Before discussing consumption, let me illustrate the general concept with an analogy. Suppose you have a population that experiences a major increase in life expectancy. Should that create a problem for public pensions? Many people would say “yes”, but it’s not obvious why. In general, improvements in life expectancy go hand in hand with improvements in the number of healthy years of life. So if your policy is for people to work 80% of their expected adult life, and then retire, it doesn’t matter whether life expectancy is 80, 160, or 800 years.
On the other hand, if the policy if for people to retire at age 65, then increased longevity does create a fiscal problem. But that’s not because of the longevity itself, rather it’s due to the arbitrary decision to fix the retirement age at 65, even as life expectancy increases.
Now suppose that an epidemic forces the shutdown of 20% of the economy. For simplicity, I’ll assume all economic activity is consumption, but the broader points will still hold in a more complex model.
As you may recall from EC101, aggregate output equals aggregate income. If aggregate output falls by 20%, then so does aggregate income. In a pure consumption economy that’s not a problem at all. If consumption falls hand in hand with falling income, then people with 20% less income are still able to consume the current consumption basket, which is 20% less costly than before the epidemic.
Of course the impact of an epidemic is very uneven, and some people are hit much harder than others. But in aggregate, people still have enough income to buy the prevailing consumption basket. Perhaps the government might want to redistribute that income somewhat, in order for the unemployed to be able to consume, but there’s no aggregate shortage of income.
In the US, we are responding to the epidemic as if it is essential to prevent people’s aggregate income from falling by 20%, even though their consumption expenditures are falling sharply. Thus while state and local governments take in far less sales and income tax revenue; they continue to pay roughly the same nominal salaries to public employees. Unemployment insurance has also been made much more generous. Lucky private sector employees like me have an unchanged nominal wage, even though my expenses have plummeted sharply.
Governments at all levels have decided to prevent a 20% fall in incomes via massive borrowing. That may be the way to go, but the motivation for this decision is not obvious. So let’s consider some possibilities:
1. Fairness: The impact of Covid-19 is very uneven, and it’s not fair for those hurt by epidemic to suffer disproportionately. I have sympathy for this argument. But on close inspection it calls for redistribution, not borrowing. Pay teachers and police and firefighters 20% less, and give that money to the unemployed. Tax people like me to provide aid for the unemployed.
2. Stimulus: All this borrowing helps to stimulate the economy. But recall that we are assuming that 20% of the economy must shut down for health reasons, so what good does stimulus do? Perhaps the goal is to provide stimulus for when the economy re-opens, but that’s done much more effectively via money creation, which doesn’t impose a debt burden on future taxpayers.
In my view, the real reason for this orgy of borrowing, this attempt to make everyone “whole”, is fairness combined with complexity and money illusion. The government naturally wants to avoid a situation where millions are suffering greatly from a steep drop in income. In theory, this could be accommodated in the way I describe above, but the redistribution would be highly complex and difficult to ramp up quickly. Furthermore, because of money illusion, the public is not keen on 20% pay cuts even if their “cost of living the way we live now” has fallen by 20%.
A policeman or teacher thinks he or she is just as productive as before, even though Covid-19 makes them far less productive. People have trouble grasping this concept, so an international example might help. In Pakistan, barbers do roughly the same job as in America, in a physical sense. But while an American barber is embedded in a highly productive economy, and thus might make $15/hour, a Pakistani barber is embedded in a low productivity economy, and thus might make $1/hour (or $3/hour adjusted for price level differences.).
The coronavirus epidemic makes America less productive, a little bit more like Pakistan. Because labor can flow between markets, people move at the margin until wages get equalized, adjusted for difference in skill levels, work environment, etc. Thus over the years, people in America left low paying jobs like cutting hair until wages rose from $1/hour to $15/hour, at which point alternative jobs no longer seemed so attractive. Pakistani barbers don’t have that $15/hour alternative.
Because most Americans don’t know why barbers here make 15 times more than in Pakistan, they are not likely to be happy seeing their wage fall when the productivity of the American economy falls sharply. And it’s not just barbers; teachers, police, and other jobs also pay for more in America than in Pakistan, much more than could be explained by differences in physical productivity. It’s the privilege of being embedded in a highly productive economy.
