I read an article in the Financial Times earlier this week (September 23, 2023) -…
Economists like to think in terms of demand and supply. Often by assuming the independence of the two, they make huge errors, none the least being when in the 1930s they advocated wage cuts to cure the unemployment arising from the Great Depression, on the assumption that the cuts would reduce costs for firms and encourage them to hire more. But they failed to understand that economy-wide wage cuts would undermine aggregate spending, upon which production decisions, and, ultimately, employment decisions depended. The coronavirus outbreak is one of those events that emphasises the interdependence between the demand and supply sides of the economy. It is a supply shock – in that it has reduced the growth in output supply as firms stop producing because their workforces are quarantined. And that shock then feeds into a demand impact as the laid off workers lose incomes and reduce their spending accordingly. However, there is also a separate demand shock associated with the crisis, quite apart from the supply impetus. The fear and uncertainty associated with a possible pandemic has meant that consumers are altering their spending patterns rather quickly with airline travel and other such activities falling sharply. So this is a very special type of calamity that doesn’t fit the usual types of shocks that economies endure. And as a consequence, it makes the task of designing an economic policy response rather more difficult. But make no mistake. Fiscal deficits will have to rise substantially for an extended period and governments will have to do things they have never really contemplated before if a deep recession is to be avoided. This is Part 1 of a two-part series of my current assessment of the coronavirus crisis, or whatever you want to call it.
Supply shocks come in two forms:
1. A price shock – example, the OPEC price hikes in the 1970s that immediately injected inflationary impulses into oil-dependent importing nations.
The problem then becomes a distributional one – which sector(s) is going to take the real income loss that the rise in the imported raw material necessitates.
The real income loss is because the nation has to devote more of its income to paying foreigner than beforeto keep using the raw material.
Obviously, over time, substitution away from the raw material evolve. For example, In Australia, household heating was dominated by oil heaters in the early 1970s. Within a short time, that became uneconomic and new forms of heating were substituted.
Same story goes from the replacement of the big six and eight cylinder cars that were comon in the early 1970s with the smaller four-cylinder vehicles.
But, that process takes time and in the interim the nation has to determine how the real income loss will be shared.
If workers are forced to take the loss via real wage cuts as the price level rises that is not only unfair but in many cases will provoke wage demands and other forms of industrial action (sabotage, absenteeism, resignations, etc).
So some income loss sharing arrangement sponsored by government is required to avoid an inflationary spiral from emerging.
2. An output shock – example, the collapse of farm out in Zimbabwe after the takeover of the farms by the freedom fighters.
In this case, a spending stimulus is tricky because it is likely to trigger inflation especially in the case of Zimbabwe, where the output loss was food and there was the danger of mass starvation.
The trick is to try to stimulate areas of the economy that have capacity to respond in real output terms.
So, in the case of the coronavirus, the sudden drying up of JIT components from Chinese factories for local firms, will damage their sales position.
The government can always offer these firms some short-term debt relief and other cash inducements to tied them over.
But the major damage will not come because we cannot purchase some Apple products for a while (noting that Apple has withdrawn many product lines temporarily due to lack of ability to supply).
Rather, it will be the impacts coming from the rising unemployment and income loss as workers are laid off due to inactivity.
This is when the ‘supply’ problem morphs into a demand problem.
And the government has all the capacity it needs to prevent those income losses from multiplying.
I have long criticised the way we construct crises and their solutions in Australia.
For example, in this blog post – Framing matters – the unemployed and the farmers (August 7, 2018) – I argued that there is an hypocrisy in the way we deal with unemployment and the unemployed vis-a-vis other groups in society that we endow with higher privilege, especially in this neoliberal era.
We have seen this hypocrisy countless times in Australia when governments deal with drought assistance to farmers.
When Australia is experiencing a serious drought, Federal and State governments trip over each other to offer very large support packages to farmers and their communities to tide them over while their income dries up (excuse the pun).
There appears to be no limit to the support these governments are announcing.
But the same largesse is never applied to the unemployed, who, like the farmers are caught up in income losses as a result of a systemic failure – lack of spending in the first case, lack of rain in the second.
One could say that, in fact, the farmers are, in part, the cause of the drought due to their aberrant farming measures.
But that aside, the vastly different way the government treats farmers relative to unemployed highlights, once again, that the way we construct a problem significantly affects the way we seek to solve it.
Mainstream economists teach their students that the unemployed have chosen their ‘leisure’ state over work and are thus just welfare soaks.
