain a low infection rate while removing lockdown restrictions and to allocate the tests and vaccines to those who need them most, be they countries or people within countries. Absent such coordination, the outcome is likely to be price wars, with the tests and vaccines going to richer countries and, absent state control within each country, to richer households. Ideally, a multinational institution, mandated first to give incentives to producers and then to allocate the tests and vaccines fairly, is the solution. Agreements within groups of countries, say within the European Union, may be a more realistic goal.
What about other dimensions of coordination? A typical argument for fiscal coordination is the presence of demand spillovers. When a set of countries faces a shortage of demand, each country may be reluctant to embark on a fiscal expansion because the increased spending will fall in part on the other countries and thus be “wasted” from the point of view of the embarking country. In such a case, the case for a coordinated fiscal expansion is indeed a strong one. Each country benefits from the actions of the others, and every country is better off. This was indeed the case underlying coordination of fiscal policies during the global financial crisis in 2007–09. The case is quite different today, however. The primary goals are, for the time being, infection fighting and disaster relief, and countries are clearly willing to do whatever it takes, independent of what others do. Coordination may become more relevant later in the recovery, when support of aggregate demand becomes more of a focus of policy. But, for now, coordination is inessential. The important thing is to act.
* The members of the G20 are Argentina, Australia, Brazil, Canada, China, the European Union, France, Germany, Japan, India, Indonesia, Italy, Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, the United Kingdom, and the United States.
2. Paul Romer has argued that testing 7 percent of the US population (22 million people) every day would allow to fully remove the lockdown and still keep the infection rate down. He also argues that it may be feasible to achieve such a number within a few months for a few billion dollars, a large cost but still small relative to the potential increase in output.
3. According to a Federal Reserve survey conducted in 2018, only 61 percent of those surveyed would have enough liquidity to pay for an unexpected expense of $400. According to a September 2019 study by the JPMorgan Chase Institute, half of US small businesses have less than 15 days’ worth of cash on hand.
5. Large public investment programs, as needed as they are, are not the right instrument to deal with the challenge at hand. Again, planning is good, but execution should be contingent.
6. The mandate of the European Central Bank prevents it, for the time being, from making such an unlimited commitment. But it has adopted the Pandemic Emergency Purchase Programme (PEPP), which allows it to perform a very large intervention if needed.