The Covid Trauma Has
Changed Economics—Maybe Forever
Policymakers learned the lessons of 2008 and deployed a
wider set of tools to help repair the damage from Covid. They know how to
create a recovery, but can they manage the boom?
Once ideas about how to manage the economy become
entrenched, it can take generations to dislodge them. Something big usually has
to happen to jolt policy onto a different track. Something like Covid-19.
In 2020, when the pandemic hit and economies around the
world went into lockdown, policymakers effectively short-circuited the business
cycle without thinking twice. In the U.S. in particular, a blitz of public
spending pulled the economy out of the deepest slump on record—faster than
almost anyone expected—and put it on the verge of a boom. The result could be a
tectonic transformation of economic theory and practice.
The Great Recession that followed the crash of 2008 had
already triggered a rethink. But the overall approach—the framework in place
since President Ronald Reagan and Federal Reserve Chair Paul Volcker steered
U.S. economic policy in the 1980s—emerged relatively intact. Roughly speaking,
that approach placed a priority on curbing inflation and managing the pace of
economic growth by adjusting the cost of private borrowing rather than by
spending public money.
The pandemic cast those conventions aside around the world.
In the new economics, fiscal policy took over from monetary policy. Governments
channeled cash directly to households and businesses and ran up record budget
deficits. Central banks played a secondary and supportive role—buying up the
ballooning government debt and other assets, keeping borrowing costs low, and
insisting that this was no time to worry about inflation. Policymakers also
started looking beyond aggregate metrics to data that show how income and jobs
are distributed and who needs the most help.
While the flight from orthodoxy was most pronounced in the
world’s richest countries, versions of this shift played out in emerging
markets, too. Even institutions like the International Monetary Fund, longtime
enforcers of the old rules of fiscal prudence, preached the benefits of
government stimulus.
In the U.S., and to a lesser extent in other developed
economies, the result has been a much faster recovery than after 2008. That
success is opening a new phase in the fight over policy. Lessons have been
learned about how to get out of a downturn. Now it’s time to figure out how to
manage the boom.
FOR CENTURIES, theorists have pondered the recurring and
inevitable swings that make up the business cycle. They’ve looked for causes in
mass psychology, institutional complexity, and even weather patterns. According
to the traditional laws of the cycle, it should’ve taken years for households
to claw their way back from 2020’s sudden collapse in economic activity.
Instead, the U.S. government stepped in to insulate them
from its worst effects in a way that hadn’t really been tried before: by
replacing the wages that millions of newly out-of-work Americans were no longer
receiving from employers. In the aggregate, benefit checks made up for all the
lost paychecks and then some—even though creaky systems for delivering
unemployment insurance or one-time stimulus payments meant that many people
missed out.
The scale of this innovation is apparent in what Jan
Hatzius, chief economist at Goldman Sachs Group Inc., has called “the most
amazing statistic of this entire period.” In the second quarter of 2020, a time
when economic activity—measured by the conventional gauge of gross domestic
product—was shrinking at the fastest pace on record, U.S. household income
actually went up.
Old Rules No Longer Apply
U.S. politicians moved rapidly because they could see the
calamity that would result if they didn’t. But pandemic-era policies were also
shaped by regrets, which had been building for a decade, over the response to
the last crisis in 2008. In hindsight, economists have come to regard that
response as lopsided and inadequate. Bank bailouts fixed the financial system,
but little was done to help debt-burdened homeowners, and household incomes
were allowed to fall.
The new pandemic economics also shielded the financial
system, but from the bottom up instead of the top down—a point repeatedly made
by Neel Kashkari, who helped lead the rescue as a U.S. Department of the
Treasury official in 2008 and who’s now head of the Federal Reserve Bank of
Minneapolis. As their jobs vanished in the spring of 2020, Americans struggled
to make rent, pay mortgages, and cover car payments. Without the government’s
efforts to replace lost income, the health crisis that had already triggered a
jobs crisis would have morphed into a financial crisis.
“How have Americans been able to pay all their bills? It’s
because Congress has been so aggressive” with fiscal stimulus, Kashkari said in
October on CNBC. “If they don’t continue that, these losses roll up into the
banking sector, and nobody knows how big those losses will ultimately be.”
After an initial burst of spending, many countries quickly
pivoted to reining in their budgets in the years after 2008, driven by concerns
about rising public debt—a trend that was most pronounced in Europe. In the
U.S., state and local government cutbacks resulted in mass job losses. In both
cases, relatively high unemployment and low growth rates persisted for much of
the decade.
In 2020 the doctrine of austerity went into rapid retreat
all over the world. Germany, where politicians and central bankers have long
been obsessed with fiscal discipline, scrapped a rule requiring balanced
budgets and dropped its opposition to joint borrowing with other euro-area
countries. The IMF noted concerns about rising debt levels but said a bigger
risk was that governments would curtail their spending too soon.