The same hypocrisy is being demonstrated in the recent bushfire crisis.
Why should people who freely choose to live in high bushfire prone areas and enjoy the private benefits of the tranquility and peace tha a bush-setting brings then be able to receive public bailouts when a fire comes – as statistically they do with some frequency?
And juxtapose that question with the reality that the unemployed are forced to live on income support payments that are well below the poverty line in Australia and face pernicious work test regimes in order to receive their pittance from the federal government.
The point is that the coronavirus is likely to cause a sharp rise in unemployment and an immediate response from government should be to ensure that incomes are tied over for the period of the crisis.
Whether we want to call this a wage subsidy (which employers typically abuse) or a once-off payment to workers who lose their jobs during the crisis is not really the point.
With consumption the largest component of national spending and wages the driving force in determining spending growth, it makes sense for the government to ensure that it picks up the income loss tab for the unemployed during the crisis. More on this below.
Which then introduces the other type of shock – the demand shock.
The income losses arising from the initial factory shutdowns induce a decline in spending.
However, the fear and the panic is also impacting on spending directly – via a reluctance to travel etc.
Some of my events in my next speaking tour of Europe in June have been cancelled already. Perhaps others will be.
Tourism operators are facing a massive loss of income as their markets decline. Airlines are mothballing planes and scrapping routes.
The government has the capacity to minimise these sorts of losses if it chooses.
What is the relative strength of each part of the crisis?
While there are supply-side dimensions to this crisis – the Chinese factories being closed and global supply chains being interrupted – I think that this is the lesser issue relative to the subsequent demand-side failures that are going on as people deal with fear and uncertainty.
The Zimbabwe farm crash was very severe and long-lasting.
The supply halt driven by the shutdowns and quarantining are temporary and I do not expect any sustained supply shortages enduring.
But the demand-side impacts are already looking fairly pronounced and will be long-lasting if governments do not intervene.
As I will argue later, we enter this crisis in an already fragile state:
1. The labour market is far from recovered from the GFC and has been in reverse over the last year or so.
2. GDP growth is poor.
3. Business investment growth is negative and has been so for several quarters.
4. Household debt is at record levels and wages growth is flat.
5. On a global scale, it is clear that governments did not deal with the GFC properly. The extended austerity has created significant structural damage to economies and there are a high proportion of banks and corporations that can best be described as being in a ‘zombified’ state.
The Bank of International Settlements report in its September 2018 Quarterly Review – The rise of zombie firms: causes and consequences – estimated that:
The prevalence of zombie firms … defined as firms that are unable to cover debt servicing costs from current profits over an extended period … has ratcheted up since the late 1980s … [due] … to reduced financial pressure, reflecting in part the effects of lower interest rates … [and] … are less productive and crowd out investment in and employment at more productive firms … [and constitute] … some 12% in 2016 … [of all firms]
There is also a significant proportion of so-called ‘impaired banks’ that have been able to keep trading because of extensive central bank support that are effectively insolvent.
The two states are linked.
The zombie banks have been able to ‘carry’ non-performing loans of zombie corporations, which has kept both from going bust.
By keeping these zombie organisations afloat, central banks have stalled productivity growth in the wider economy.
Further, I have already documented last year – for example, Is the British Labour Party aboard the fiscal dominance train – Part 2? – the large global pension funds and insurance funds are also facing a major maturity mismatch between the returns from their assets and their contractual liabilities.
And to resolve the mismatch, they have been seeking to generate higher returns on their assets, which means they are taking on higher risk and exposing themselves to higher probabilities of insolvency in the face of any new crisis.
As we go into this crisis, many pension funds and insurance funds are teetering on the edge of insolvency and increasingly riskier investment positions as they chase yield in this negative interest rate environment.
The conclusion is that a reliance on monetary policy has destabilised the whole financial system and a return to fiscal dominance is essential.
6. The Eurozone is dependent on Germany and it is dependent on its export strength, given its pathological unwillingness to stimulate domestic growth.
And, as a result of its demolition of prosperity among its EMU partners (through insistence on prolonged austerity), that strength now relies on China.
And as China is currently in strife, Germany is also heading into recession, which will take the rest of the Eurozone with it, given the austerity mindset of its leadership and its reliance on monetary policy.
In this context, the demand-side crisis has the potential to be very deep and damaging and governments should abandon the idea that only small, temporary fiscal interventions will be required.
My assessment is that large fiscal shifts are required – to prop up incomes and spending – and that they should endure while governments also sort out the structural mess that the extended reliance on monetary policy has created.
