When thinking about future policy challenges, it is important for governments to distinguish between two issues. The first is the need for fiscal policy to support aggregate demand. How should governments time the withdrawal of such support as economies recover? What measures should be rolled back first? And what are the risks associated with withdrawing support too soon or too late?
The second issue relates to the role of fiscal policy – and the state more generally – in a post-pandemic world. Economies after COVID-19 are likely to look different. Some sectors will shrink and others will grow. Consumer and business preferences and behaviour will change. Governments must decide the extent to which this transition should be left to the market or guided by public policy.
These are a formidable set of challenges. An effective response will require fiscal policy to evolve as economies recover.
The immediate priority is to stay the course
The economic outlook has brightened significantly following the rapid development of successful vaccines. It is now possible to believe that the spread of the virus may soon be curtailed in many countries. Even so, over the next two to three years the priority should be for fiscal policy to support demand and entrench the economic recovery. Even before the pandemic struck, several major economies, particularly in Europe, were suffering from extremely weak growth and were on the brink of recession. The biggest danger is that governments withdraw support too early.
Calls to taper support immediately are rooted in two concerns. The first is that its sheer cost will precipitate a string of fiscal crises. Total public debt is on track to have risen to a post-Second World War high of almost 100 per cent of global GDP in 2020. Debt ratios are likely to rise further in some, though not all, countries in 2021–22.
The second concern is that the huge amount of fiscal support provided in response to the pandemic means that a period of much higher inflation may lurk just around the corner. These concerns are interrelated. After all, faced with high and rising debt burdens, governments (and by extension the central banks that answer to them) may be more likely to tolerate – or even target – higher inflation to bring down debt ratios over time. Conversely, a rapid and uncontrolled rise in inflation would require central banks to raise interest rates, thus causing government borrowing costs to rise and public debt ratios to spiral.
The arithmetic that underpins the public debt-to-GDP ratio is governed by the delicate interplay between sovereign bond yields (r) and the rate of nominal GDP growth (g). When r is greater than g, countries need to run a primary budget surplus (i.e. after interest spending) to keep the public debt ratio stable. But when r is lower than g, the need to run a primary surplus to achieve this goal disappears – moreover, the further r falls below g, the greater the ability of governments to run a primary deficit and still keep the debt ratio stable.
The key point here is that with interest rates kept low by ultra-loose monetary policy, bond yields are likely to stay below the rate of nominal GDP growth in most major economies over 2021–22. In these conditions, it is unlikely that public debt ratios will spiral out of control.
Of course, fiscal hawks can reasonably argue that bond markets are fickle and that a spike in borrowing costs is possible, particularly if investors become spooked by the prospect of never-ending fiscal largesse. This is true. But were this to happen, most governments could rely on central banks to contain upward pressure on yields. Among the major economies, central banks now hold anywhere from one-quarter (in the case of the US) to one-half (in the case of Japan) of outstanding government bonds. Central banks and governments will need to coordinate and communicate a plan for adding to (and subsequently managing) central bank holdings of government debt. But a key principle should be that this is done in a way that keeps yields below the rate of nominal GDP growth until economies return to full employment.
This should be possible because, turning to the second concern, the risk of a sustained rise in inflation over the next couple of years is also low. Admittedly, inflation is likely to accelerate in most economies in the second quarter of 2021 as the effects of last year’s sharp fall in energy prices drop out, and as (in some cases) indirect tax cuts start to be reversed. But this will be a temporary effect that does not require a response by central banks.
The public sector must counter any weakness in private demand until the economic recovery is entrenched. A failure to do so would slow growth, cause greater long-term scarring, and thus magnify the scale of future fiscal challenges.