In 2008, U.S. policymakers were overly selective about who
should and shouldn’t receive aid and erred on the side of doing too little,
according to Kashkari. In a Washington Post op-ed article published on March
27, 2020—the same day lawmakers passed the $2.2 trillion Cares Act, the main
pandemic stimulus package—Kashkari reflected on those earlier efforts to help
homeowners struggling to pay mortgages.
“By applying numerous criteria to make sure only ‘deserving’
families received help, we narrowed and slowed the programs dramatically,
resulting in a deeper housing correction, with more foreclosures than had we
flooded borrowers with assistance,” Kashkari wrote. “The American people
ultimately paid more because of our attempts to save them money.”
By contrast, the logic of pandemic policy went more like
this: Clearly no Americans thrown out of work by the pandemic—mostly low-paid
workers in restaurants and other service industries—lost their jobs through any
fault of their own. This made politicians comfortable supporting a big fiscal
response. Unlike the Fed actions that dominated crisis firefighting in the
past, government spending landed directly in people’s bank accounts.
“If you can replace 100% of the lost income in a crisis like
this, why don’t we replace 100% of people’s lost income in every cyclical
downturn?”
Even before Covid-19, the plight of low-paid workers was
increasingly a focus of economic policy. The depth of the Great Recession and
the slow recovery—it took more than a decade to restore pre-2008 levels of
employment—put issues such as economic inequality and racial justice in the
spotlight. Wealth and income gaps, especially in the U.S., but in other
developed countries, too, have been widening since the 1980s as government
intervention in the economy was supplanted by an overreliance on the free
market.
Direct payments to low-income households could be a powerful
new tool to protect people at the bottom of the economic ladder from the wealth
destruction that always accompanies downturns. Now that they’ve been used in
one recession, it will be hard to argue that they shouldn’t be used in the next
one, according to J.W. Mason, an associate professor at the John Jay College of
Criminal Justice in New York.
“If you can replace 100% of the lost income in a crisis like
this, why don’t we replace 100% of people’s lost income in every cyclical
downturn?” he says. “What is the excuse for saying that because we have some
sort of financial crisis—something’s gone wrong in the mortgage market, there’s
been a stock market collapse—that ordinary people should see a fall in their
living standards?”
A New Economic Mindset Emerges From the Pandemic
THE PROMINENCE of such transfer payments during the
pandemic highlights another big shift in economics: the handover of power
from monetary to fiscal policy and the receding role of the inflation-fighting
central bank.
In the early ’80s under Volcker, the Fed kept interest rates
high to stamp out the double-digit inflation that had taken hold in the
previous decade. One effect was to make it prohibitively expensive—in the eyes
of policymakers—to pursue social goals by running government budget deficits.
Now, after a long period of declining interest rates and
largely absent inflation, the central bank is taking the opposite approach. Fed
Chair Jerome Powell and his colleagues have been vocal supporters of deficit
spending during the pandemic, and they’ve promised to keep interest rates near
zero at least until pre-pandemic employment rates have been restored. In March
2020, as Congress met to authorize the largest fiscal package in history, House
Speaker Nancy Pelosi said Powell encouraged her to “ think big” because
“interest rates are as low as they’ll ever be.”
Even a year later, with trillions of dollars more spending
approved or in the pipeline, the Fed’s message hasn’t changed. As President Joe
Biden’s $1.9 trillion pandemic relief bill was passing through Congress in
March 2021, Fed officials played down the inflation risks. White House
economists say that if their spending plans, including the $4 trillion
infrastructure and child-care packages they hope to pass next, do end up
causing unacceptable levels of inflation, then the Fed can always step in and
clean up the mess.
Regime Change
There’s a heated debate over how big of a risk inflation is.
On one side, some economists and Wall Street investors point to households that
are flush with cash as a result of pandemic stimulus and savings under
lockdown—and itching to get out and spend the money in a reopening economy, as
vaccination becomes more widespread. That’s a recipe for an inflationary boom,
they say, an argument bolstered by April’s 4.2% inflation rate, the highest
since 2008. Bond-market measures of expected inflation over the next five years
are also at decade-highs, though after adjustment for the Fed’s preferred gauge
they still suggest an inflation rate around where the central bank wants it to
be.
Lawrence Summers, who served in the last two Democratic
administrations (as treasury secretary under Bill Clinton and as director of
the National Economic Council under Barack Obama), says Biden has poured too
much money into the economy relative to the size of the hole caused by the
pandemic. “You need to be progressive, but you also need to get the arithmetic
right,” he said on Bloomberg TV in April. “I am worried that this program could
overheat the economy.”
Conservative economists share the inflation concern, but
they have a deeper objection to the new direction under Biden and Powell. They
think it’s in danger of losing sight of some fundamental laws of economics.
“Fiscal policy has to confront the fact that we do have to
pay for things in the long run,” R. Glenn Hubbard, dean emeritus at Columbia
Business School who served as chairman of President George W. Bush’s Council of
Economic Advisers, said on Bloomberg TV on April 29.
