Shock therapy

Governments and central banks around the world are unveiling their policy responses to the coronavirus threat. The Federal Reserve has led the way in cutting rates and Donald Trump has promised a response from the government, although he still seems more exercised by the fall in stock prices than by the threat of the virus itself.  Italy has basically locked itself down and at the same time has suspended all household mortgage payments in order to ease any possible pressure on family budgets.

With CNN and the other 24-hour news outlets seemingly intent on stirring up panic, these official responses were probably inevitable.  That said, it is far from clear that a global recession can be avoided, and not at all obvious that there are any policy responses that can ensure that any recession is short-lived.

Economists make a distinction between demand shocks, for example events such as hurricanes or earthquakes that lead to a sudden fall in demand,  and supply shocks, events such as the long-ago OPEC oil embargoes that lead to a sudden price rise or physical shortages of a key commodity.  Governments are reasonably adept at dealing with demand shocks*, through emergency financial and reconstruction aid and such; demand shocks tend to be relatively short in duration.  Supply shocks are another matter: the response to those OPEC embargoes was horribly botched, directly contributing to the endemic inflation problems of the 1980s.

What the global economy faces now is without precedent: at once both a demand and a supply shock, yet not quite exactly either.  The draconian lockdown in Hubei Province has dramatically slowed the spread of the virus there, but at the cost of a serious deceleration in the Chinese economy.  Thanks to globalization, that deceleration has rapidly produced problems and shortages in global supply chains. If other countries in Europe follow Italy in announcing quarantines of their own, and even more seriously if the same happens in parts of the United States, global growth is bound to go into reverse.

This is not to say that policy is impotent here.  Reductions in interest rates will make it easier for heavily-indebted households and businesses to cope with any squeeze on cashflow -- though there is also a risk that they will boost property prices bubbles and yes, Toronto housing market, I'm looking at you. Measures by governments to protect household incomes, for example by extending paid sick leave, would both keep families afloat and help slow the spread of the disease.

What is much less clear is that outright fiscal stimulus would be effective.  If you give businesses more money in current circumstances, they aren't likely to undertake new investments or ramp up production -- they will probably sock it away in case things get even worse. And if you give more money to households, what are they going to spend it on (apart, perhaps, from more toilet paper)?

Sporting events and concerts are being canceled left and right; it can't be long before theatres and restaurants start to feel the pinch, or even get closed down by the authorities as a precaution.  If you gave every Italian family 100,000 euros right now, they wouldn't go out and spend it.  They would put it in the bank and then rush out to spend it once the crisis passed -- at which point you'd have an inflation problem on your hands.

It's important for governments to be seen to have a plan here; that's why the muddled response to the crisis in the US and in Japan has been so dangerous.  It's that old saw about having nothing to fear but fear itself: as long as governments seem to have an idea of what they are doing, the public is likely to be reassured, to "keep calm and carry on". However, it's important for governments not to attack the wrong problem.  A recession isn't the worst outcome here: millions of people dying is.


* The people of Puerto Rico might well disagree, but as a generalization this is true.