More fundamentally, while the restrictions on activity imposed to control the spread of the virus have reduced the supply potential of economies, this should ease as economies reopen. And while concerns are building that a rebound in demand fuelled by fiscal stimulus and the rundown of involuntary savings accumulated during lockdown will lead to a resurgence in inflation as restrictions on activity are lifted, the reality is that most major economies are facing a long road back to full employment. Indeed, the experience of Japan over the past two decades suggests that even when output gaps are closed, structural forces may still prevent inflation from picking up. Inflation globally may yet make a comeback, but this is unlikely within the next couple of years.
Instead, the more immediate threat is the continued weakness of private sector demand. Spending by households and firms is likely to recover as restrictions on activity are lifted. But economic headwinds will remain. Some households will be forced to cut spending as job losses mount. Meanwhile, the uncertainty caused by the pandemic may lead to a higher level of precautionary saving by households and businesses.
In such circumstances, the public sector must counter any weakness in private demand until such time as the economic recovery is entrenched. Indeed, a failure to do so would be self-defeating, since it would slow growth, cause greater long-term scarring, and thus magnify the scale of future fiscal challenges.
As economies recover, fiscal policy must evolve
The upshot is that the immediate priority for governments should be to focus on keeping fiscal support in place. This is not, however, a licence for unending largesse. As economic recoveries progress, fiscal policy will need to adapt. In this respect, governments will face two major challenges.
The first will be to calibrate the withdrawal of public sector support so that it matches the recovery in private sector demand. Withdraw support too soon and the recovery will falter; withdraw it too late and – notwithstanding the caveats outlined above – the risk of a rise in inflation later in the decade will still increase to a greater or lesser extent.
The second challenge will be to decide how to stagger the withdrawal of support measures. Which should be scaled back first, and which should remain in place for longer? Behind this lies a much bigger issue. All economies now face a transition to a post-COVID-19 world; some sectors will shrink, but others will grow. In turn, governments will have to decide the extent to which this transition should be left to the market, and the extent to which it should be shaped by public policy.
A question of timing
The textbooks provide a clear answer to the question of when fiscal support should be withdrawn. The objective should be to keep economies at or close to full employment. To this end, fiscal support should start to be tapered once unemployment rates begin to fall, and should be withdrawn completely once economies return to their ‘natural rate’ of unemployment (that is to say, a level consistent with low and stable rates of wage and price inflation).
However, while such an approach makes sense in theory, it will be difficult to pull off in practice. For one thing, while the idea of a ‘natural rate’ of unemployment is helpful for conceptualizing the issue, for a variety of reasons it is almost impossible to observe. This leads to major problems when using it as an anchor for economic policy. (It’s worth noting that for much of 2018 and 2019 the US economy was operating below the US Federal Reserve’s estimate of the natural rate of unemployment without there being a significant rise in inflation.)
In addition, while labour market support measures by governments have helped to limit the economic damage caused by the pandemic, one consequence has been that conventional unemployment rates have become a less useful indicator of labour market ‘slack’. This is because in many countries workers who have been furloughed or are working shortened hours are not counted as unemployed but are nonetheless underutilized. At the same time, the number of economically ‘inactive’ individuals has risen as a result of the pandemic, as more people have given up looking for work and have effectively dropped out of the labour market.
This may seem like an arcane issue best confined to academic debate between economists, but it has significant implications for policymaking. In the absence of a robust measure of spare economic capacity, there is a real risk that governments will struggle to calibrate the withdrawal of policy support as economies recover. Indeed, there are several examples from recent history of this happening. In the wake of the global financial crisis of 2008–09, several central banks, including the Bank of England, initially tied their forward guidance for monetary policy to movements in the unemployment rate. When unemployment subsequently fell but upward wage and price pressures failed to materialize, this approach was quietly dropped.
So how can governments avoid repeating the mistakes of the past? The starting point should be to accept that no single indicator can guide the withdrawal of policy support. Given the huge distortions caused by the pandemic – and the enormous structural change it has wrought – governments would be better advised to calibrate their policy support against a basket of hard and soft indicators. A preliminary (but not exhaustive) list should include:
- The unemployment rate;
- The underemployment rate;
- The employment-to-population ratio;
- Hours worked;
- Wage growth;
- Survey measures of labour market slack, such as difficulty in filling positions and vacancy rates; and
- Measures of output relative to trend, both at an aggregate level (e.g. output gaps) and, to the extent support is targeted, at a relevant sectoral level (e.g. restaurant bookings, hotel occupancy rates, air and rail travel, and so on).
