COVID-19 Crisis and Policy Response

There are two key concepts we should keep in mind from Macro 101 as we think about both the circumstances of the COVID-19 crisis, and the government's response so far.

1. Expenditure = Income, i.e. your spending is someone else’s income.
2. The multiplier effect (or aggregate demand multiplier) works in both directions. As you add money to economy through spending, that gets multiplied through into a higher level of output as each person spends their income (depending on marginal propensity to consume, marginal propensity to invest, and the marginal tax rate). But it also works in reverse. Withdrawing or cutting back on spending from the economy results in a rapid decrease of output because of the multiplier effect. 

In response to the spread of the virus, Federal and state governments have recommended “social distancing” (more on this later), and some have declared a state of emergency to ensure it is enforced. This has resulted in the suspension of a great deal of everyday economic activity—that is spending on goods and services. This has led many restaurants, bars, and stores to shut down. It also means limited travel, especially overseas, which means very few people are flying. That is why the airline industry, for example, is hemorrhaging revenue and asking the government for a bailout.

Again, spending is equal to income. That means the flow of income for businesses has stopped. Which means they cannot pay their workers. If workers in turn don’t have income, they cannot pay their rent or mortgage, their bills, or buy food. 

MONETARY POLICY RESPONSE:
The disruption in the flow of income also makes for a disruption in the banking system which relies on a steady flow of your income to pass through them so they can make payments on your behalf and others, and pay their own obligations (e.g. interbank loans). Thus, the rapid and extraordinary response of the Fed to supply as much liquidity as needed to the banking system. Fed restarted QE (Quantitative Easing), which now allow banks to exchange multiple assets types—including treasuries, commercial bonds, mortgage backed securities, and even now municipal bonds—with the Fed for money. The Fed is making sure that markets for these securities don’t collapse, otherwise the prices of these assets would plummet because everyone is trying to sell them all at once, but no one is buying them. Therefore, the Fed has had to step in to be the buyer of last resort so to speak for these securities, which ensures their values do not fall to zero, and also provides the liquidity to the banking system and other economic participants who need it. The Fed has also dropped the policy interest rate to zero, or i = 0, to provide cheap credit to businesses in need. However, doing so in this case isn’t about spurring investment, it’s just to keep businesses a float long enough for the crisis to pass and economic activity to resume.
 
FISCAL POLICY RESPONSE:
To address the economic impact from social distancing measures, Congress has passed the CARES Act (or Coronavirus Aid, Relief, and Economic Security Act), a $2 trillion aid package to provide interim income for households and businesses to help them get through the crisis. According to NPR, the aid package is broken down as follows:

• $ 560 billion to individuals and households
  • Cash payments to households
  • Expanded unemployment benefits
    • Now includes contractors, self-employed, and gig workers
• $ 500 billion to big corporations via loans
• $ 377 billion to small businesses via loans
  • Small businesses can get loans forgiven if mostly used to keep people on payrolls, i.e. employed
• $ 339.8 billion to state and local governments
• $ 153 billion for public health
  • Hospitals, community health care centers, telemedicine, VA
  • Medical supplies and equipment
  • CDC
• $ 43.7 billion to education/other
  • Student loan payment suspension
• $ 26 billion to safety net programs
  • Child nutrition, Food stamps, and Food banks

 
The point of the aid package is to restore some cash flows to households and businesses. The $339.8 billion to state and local governments is also very important. The Federal government prints our currency (in the US), and thus has unlimited finance to mobilize resources. State and local governments do not have this capacity, and instead rely on taxes and bonds issuances to raise revenue for public services. Since tax revenue is procyclical, meaning during a downturn revenue goes down (and up during a boom), local governments are experiencing a massive short fall in funding as well making it difficult to sustain essential public services. The last thing we want is for local governments to cut those essential services. State and local governments are also employ millions of people. So that aid package to states and local governments will help prevent cuts to services and more mass unemployment—something Federal government failed to do in during the Great Recession. And the Fed’s actions in accepting municipal bonds will also help prop up municipal bond markets.
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States are also the source of higher education funding. If states have to cut back on education funding for higher education, that means universities will need to raise tuition rates (which they had to do during the Great Recession), thus increasing the burden of student debt for future graduates.
 
Unfortunately, the $2 trillion dollar aid package is not likely to be enough. It is also likely to be rolled out too slowly. There is a lot of bureaucracy is involved in getting the payments out, in applying for loans, and even for those who have already been laid off, applying for unemployment benefits. The longer it takes for people and businesses to receive aid, the deeper the recession will be. More aid will be needed. Just how much depends on how long this health crisis lasts.
Then once the crisis is over, the government will need to think about an actual economic stimulus. When all is said and done, we are probably looking at several trillions of dollars needed to get the economy back on track to where were in terms of growth and employment before the crisis--which was just barely recovered to where we were before the Great Recession 10 years before that. 

You may have heard in the News that the purpose of social distancing is to “bend or flatten the curve.” What curve are they referring to exactly? And why is that important?

Social distancing, or physical distancing, is maintaining a physical distance between you and other people and reducing the number of times you come into close contact with them in order to reduce the spread of a disease like COVID-19 or even the flu. 

The figure below illustrates why this is important so as not to overwhelm our health care resources. Notice the y-axis represents new cases of corona virus infections and the x-axis is time. The dotted line is the capacity of our health care system to handle demand. Uninhibited by social distancing measures, the red curve represents the trajectory of new cases that would occur as the virus spreads, which likely would overwhelm our health care capacity. Social distancing slows the spread so that our health care system can handle it. This is good, and it will save lives. But it also means we have to prolong the crisis as new cases will be stretched out longer over time. The longer it lasts, the deeper the economic impact will be without substantial aid from the government.

Hope this is helpful. So remember to mind your distance. And pay attention to what the government is doing as it matters a lot for the outlook of the economy and the labor market once the immediate medical crisis is over.