Economics is not good at forecasting but better at cures. We need to switch from the former, which dominates the news, and concentrate on solving our major problem. Before the pandemic this was stagnation, we now face the prospect of a long-term decline in our standard of living. Since the end of the World War II financial journalists have concentrated on how demand should be balanced to avoid either unnecessary unemployment or rising inflation. The apparently unthought justification for this myopia, was the assumption that the economy’s ability to produce and supply goods and services rose year by year by a process which was automatic or too boring to justify serious attention. As well as demand, we need to worry about supply, our ability to produce, and this was urgent even before the pandemic. Since the recession GDP per head has only grown at just over 1% p.a. The pandemic will slow growth not just this year but on a continuing basis. Unless we make a major change in the way we manage the economy, we risk a sustained fall in living standards. As well as making us miserable this threatens to destroy voters’ trust in liberal democracy.
Damage limitation is the short-term goal, which means limiting bankruptcies and managing demand so that we avoid inflation and needlessly high unemployment. If a short-term collapse in profits causes viable businesses to go bust our capacity for recovery will be damaged. This is a solvency not a liquidity problem. When companies become illiquid, the underlying business can usually be saved after refinancing, but if many suffer at once the supply of skilled bankers and accountants will be insufficient to prevent their businesses from going under. The difference between insolvency and illiquidity and between companies and their business needs to be understood. There will probably be mistakes made in the implementation of policy, but we seem to have started sensibly with the provision of grants, including wage subsidies, which address the problem of insolvency and guarantees for loans, which address the issue of liquidity.
Unemployment is often and reasonably seen as a worse evil than inflation. If inflation did not cause high and sustained unemployment it would be sensible to favour the risks of inflation over those of unemployment. The lesson of the oil crisis, which was the major supply shock before Covid-19, is that inflation causes unemployment, which is both high and sustained, while the unemployment that comes when inflation is low, can readily be cured by boosting demand. Rising inflation is therefore the mistake we must avoid. When it does it will, if not immediately halted, cause expectations of future inflation to pick up and we then enter a vicious circle in which these lead to inflation accelerating. We then have stagflation in which both inflation and unemployment rise. To bring this under control there has to be a shock rise in interest rates, which hit 16% in 1980. Unemployment then goes up even further and takes years to fall back to its previous level (as Chart 1 shows).
Full paper: The Economics of Covid [May 2020]