Sequencing the rollback of support
The above approach should inform government decisions on the timing of withdrawal of policy support. But what about decisions on which measures to withdraw and in what order? Here policymakers should follow two broad principles.
First, rather than providing blanket support across the economy, governments should increasingly deliver targeted assistance. In this sense, the measures themselves shouldn’t necessarily change, but – for as long as restrictions are required to contain the spread of the virus – their focus should shift to the firms and households most heavily affected by continued sectoral closures. Rather than trying to separate jobs that have ‘viable’ futures from those with ‘unviable’ ones, governments should limit support for jobs to those sectors explicitly affected by restrictions on activity. They should remove the support provided to other sectors, replacing this with help for displaced workers in the form of unemployment benefits and retraining programmes.
The second key principle should be that, while measures to support consumption can be withdrawn as labour markets improve, policies to support investment should be kept in place for longer. Investment not only stimulates demand and thus short-term growth, but by improving and expanding the capital stock it can also boost long-term growth. Moreover, with the notable exception of China, investment rates in major economies were already running at multi-decade lows on the eve of the pandemic. So while the pandemic is likely to spur investment in new sectors (e.g. digital technologies), the bigger risk in the near term is that the disruption from the crisis results in a lingering weakness in overall business investment. In such circumstances, and against a backdrop of low (and in many cases negative) real interest rates, research shows that public investment not only helps to offset weaker private investment, but can also stimulate it.
Accordingly, fiscal policy will need to evolve through the post-pandemic recovery to a) focus support on the most heavily affected sectors; b) transition labour market programmes from supporting jobs to supporting workers; and c) ensure that public investment is the last pillar of short-term support to be withdrawn.
The role of the state in the post-COVID-19 transition
This brings us to the more fundamental question about the role that governments should play in influencing the structural transition of economies in the wake of COVID-19. While there is a strong case for heavy fiscal intervention during the acute phase of the crisis, a different principle should apply to policymaking over the long term.
For a start, it is impossible at any given point for policymakers to see what the future will look like. The pandemic is a good example of Keynes’ principle of ‘fundamental uncertainty’: some things are simply unknowable. It is likely that many of the trends that were under way before COVID-19 – such as working from home and shopping online – will be accelerated by the pandemic. But in other areas, history suggests that activity and behaviour will return to something like normal once the spread of the virus is eventually suppressed. Pubs, restaurants and theatres have existed through centuries of war, famine and disease – it’s unlikely that demand for their services will be killed off by COVID-19. Yet at this stage it is difficult to say much more beyond these general points – and this cannot form the basis of a comprehensive industrial policy.
The market may sometimes be flawed, but it remains the least flawed of the possible ways of allocating resources. In light of the huge uncertainty over the shape and structure of the post-COVID-19 economy, and given the frequent temptation of governments to take the path of least resistance and prop up dying industries for too long, the overriding principle should be to leave as much as possible of the post-pandemic transition to the market.
Instead, governments should concentrate their efforts on providing a platform to enable the transition to a modernized and resilient post-COVID-19 economy. It is beyond the scope of this paper to address in detail the specific policies that such a transition is likely to entail, not least because these will vary between countries, but in general policy should focus on three areas:
- Investment in infrastructure, both physical (e.g. suburban rail) and digital (e.g. 5G telecommunications rollout) with an emphasis on ‘green’ initiatives.
- Investment in human capital, including skills (to create an adaptable workforce) and measures to promote labour mobility (since new industries may not emerge in the same places as old ones).
- Correcting market failures, such as monopolistic behaviour, that would otherwise slow the transition to a post-COVID-19 economy.
