We need a Phase 4

What is the proper economic response to the coronavirus pandemic? Fear of infection and quarantines imposed by state and local officials have led to a severe contraction in spending and employment.  In response, Congress has passed three bills: a Phase 1 bill provided funding for health agencies and testing, a Phase 2 bill offered benefits for employers to expand paid sick leave, and the omnibus Phase 3 bill massively expanded unemployment benefits, sent checks to the majority of households and provided funding for the Federal Reserve to lend to businesses, among other things. All of these bills have been termed as “stimulus” necessary to boost the economy out of a recession.

One standard framework for understanding recessions is the aggregate demand - aggregate supply model (AD-AS). Aggregate demand can be thought of as the sum of all spending in the economy. The typical recession in the United States is caused by a shortfall in aggregate demand. For example, the collapse in housing prices in 2007 led to a decline in spending and a recession that began late that year. The standard response to an aggregate demand shortfall is to use both expansionary fiscal and monetary policy. Fiscal stimulus, as advocated by Keynes, puts money directly in people’s pockets. As one’s spending is another’s income, this can multiply through the economy and boost spending back to its prior growth path. Monetary stimulus works by making credit cheaper for borrowers, which boosts their ability to pay for goods and services. The aim of both fiscal and monetary policy is to smooth the growth rate of spending in the economy. If people and businesses see a sharp decline in income, they will not be able to meet fixed costs such as mortgages and business loans. This will lead to further contraction as people default on their obligations, as lenders will be unwilling to extend new loans to preserve their capital. A smooth growth path of total spending will prevent such a vicious cycle from occurring.

One of Keynes’ great insights was that aggregate demand shocks were essentially crises of confidence. Such a recession is not induced by any fundamental change in the real resources available to the economy. The labor and capital necessary to resume production are available but idle. Proper expansionary fiscal and monetary policy may not be able to prevent a short blip in production. However, keeping spending on its growth path will prevent a severe contraction from happening while the fundamentals of the economy adjust to the new reality.

This is not the case for the present crisis. The closest analogy to the present is the oil shock of 1973. OPEC cut the flow of oil to America, which reduced the real resources available in the economy. Fiscal or monetary policy could smooth spending to prevent a vicious cycle of aggregate demand contraction, however they could not pump more oil out of the ground. The need to ration oil was a fundamental limit on the productive capacity of the economy. This is analogous to the present day. Stay-at-home orders and social distancing imposed by state and local officials in response to the coronavirus have limited the productive capacity of the economy, mainly of the supply sector. The massive spike in initial unemployment claims seen in the past two weeks point to a sharp contraction in spending in the economy. The CARES act recently signed into law attempts to ameliorate this situation by providing cash to most individuals and massively expanding unemployment benefits. In addition, the Federal Reserve has cut interest rates, provided support in credit markets, and expanded lending to include both small and large businesses.

Both the fiscal and monetary measures aim to prop up spending in the economy. These measures may yet prove to be inadequate, it remains to be seen. However, there still remains the fundamental constraint on the real resources available due to the coronavirus and the measures imposed to reduce its spread. Due to the exponential nature of the virus’s growth, these measures have to be imposed to prevent a collapse of the healthcare system. Thus any future stimulus bills must expand our capacity to fight the virus. There are two main avenues to consider. The first is preventative measures to stop the virus from spreading more in the general population. Doing so will require a massive retooling of the country’s manufacturing base to produce masks and ventilators. The second is a broad-based scientific push to expand testing and treatment. Funding should be provided to develop faster tests for coronavirus. Serological tests should be developed to better understand the proportion of the population that has already had the virus. Prizes should be awarded to vaccine developers to speed up research. The first three bills passed by Congress have focused on preventing a collapse in spending. However, the long hard fight against the virus still remains ahead.