In that regard, this should be the time that governments seriously clean out the financial sector. They should allow the zombie firms and banks to exit while protecting their workers and their entitlements.
They need to provide an extended spending support for income growth so that households can reduce their debt positions.
As the July 2019 tax cuts showed in Australia, the beneficiaries did not go on a spending spree as a result of the increased disposable income. Instead, they paid down debt, and the actual growth stimulus from the measure was weak.
That didn’t mean that fiscal policy is ineffective. It just meant that if the intention was to stimulate growth (from its current parlous rate) then the stimulus was far too small, given the massive debt burdens that households are carrying.
That should be a warning to governments currently planning stimulus interventions.
They have to be large and maintained for an extended period.
That is because they have to not only deal with the spending collapse in certain sectors (tourism etc) but they also have to underpin debt restructuring and reductions and the chaos that will follow the ultimate destruction of the zombie corporations and banks.
If governments prop up these zombies then they are misusing their fiscal capacity.
Governments should focus on securing the position of workers not firms.
Monetary policy is not the answer
Already, central banks around the world are cutting rates as a standard neoliberal policy response in the context of treasury departments continuing to go missing.
Cutting interest rates will not help alleviate the crisis.
Firms will not borrow if their markets are collapsing.
Consumers will not be able to take advantage of the lower rates if they are losing their jobs.
A lower exchange rate and increased international competitiveness will not overcome the falling spending if the crisis is widespread.
Ignorance is not the answer
A former Australian Labor government advisor, now in private consulting practice, wrote the other day that the Government cannot “stimulate our way out of the virus crisis” because it is not a standard demand shock where (Source):
Government stimulus works by showering consumers with money and coaxing them back to the shops
He claimed that:
It’s a supply shock caused by businesses having less to sell because their factories are closed, their supply chains are disrupted and their workers are quarantined at home. Trying to stimulate your way out of a supply shock is like throwing water on a grease fire. In a worst-case scenario, stimulus can exacerbate the shock as panic buying creates shortages and rising inflation.
There is an element of truth in that.
But he ignores that both types of shocks are present here and as I explained above, the demand-side shock is the more dangerous for long-term prosperity.
Factories will reopen soon and the supply chain will start flowing fairly quickly. And, there are still inventories available in many product lines.
The damage will come from the spending collapse not the temporary supply restraints.
Also the OPEC shenanigans (disagreements leading to increased supply) will help offset some of the supply chain interruptions. Production costs will be lower as a result of cheaper oil.
The airlines, for example, will benefit in this way.
Further, the former advisor completely misunderstands the capacity of the Australian government as the currency-issuer:
Australian policymakers face another problem – there isn’t much stimulus ammunition available … The sobering question now is: how many of those stimulus measures are available today? The answer is very few. China is the cause of the problem, not the solution. The Aussie dollar is already below 65¢ and doesn’t have the same room to fall. There is no budget surplus to spend and the Reserve Bank of Australia told Parliament this week it only had capacity for one more interest rate cut. In 2008, we had a locker full of ammunition to fire at the crisis. Today that locker is bare.
This is an oft-heard claim – the empty “locker” story.
It is why governments withdrew their stimulus support during the GFC too early in many nations and as a result the world is in a worse position now than before the GFC.
First, governments do not “spend” budget surpluses. Surpluses are the net result of two flows that are here today gone tomorrow.
The Australian government, as the currency-issuer, can always increase its net spending irrespective of what it did yesterday. There is no financial constraint on the government introducing a massive stimulus if that is seen to be appropriate.
It can sustain that stimulus for as long as is necessary.
All the arguments about rising interest rates, inflation threats, crowding out are wrong, have always been wrong, and if given the centre stage will mean the crisis will be amplified.
Commentators who run the “locker is bare” argument should be ignored.
Second, on September 24, 2001, the Australian dollar was trading at 0.4912 against the US dollar and by July 18, 2011 it was trading at 1.0851. To say that somewhere around 65 cents is the limit of its movement is ludicrous.
Third, thinking that interest rate cuts are to be part of the solution is, like the rest of this sort of argument, just a sop to the standard mainstream neoliberal macroeconomics that has got us to this point – a crisis with deficient medical systems, precarious workers and massive private debt levels.
Tomorrow, I will complete the series and offer some more ideas about how an Modern Monetary Theory (MMT) economist constructs the coronavirus crisis and its solutions.
That is enough for today!
(c) Copyright 2020 William Mitchell. All Rights Reserved.