This is an unbelievably bad time to drag the world into an economic downturn.
In my previous blog post, I argued that Sweden’s response to the pandemic was not a crazy experiment, but a very sensible one given the cost of the ‘mainstream’ approach. Below I outline why now is the worst possible time to close our economies down. I am Jim Breen and I am a development economist living in Stockholm, Sweden. At DIS, I teach in our Economics program.
Whenever my five year-old daughter can’t sleep, I lie beside her and talk to her about public finance. Kerplunk, she drops straight off. If she is especially restless, I have to move to budget deficits. Sadly, that works for most of the voting public too. My academic colleagues tell me it is like watching paint dry.
Economists have a bad habit of concentrating so much on theory, they forget about the real world. As the U.S. budget deficit has hit unprecedented levels, many economists have taken great pains to explain to people why that doesn’t matter. If anything positive comes out of the current pandemic, it may just be that it knocks some sense in some heads on how not to run an economy.
Okay, so what does this have to do with COVID-19?
GDP is defined to be the sum of all spending: by normal people (Consumption = C), businesses (Investment = I), and the public sector (Government = G). If GDP goes down, it’s bad, right?
Well, you are not spending much money these days, are you? (bright side to everything…) Neither are companies. In fact, not only are many not investing in new factories and stuff, they are laying people off. So unless governments decide to spend more than that decrease in what normal people and companies have stopped spending, GDP will fall. Ouch. Welcome to bad times. It’s called an economic crisis.
Governments have two main tools for dealing with crises. The first is creating money.
Physically. The central bank puts more money in the economy. That lowers interest rates. There is more money around, and it’s cheaper to get your hands on it (borrow it). As a result, people consume more (C goes up) and companies borrow money to build those new factories (I goes up to). Presto!
The second is the government spends money itself. It builds dams, or bails out GM and large banks, or creates the Interstate Highways Commission. It typically has to borrow money that it then spends.
The problem with printing money
Central banks have already been pumping money into the economy since the last crisis in 2008. But that has just created debt. Sadly, it’s highly unlikely that pushing more money out and lowering interest rates will have any effect – in any country.
Having created historic levels of government debt, this is a really bad time for governments to go in even deeper. Let’s go back to my bedtime stories for my daughter. Her least favorite is one by economist Oliver Blanchard. It’s not rocket science, it’s more of a mathematical axiom. In brief, he clarifies the following, (you can’t argue – it’s math): as long as GDP grows faster (say 3%) than the interest paid on the debt (say 2%), we don’t have to worry. You will sort of grow out of your debt. Historically, that has almost always been true.
When I take students through the article, they say, ‘No sweat. Borrow away. The interest rate is not going to rise.” And I agree with part of what they were saying. But there are two halves to Blanchard’s equation.
Taxes and interest on the rise
The U.S. economy is due to drop by at least 38% between now and June. Other countries are similar or worse. From 2019 (when growth was about 2%) that’s a 40% fall. Imagine the interest you pay on your mortgage, your car loan, and your credit cards all went up by 40%. Your mortgage would go from what? 3.5 to 43.5%? The car loan payments would go from 4% to 44%. Right now. In this economic climate. Does that feel comfortable to you?
And where do governments get revenue to pay for things? Taxes. What happens to tax revenues when everyone, including companies, earn less or no money? They shrink or vanish. Governments currently don’t have the tools to kick-start economies back to life. If one stalls, it could stay that way – for years. And this is the time when we have chosen to shut our economies down.
A solution: Open up the economy
We have never done this before, created an economic self-immolation. And we are doing it at the worst time in history. We need to open up economies as quickly as possible. The current approach, if continued, could throw us in a hole for literally years. Fortunately, politicians seem to be catching on to this.
After an economic crash, you know what happens in elections? In many countries people tend to vote more extremist. 20th and early 21st century history is full of example where populists came to power with a very clever strategy: find a scapegoat for existing problems, and propose seemingly easy fixes for these problems. Sadly, that can often lead to war.
If we continue to dig ourselves into a deep enough economic hole, that is what could be waiting for us at the end of the tunnel.
Still awake? Anyone fancy another coat?
Jim Breen is a DIS Stockholm Faculty Member. He teaches courses in comparative and behavioral economics. He’s a practicing economist with 20 years of experience in the field and has taught at The International Training Centre Of The United Nations’ International Labour Organization. Jim has been with DIS since 2017.