I’m trying to steer clear of normative claims, and focus instead on why this is all happening. It’s perfectly fine to argue that we should add trillions of dollars in debt in this sort of crisis. But it’s not true that we need to do so in order to maintain adequate levels of consumption. The epidemic is causing a big drop in both aggregate income and consumption, and debt doesn’t change that fact. The debt is being created for a complex mix of other reasons, of which the general public is largely unaware. Future generations will have to deal with the consequences.
PS. Just to be clear, I do support maintaining stable growth in nominal GDP, in order to help stabilize credit markets. This post is discussing real income and real output.
PPS. The standard model says the budget deficit should rise during recessions, in order to smooth out tax rates (and thus the deadweight loss from taxation) over time.
READER COMMENTS
Lorenzo from Oz
May 7 2020 at 8:59pm
I see money illusion as economising on cognitive effort in calculation. In a situation where people have no experience of price changes, what else can they calculate responses than the information up to now?
Especially as there are unpredictable supply effects in play and a lot of prices in developed economies are sticky anyway.
Market Fiscalist
May 7 2020 at 9:09pm
Great article.
I have a question:
Suppose you are the government when a supply shock hit that means that RGDP will fall by 20%. You set yourself 2 goals:
Spread the loss of income from covid fairly so that everyone’s income falls by 20% in real terms
Keep NGDP on target so that the supply shock doesn’t also become a demand shock
The government addresses the first goal by increasing income tax and using redistribution to ensure everyone’s real income falls by the same amount (assumed to be 20%). With no monetary policy this would also be a nominal income fall of 20%, right ?
The CB then needs to keep NGDP on target just with monetary policy and this in effect means creating 20% inflation just by buying assets.
But could monetary policy realistically be used to achieve this goal ? How many and what kind of asset purchases could realistically lead to 20% inflation ?
Wouldn’t the (market fiscalist?) approach of funding the loss of income via direct money creation (even if it meant increased taxes for a while when RGDP recovers and we are back at full employment) be guaranteed to work and actually make more sense ?
Scott Sumner
May 7 2020 at 11:37pm
There is no such thing as “no monetary policy”. As long as you have a monetary system there will be monetary policy.
I don’t know how many bonds (if any) need to be bought to hit the target, but I don’t see that as an important criterion for determining the optimal policy.
No policy is “guaranteed to work”.
Rajat
May 8 2020 at 7:14am
I agree that most of the COVID-19 transfers are really about redistribution rather than stimulating overall output. How could they not be, given output is being deliberately constrained? In Australia, there was a somewhat disingenous debate early on that effectively paying a higher unemployment benefit to people who had lost their jobs (or were furloughed) due to COVID than to people unemployed previously or for other reasons was necessary to maintain ‘crucial linkages’ between employees and employers. But c’mon – if the shutdowns continue for long enough, the linkages won’t mean anything; and if furloughed staff find other jobs sooner than their old workplaces return, they will take those new jobs. Advocates should have just been honest and said that they wanted to redistribute wealth from those with jobs to those without. And because, as you say, there isn’t much to spend on now, most of the redistribution relates to future consumption.
Just on the point about pay cuts to public servants, these are people who have voluntarily taken jobs that offer lower average income and less upside for less downside. Should they bear the same % loss from a shock such as this as those who chose to run their own businesses or work in the private sector? I don’t think so.
Kenneth Duda
May 8 2020 at 2:01pm
Does that mean the preferred outcome is 25% inflation (assuming a 5% NGDP growth target)?
Does that also mean that, assuming everything is 100% restored in 2021, we would expect -15% inflation that year?
This is hard even for me (a committed market monetarist) to grasp.
-Ken
Matthias Goergens
May 11 2020 at 7:25am
The numbers might be too large, but it’s not too weird.
We have big price changes in eg the oil market all the time.
Things are scarce now, so they could very well be 20% more expensive, and when things go back to normal, they become cheaper.
At the moment, I can’t buy in-restaurant dining at all. But you could imagine a version of the lockdown that would still allow one single party to dine at restaurants. That would probably be more expensive than dining used to be. But some people would still dine.
Medical grad face masks should arguably be more expensive, and become less expensive later. Lots of example like that.
Comments are closed.