Policy dilemma: Is the Covid-19 pandemic a demand or supply shock?

The events that have transpired over the last month or so, have been dramatic at the very least. As the novel coronavirus (Covid-19) spread its footprint, the country was locked down to contain it. For close to a month now, economic activity came to a virtual standstill with nothing except essential activity permitted. As a result, there is widespread loss of income and consequently, demand destruction. And even though many measures to manage the first order impact of the lockdown have been announced by the government and its regulatory agencies, the clamor for more wide-reaching relief from finance and industry has only grown louder. In the meantime, governments of other nations and their central banks have announced and implemented widespread economic and market intervention which has led to accusations of complacency and ineptitude being cast on our government.

However, much of the interventions undertaken by foreign governments and central banks which include income replacement and monetary easing, follow a standard playbook developed over the years. This playbook, which is designed primarily to manage a demand shock has been swiftly executed with comparisons drawn with the pace of actions in 2008. Plaudits have been handed out for the swift response this time around. However, in the rush to roll out these measures, some basic facts about the current economic challenges seem to have escaped attention.

This is the first economic shock after the establishment of the modern monetary system that reduces both demand and supply simultaneously. Along with the loss of income which leads to the demand shock, one needs to account for the widespread and long-lasting supply chain disruptions. This will be compounded with the reverse migration of labour to the villages which will affect both, demand as incomes are lost and supply as labor shortages manifest. This is completely unprecedented.

Even though the extent of reduction in each will become apparent only as time passes, there is no possibility that either will remain untouched. And there is no established playbook for this scenario. In the absence of clarity about the impact of this crisis on demand and supply, any measure undertaken presents the possibility of proving to be eminently wrong when clarity eventually emerges.

The primary uncertainty that faces policy makers in the current situation is which will fall more, demand or supply. While demand destruction is immediately visible and supply disruptions will become apparent only with time, it is extremely tempting to treat this as a demand shock and take appropriate measures. These include large scale income replacement initiatives through direct transfers for individuals, bailouts for industry and monetary & liquidity easing. And while they seem to provide some palliative relief; after all, throwing money at an economic problem always seems to help in the short run, these very measures will be economically poisonous if supply reduces even more, causing widespread inflation at a time when economic activity is falling. That’s a specter that haunts every economy that has implemented a demand shock oriented fiscal and monetary stimulus.

On the other hand, treating this as a supply shock isn’t an option because the fiscal tightening, higher interest rates and light liquidity conditions needed to combat it would worsen an already bad situation for finance, industry and individuals. But given that this clarity may take some time to emerge, is inaction the only way out? Not exactly.

For one, symptomatic relief to industry and finance segments facing an immediate threat must be provided on priority if we are to prevent widespread credit contagion. But the real challenge facing us is about providing relief to those among us who face a difficult future and to do so in a manner that doesn’t jeopardize the economic future of our country.

Even in this environment of uncertainty there are things that we do know for sure and it is these certainties that must guide remedial initiatives. We know both demand and supply will reduce, and that unemployment will increase. We also know that there will be reverse migration from cites to villages as increasingly fearful migrant workers head back to a seemingly safer village environment and not return for a while, fearing for their lives in the high density, zero distance existence they lead in most cities.

To combat the resultant loss of income and demand, we may be tempted to implement long-term initiatives which provide income and relief to people, irrespective of where they choose to be. It has already been suggested that existing welfare initiatives like the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) be expanded considerably to accommodate those moving back from the cites. This suggestion, though well intentioned is the perfect example of being exactly wrong. Migration of labor from industrial clusters also exacerbates the supply disruption faced by the economy by depriving it of labor where it’s needed the most. As such, relief measures which either encourage this migration or discourage its reversal will only worsen matters.
This does not mean that the government shouldn’t provide relief. It must, but in a manner that rewards those who choose to stay back or return to industrial clusters, by providing income and other relief based in industrial and employment clusters based on one’s verifiable presence in such a location. Accompanied by measures that compel employers to offer better working conditions, this would ensure that labor shortages are avoided.

In this environment of uncertainty, every step must be taken in the awareness that there is a lot we don’t know. We must leverage what we know while not assuming too much of what we don’t. This is the only way we will keep the pandemic from leaving a trail of economic devastation.
The author is an economist, capital markets expert and the former CEO of Essel Mutual Fund

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