Covid-19 needs a sustained fiscal response

The policy response to the current economic downturn will not be a rerun of the response to the 2008 global financial crisis. Many commentators have been highlighting the parallels between the two crises, but this time the situation is different so the responses must be different.

In 2008-09, led by the US, the steps take were: interest rates cut to near zero, large fiscal stimulus, unconventional monetary policy, and fiscal tightening to rein in public debt. This was possible for two main reasons: the crisis came after almost two decades of growth and price moderation, and monetary policy had considerable scope for action.

On the back of the Covid-19 outbreak, the monetary policy response came first, and the fiscal policy measures followed. Compared with 2008, monetary policy is now considerably limited in scope (the Fed rates were around 5% in 2007, compared to around 2% in 2019). Hence, the rational has been to provide plenty of liquidity to prop up the banking and financial sector – as opposed to using monetary policy as a tool to stimulate economic growth.

The current fiscal policy response has been much larger than in 2008 as concerns about the size of public spending have been put aside.  So far, the total fiscal measures worldwide amount to 11.7 trillion dollars, or 12% of global GDP – an amount that is most certainly bold. Like in the case of monetary policy, the objective has been to prevent the collapse of the real economy – “to save lives and protect livelihoods”, as the IMF MD Kristalina Georgieva said – rather than of stimulating GDP growth.

The critical point is that the world economy went into the pandemic in a weaker position than when it faced the global financial crisis. The real GDP annual growth rate for the world economy was 5.5% in 2007, compared to just 2.8% in 2019. Furthermore, many countries and people feel some crisis fatigue after the prolonged recovery from the 2008 crisis that has been emerged, among others, in extreme politics.

This said, we should expect a strong rebound in real GDP growth (5.2% for the world economy in 2021 against a 4.4% drop this year), followed by a slowdown in the subsequent years. The bottom line is that the world economy will need time to recover from the losses caused by the pandemic and the recovery will have significant country/regional differences. This outlook is based on the assumption that everything stays the same, i.e. that we will eventually switch back to the pre-pandemic world. But we know that this is unlikely.

Against this background, we need to ask how economies will be supported through the current second wave of contagion. Most of all, how will a broad and robust recovery be engineered? It is critical to achieve GDP growth rates that not only allow losses to be recovered but also create more output. This is essential to make the current fiscal effort – and in particular the growing debt – sustainable over the long run.

Given the current circumstances, the correct policy response requires more fiscal stimulus in the short to medium term. So expect more debt. If fiscal action is directed towards long-term economic growth, then servicing the debt should not be a problem – and indeed, it is not the sheer size of debt that matters, but whether or not it is sustainable against future economic activity. Low interest rates should also help – and they should remain low for longer.

There is also a political argument that suggests that withdrawing the fiscal stimulus as soon as the recovery is under way – as happened in 2010 – is no longer feasible. The post-2008 recovery pushed the burden of adjustment on the labour market and on public spending. Wages were frozen or dropped in real terms while public spending was curtailed. Nowadays, this adjustment would be politically unfeasible. There are a number of scenarios that could play out as the crisis subsides, but which one occurs depends on how the burden of adjustment is distributed. This can happen through higher tax rate, inflation, regulations, or even debt restructuring. Any of these – or their combination – will depend on the political environment and the robustness of the recovery when it will be eventually under way.

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