My last post was a bit long and technical, so I will condense the information by describing two scenarios which I believe to be the extreme ends of the realm of possibilities.
There is probably no avoiding a downward economic cycle at this point. The stay-at-home orders have meant a significant decline in economic activity since the second week of March. Moreover, most businesses have probably reduced investment and orders for materials in the last month, as well, so demand is going to be low across the supply chain. Many of the people newly unemployed will not be able to return to work right away, and there are likely to be some businesses that go under even with the best economic policy.
Scenario 1: A mild recession
Despite some headline figures of GDP dropping at historical rates in the second quarter, the economy could return to the previous path relatively soon. Pent up demand for consumer goods other than groceries and toilet paper could lead to a small and temporary spending surge when people are finally let out of their homes. After having spent weeks at home, people will be keen to upgrade that computer or oven they’ve been putting off for months, or they might finally buy that road bike after weeks of inactivity. This quick boost in demand will give businesses confidence to start making purchase orders from their suppliers again, and the supply chain will grind into movement. This increase in demand will allow people who were recently laid off from their jobs to return to their old jobs without having to reapply, reducing frictions normally burdensome on the employment market. Despite the massive government stimulus, prices will remain steady as the supply chain increases production to meet the demand as many big retail stores have post-Covid sales to move old inventory. This, in turn, boosts the tax base, reduces mandatory spending, keeps the interest rate on government bonds low, and allows the government to gradually increase revenues.
The Chinese, having dealt with their crisis before the rest of us, will have increased production already, and the supplies that we cannot produce ourselves will already be on ships en route to Europe and the US. Chinese firms will be employing workers, and an early increase in demand in China will boost earnings of large multinational organizations headquartered in the west further supporting investment and allowing people to return to their previous jobs. This, in turn, will ease stock market swings and boost consumer confidence further.
Scenario 2: Everything goes wrong at once
As businesses are forced to stay shut for extended periods of time, the fixed costs of keeping the business running will require more and more debt. Once the debt levels become larger than the assets of the businesses, bankruptcy will ensue. After one or two high profile bankruptcies, the interest rate on corporate debt will increase due to a risk premium on the remaining businesses, pushing their interest rates higher and increasing the likelihood of further bankruptcies. As small businesses and large corporations go bankrupt, their suppliers will face a decrease in demand for their products, and the bankruptcies will spread down the supply chain.
The employees of recently bankrupt firms will reduce their consumption as they face an uncertain job market. No amount of unemployment insurance or government payouts will overcome the inherent uncertainty of the possibility of being unemployed for a long period of time, and any benefit the government provides will be put aside for essentials.
In addition to the lack of demand from consumers, businesses will face a shortage of supplies. Hotspots of the virus will continue to pop up in the less developed countries that supply many companies with cheap manufactured goods, and transportation lines will be severely hampered by health monitoring and travel restrictions. Domestic bankruptcies will compound the supply shortage, and the cost of supplies for businesses will increase. As a result, suppliers will be forced to increase prices to stay in business, further decreasing quantity sold. Larger firms in concentrated markets will try to squeeze out the competition by paying suppliers a large premium to shore up the entire supply line, passing these costs onto the consumers at monopoly prices.
These price increases will cause inflation levels to increase quickly above the 2% target, prompting the federal reserve to start contemplating an increase the interest rate. This will cause government bond prices higher, interest rates on corporate debt higher, and the federal budget into a larger deficit. As the crisis drags on for months, budget season will roll around in an environment with higher interest payments and non-discretionary spending. The government will resume the political stalemate over cuts to core services vs. raising tax rates, and there will be potential decreases to services that we have relied on throughout the pandemic, such as the CDC.
The difference between the scenarios:
The big differences between these scenarios are (1) the level of corporate and small business bankruptcy and (2) the economic health of rest of the world. The variables economists normally concern ourselves with—the fundamental relationships between investment, unemployment, and inflation—are important to both scenarios. However, these mechanisms only magnify the effects of bankruptcy and trade, the two big unknowns in the economy at this point.
Part of the reason bankruptcy and trade are so uncertain is that they are heavily reliant on public policy. Much of policy so far has been focused on providing liquidity to cash-strapped firms. Forcing firms to go further into debt, however, leads to the question of solvency (whether the debt is larger than a firm’s assets). For some firms, bankruptcy will be unavoidable, but other firms might be able to survive given the right support. “Infrastructure spending” has been floated as an idea, but federal contracts are always a haphazard and controversial method for dealing with this problem, and they tend to help larger businesses. Government relief in the form of payroll support is a good start, and it probably disproportionately helps small businesses with smaller capital costs (making payroll a higher proportion of overall costs). Money spent on further debt relief for small businesses would be a good investment for the government.
Multilateral international policy will be crucial in this period, as well. Disruptions to global supply chains represent a potentially large negative supply shock, first from the lack of primary and intermediate goods necessary for production and later from the efficiency loss from reduced economies of scale. Continued hotspots of the disease will require attention, and many of them are likely to pop up in lower income countries with weaker public health systems. International support will be required to prevent these areas leading to a second contagion.
The path of the economy over the next six to twelve months will probably fall somewhere between these two extremes. However, the magnitude and duration of the economic crisis will invariably rest on levels of bankruptcy and international trade, with business investment, consumer confidence, inflation, unemployment, and fiscal policy responding in kind.
With fiscal policy, now is the opportune time for politicians to start discussing the possibility of a fiscal rule, or a requirement that the government run a surplus based off of GDP and unemployment numbers, potentially even requiring an increase in revenues. This type of rule has been used in some countries with success, notably Chile, and has the support of some prominent economists, including Ben Bernanke. One potential benefit would be guaranteeing a path to sustainable debt in the future, taking pressure off of politicians while the economy is still weak.
In the US, the fast majority of fiscal spending is already non-discretionary, meaning it is not subject to negotiation in annual budget reviews. And many of these non-discretionary items include benefits that automatically increase during economic downturns, creating automatic fiscal stabilizers. Nonetheless, much of the discretionary funding is for very useful and vulnerable programs, such as funding for agencies like the CDC and FDA. Furthermore, while much of the spending is non-discretionary, the revenue side is renegotiated every year. An overall fiscal rule would help resolve many of the political issues related to negotiating this every year.
 Many economic forecasts have a mild decrease in GDP in the first quarter of 2020 followed by a sharp decrease in the second quarter. Don’t be fooled by this… the mildness of the first quarter numbers are only due to the strong economy in January and February.