As for the Fed, its low-rates policy may struggle to deliver
the desired level of employment in labor markets that are undergoing structural
change as a result of the pandemic. “It’s an economy readjusting, and the Fed
being easy isn’t going to help that,” Hubbard said. “It’s not really a matter
of running the economy hot.”
In the opposite camp are economists in the Biden
administration and the Fed, along with most Wall Street forecasters, as well
as the investors who buy inflation-protected bonds. They all expect prices to
stay relatively contained after a temporary spike.
That view has been shaped by the decade before the pandemic.
Higher inflation was supposed to show up in the early 2010s, as a result of
post-crisis budget deficits and Fed money-printing—and in the late 2010s, when
unemployment rates fell to the lowest levels in half a century. But it never
did. Inflation has been declining all over the world for decades.
MANY OF THE PEOPLE in charge of central banks, finance
ministries, or economics departments have some recollection of the
inflationary 1970s and their aftermath. But their offices are increasingly
staffed by younger economists who’ve never seen much price instability in the
developed world—and who object to the single-minded focus on inflation at the
expense of social priorities such as full employment and fairer distribution of
income and wealth. These economists are more likely to see inequality as Public
Enemy No. 1 than inflation.
Pick Your Problem
That kind of thinking underlies the Fed’s strategy review,
which last year resulted in a new framework for setting interest rates. The
central bank will let inflation overshoot its target for a while before raising
rates instead of taking preemptive action that might risk choking off an
economic recovery. The idea is that this will allow the benefits of growth to
reach every corner of the economy—even people who typically don’t reap gains
until late in an expansion, such as low-wage earners. That’s a reversal from
2015, when the Fed began raising rates even though unemployment among Black
Americans was 8.5%, almost double the rate for White Americans.
Biden’s team has embraced the new economics with fiscal
proposals designed to combat inequality. He’s proposing higher taxes on the
rich and more spending to benefit the poor, policies that have been out of
favor since the ’70s. The administration is also backing a higher minimum wage,
and there are signs that more generous unemployment benefits during the
pandemic—coupled with some workers’ reluctance to return to work during a
health crisis—are already pushing employers in low-wage industries to raise
wages.
As rich-world policymakers take steps to reduce wealth
disparities in their own countries, there’s a danger that the gap between
those economies and those of the developing world is widening. Governments
in poorer countries can’t spend as freely to help their populations during the
pandemic without triggering inflation or scaring off international investors.
The Group of 20, the main international gathering of the
world’s wealthiest nations, has supported a suspension of debt service payments
for countries that request it, but private bondholders don’t have to accept it.
Brazil and Turkey have been forced to raise interest rates to address surging
inflation and the threat of capital flight, even though their economies are
still getting squeezed by the pandemic.
In a March report, the United Nations Conference on Trade
and Development listed some of the ideas that dominated global economic
policymaking before the pandemic—“austerity, inflation targeting, trade and
investment liberalization, innovative finance, and labor market
flexibility”—and described some of their negative effects: “This path led to a
world of growing economic inequalities, arrested development, financial
fragility, and unsustainable use of natural resources before the pandemic hit.”
Of course, some say the new policies could come with
damaging consequences of their own. The Fed’s low interest rates, for example,
are often blamed for fueling rallies in assets such as stocks and housing that
benefit the rich most and widen the wealth gap.
And while the new economics has the makings of an updated
framework to deal with recessions, it has yet to grapple with the potential
problems posed by surging growth. Adherents believe that inflationary
pressures, the kind that the policy paradigm from 1980 to 2020 was designed to
contain, simply aren’t going to arise anytime soon.
If inflation risks do materialize, there’s a debate about
how they should be managed. Leaving the job to the Fed and a Volcker-style
monetary policy would throw people out of work, hitting the most vulnerable the
hardest. That would undermine the goal of achieving a more inclusive economy.
Alternative methods, such as the one advocated by Modern Monetary Theory proponents, are
gaining traction. In the view of Stephanie Kelton, a professor at Stony Brook
University in New York, the government should use fiscal and regulatory
tools to manage inflation instead of the blunt instrument of interest rates.
For instance, incentives to
manufacturers can help avert production bottlenecks that push prices
higher, and payroll taxes can be
adjusted when consumer demand needs to be pumped up or reined in.
Post-pandemic, all of these discussions will likely range a
little wider and freer than they might have a few years ago.
“We’ve had a generation where we’ve had macroeconomic
policymaking dominated by these obsessive fears of doing too much,” says Mason,
the heterodox economist. “The fear of inflation lurking around every corner,
the fear of government debt passing some poorly specified but frightening
limit, the fear that too much assistance to people who are out of work will
undermine work incentives.
“In the past year,” he adds, “we seem to have broken out of
that mindset.”
Boesler covers economic policy in New York.
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