Coronavirus and the Economy

It’s hard to imagine all the economic impacts of the current Coronavirus crisis.  A recession – official or unofficial – seems likely.  (An official recession is defined as two consecutive quarters of declining GDP.)  If the crisis lasts for only three months, there will be a “Newtonian” surge (an equal and opposite reaction) in demand in the third quarter that will even out the economy for the year.  

Government can and should play a role in managing the economic crisis.  But what is that role and how should they play it? 

Generally speaking, there are two kinds of shocks the economy can experience: a demand shock and a supply shock.  The first occurs when consumers develop some fear – rational or irrational – about their near-term economic future.  In that case, they hold back on purchases, first of durable items like cars and appliances and then more routine purchases like clothing and eating out.  A supply shock occurs when there is some disruption in the supply of essential goods and services driving prices up dramatically.  The Arab oil embargo of the 1970’s is a good example.  

A demand shock often can be effectively dealt with by the Federal Reserve lowering interest rates thereby lowering the cost of purchasing durable goods.  Supply shocks are tougher to deal with as they may be caused by factors outside the government’s control.  Again, the Arab oil embargo serves as a good example.  

The US economy was stable at the beginning of the year.  When demand and supply are balanced, the economy is said to be at potential real output.  But the coronavirus response may cause both a demand and a supply shock simultaneously.  Demand is down because people are staying indoors affecting large purchases like cars and homes as well as routine small purchases.  A supply shock might occur if supply chains providing essential products are disrupted -- if, for example, workers cannot go to work in domestic factories.  In the case of a supply disruption prices will rise at a time when many Americans are out of work.  It is not straightforward to recover from a recession clobbered from both sides. This is the worst possible case because neither Fed action (monetary) nor Congressional action (fiscal) can maintain a supply chain or get people back to work.  So, the Fed can react or do nothing.  Lowering interest rates keeps unemployment low but raises prices causing inflation.  Doing nothing keeps inflation low at the expense of higher unemployment. So, the best government can do is try to lay some foam on the runway to ensure a soft landing.  

Many government and health officials have been praised for their candor, decisive action and leadership in this crisis.  We need the same degree of honesty about the economy.  There will be an economic disruption lasting three to six months.  We should not overreact.  Inflation and deficit spending will increase, and we shouldn’t be too worried about it in the short term.  Remember: borrowing is cheap right now.  So, let’s do what we need to do without too much handwringing. 

The Fed is doing the right thing by lowering borrowing costs for government and businesses.  Congress and the President are doing the right thing by providing stimulus for the near term.  The stimulus should be targeted to those who really need it: low income families and small businesses who don’t have the cash reserves to survive a sustained drop in demand.  

I have seen more than a few memes suggesting buying gift cards from local businesses and over tipping service staff.  These are all good measures we can take as citizens to flatten the economic curve during this crisis.  Let’s hope that government action can also flatten the curve of the health crisis.  

WHO WILL LEAD?