It’s becoming increasingly clear that the fiscal response to COVID-19 in Europe and the United States will fall massively short. Policymakers are, as yet, not up to the task.
The “principle of effective demand,” the cornerstone of immediate post-war macroeconomics, requires that the government spends when the private sector might otherwise refuse—preventing a depression in spending and unemployment that would otherwise emerge. In so doing, the government ensures that employment and income across the community remains higher than individual spending choices alone would deliver. Government spending reasonably offsets private prudence.
Today, we face the opposite challenge. Instead of a lack of spending, we face a sudden drop-off of income as workers are forced into isolation—ours is a “shortfall of effective income.” That is, imagine private income absent virus-related disruptions. Our community—and the structure of credits and debits within society—is underpinned by an anticipated flow of income between economic actors. But these flows can be no longer sustained due to a temporary, vexing, and in too many cases devastating virus.
The result of these virus-related disruptions is that the community as a whole will, though isolation and social distancing, generate less income than would otherwise emerge. Temporarily, our community needs to work less—meaning income will decline. Private contracts, previously reasonable, will be disgruntled through no-one’s fault.
In contrast to traditional macroeconomics crises, when government needs to replace private spending, instead it becomes crucial for government to replace private income. No longer spender of last resort, the government provides income of last resort. Without this, previously reasonable private financial structures will be torn apart—credit risk become the defining characteristic of the pyramid of private transactions, while overall activity contracts sharply.
And so, government intervention to sustain private incomes becomes crucial—providing a bridge to future income at a time of extraordinary disruption and economic uncertainty.
But should an increase in government debt at this time become a concern? Absolutely not. It is the correct role of the government, as the backbone of the community balance sheet, to carry this collective risk. Indeed, absent such intervention, newly unemployed households will be forced into delinquency on mortgages and credit cards; businesses will be forced to default on loans that might otherwise have been serviced. Private credit risk will grow; the possibilities of private actors would be driven unnecessarily off course.
Sharing the burden of the virus equally on all shoulders through the government’s balance sheet is a fair way to carry the community through the crisis. Moreover, the government’s growing deficit will be mostly the mirror image of private saving—after all, households can’t spend if they are in quarantine. But necessary household prudence is only the mirror of growing government deficits—it’s “self-financing” for the community as a whole. All that is needed is for the government to recognize a correct role in a time of crisis—the mirror of that required during a depression of spending.
Thus, governments ought not blink—they need to generously subsidize private incomes at his time, paying private incomes in full. And through state guarantees and generously low interest, they can ensure businesses have the credit needed re-emerge in six months with a strong workforce and renewed vigour.
This doesn’t reflect upon the balance of payments in responding to COVID-19 of course. In this case, regarding the euroarea in particular, just as the sovereign balance sheet can help shoulder a weight within the “closed economy,” so does it become necessary for all governments to accept the fiscal burden within a currency area to ensure coherence and avoid those worse affected being asked to carry an unnecessary burden. Without this, the currency union will unlikely prevail—either due to immediate economic necessity, or due to reasonable future political counter-reaction.