The wrong diagnosis

Topics Coronavirus | recession | Lockdown

When all you have is a hammer, everything looks like a nail. That old line seems particularly apposite today, when the preferred response to the current economic woes of so many economists and industrialists seems to be a stimulus of some sort. Yet the fact is that the pandemic and its associated economic costs are not the same as a regular recession, and we should be very careful in using the same tools as we would during other slowdowns.

First, the obvious: Previous recessions may have some supply-shock component, but what economists seek to respond to is a slowdown in aggregate demand. By pushing money into the economy — whether through regular interest rates cuts, unconventional monetary policy such as bond-buying, tax cuts, or government spending — they usually seek to prop up aggregate demand.

Is that the correct solution in this current crisis? Perhaps not. The treatment depends upon the diagnosis of the underlying problem. And in this case, an aggregate demand shock is not the main issue. Yes, there may well be a demand shock as a consequence of supply-chain disruptions, lockdowns, and so on. But that is not the underlying problem. It is, in fact, part of the treatment of the underlying problem. We do not want production to resume at similar levels as earlier, because we do not live in the same society we did then — and will not, until a vaccine is formed. Aggregate demand, in other words, must indeed be lower by taking into account the fact that we want more people staying at home, and the consequent loss in production and efficiency. Any attempt to medicate the economy in such a way that it increases activity in the wrong areas is precisely the wrong treatment.

Some have, in fact, compared various virus-fighting restrictions’ impact on economies worldwide to a “medically induced coma”. Putting patients in a medically induced coma while simultaneously trying to wake them up with a stimulus package makes no sense at all.

illustration: Ajay Mohanty

This does not mean that there is no role for co-ordinated government action under these circumstances. Quite the opposite, in fact. Governments can and must work to ensure that the economy survives the anti-virus measures till such time as economic activity can return to its pre-virus level.

Nor is it necessarily the case that such action will be less expensive than a large-scale fiscal stimulus. This is not about saving money, but about figuring out exactly what the correct economic prescription is. The economists Emmanuel Saez and Gabriel Zucman — hardly fiscal hawks — suggest that one way of thinking about the correct way to respond would be to imagine the government as “the payer of the last resort”. The fisc would bear the burden of some form of universal unemployment insurance for those at home, as well as payments to locked-down businesses — for rent, interest, utilities, and so on. In the US, according to the two economists, the cost of such a programme would be 3.75 per cent of gross domestic product over the next few months. In some sense, given that sovereigns can generally borrow at the lowest rates in any economy, it makes sense that the cost of any such system-wide shock is borne largely by them, because that would have the lowest overall cost. What matters is that this is as direct, speedy, and transparent as possible, and that is why it should be a fiscal response but not a broad-based stimulus.

The monetary stimulus being considered in many jurisdictions is puzzling. One can understand, perhaps, the response of the European Central Bank (ECB). Given that Europe’s internal dynamics mean that fiscal transfers from one area to another are politically problematic, it is up to the ECB to support the more stressed parts of the euro zone. But the decision by the United States Federal Reserve to establish the Primary Market Corporate Credit Facility (PMCCF) is dangerous. The PMCCF “will allow companies [direct] access to credit so they are better able to maintain business operations and capacity during the period of dislocations related to the pandemic”. This is a worthy cause and, in fact, exactly what should be done. But not by the monetary authority. As one former Fed official points out:

“The Fed shouldn’t get in the business of lending directly to corporations through a vehicle like the PMCCF. Because the Fed is fixing the liquidity problems [by buying financial institutions’ stock of corporate bonds] ... its direct loans are simply a way to assume default risk without receiving a compensatory return. This is simply a direct taxpayer subsidy to corporate shareholders.” It is also beyond the competence of a central bank. No central bank is capable of judging which company is the most sound risk. That is the banks’ job, or that of the broader financial sector. Nor can a central bank decide which sectors or companies it is in the broader national interest to preserve and subsidise for the duration. That is the elected representatives’ job.

In some sense, even buying corporate bonds second hand is a doubtful intervention. It may reward those companies which take bets on leverage, and these are not necessarily those we would like to subsidise. The Reserve Bank of India’s targeted long-term refinancing operation (TLTRO) is in essence a way to support banks buying corporate bonds and commercial paper. The market is ecstatic; the spreads fell, and the initial auction had a bid to cover ratio of 4.5. As a way of financing the largest enterprises in this country, this seems sub-optimal, although it has been endorsed by several economists, including Raghuram Rajan. Even if it is legal (Section 18 of the RBI Act gives the central bank considerable, perhaps too much, powers under these circumstances), a better way to manage the risk in this situation would be to lend to a new entity, a government-controlled special investment vehicle perhaps, which would then soak up corporate bonds. The correct way to do so would be to continue to provide banks with liquidity, but allow the Union and state governments the choice of how they directly support corporations. 

This would allow accountability, instead of the opaque manner in which support is currently being provided. Also, the government would then be forced to directly provide for the costs. It would also work better. Banks have used the TLTRO window to invest mainly in the highest-rated corporate bonds — companies which could raise money in any case. The fact is that this extra cash will flow to the highest-rated companies, which is not necessarily those that need to survive in order to ensure a speedy subsequent recovery.

It is worth noting that a well-designed relief, sustenance, and recovery package will work only if governments can indeed borrow. The Union government will do fine. But state bonds now have higher yields than corporate bonds. States that have to make the life-and-death decisions when it comes to both public health and economic recovery are finding it tough to borrow. If the Union is not willing to share more revenues with states, then a one-time relaxation of states’ borrowing limits may have to be considered. State yields may increase further, but at least it will solve the problem of quantity of borrowing, if not of price.

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