Paper: Monetary and Fiscal Policies In The Covid-19 Crisis. Will They Work?

Monetary and fiscal policies to tackle Covid19

The main economies have implemented a wide variety of fiscal and monetary measures to tackle the Covid19 crisis.

  • Central banks cut interest rates (POLAND, UK, US, CHILE, BRAZIL and MEXICO)
  • Quantitative easing programs in (EUROPE, UK, US, POLAND, BRAZIL and CHILE)
  • LTROs (long term refinancing operations) in EUROPE, POLAND
  • Other programs to ensure liquidity
  • Mortgage holiday for citizens affected by Covid19. Length of mortgage holiday:3 months
  • Some countries extend loan holidays to SMEs
  • Temporary capital and operational reliefs in EUROPE, POLAND, UK, US and BRAZIL
  • EU-wide EBA (European Banking Association) stress test postponed to 2021 to allow banks to prioritize operational continuity
  • Relief on forbearance
  • State-backed guarantees
  • Liquidity lines with public guarantees.
  • Tax deferrals to self-employed and SMEs.
  • Cash injections and wage subsidies.

Fiscal measures with budget impact have been, so far, small, due to the limited fiscal space of most economies. The United States has launched the largest package, worth 6% of GDP, followed by Germany, at 4.5% of GDP.

Liquidity & Guarantee programs have been the main tool used by governments, with Germany launching a total program equivalent to 24% of GDP, the United Kingdom at 13.7% of GDP, the United States at 4.5%, and other eurozone countries such as Italy (20% of GDP), France (13% of GDP) and Spain at 8% of GDP, all according to official figures.

The wide and ample reliance on liquidity and guarantee programs reduces the risk of abrupt rises in deficits from governments, but adds significant strain to the banking sector, as most countries are launching large lending programs for businesses that may result in rising non-performing loans in the near future and will, in any case, increase the risk of the asset base of banks that have struggled in recent years to achieve return on tangible assets above their cost of capital, particularly in the eurozone.

South Korea has been one of the most effective countries in fighting the Covid19 pandemic. Its number of cases has been extraordinarily low, with no forced economic shutdown required, thanks to a testing ratio that is, for example, 2.3 times that for China (Ravikumar, B., et al., March 2020). Also, some analysts point out its economic response as basic principles that can be applied in most countries (Loayza, N.M., et al. 2020). Its economic plan included a special fiscal budget allocation. From mid-January 2020 until March 2020, the government of Korea has allocated a budget of $22 billion, around 1.5 percent of GDP, to respond to the COVID-19 outbreak. The special budget has three main categories: 1) Disease prevention and treatment (around 10 percent of the budget), which includes funding for testing, quarantine, isolation and treatment; purchasing medical equipment; and loans to hospitals. 2) Support for households and young adults (25 percent), through such means as cash vouchers for low-income families, childcare subsidies, and an expansion of the existing employment support package for young adults (Republic of Korea, Ministry of Economy and Finance 2020). 3) Support for small-and-medium enterprises and local economies (65 percent), through loans and guarantees, as well as wage subsidies to preserve employment.

The economic response to Covid19 among developed countries, especially in Europe, has revolved around monetary policy coming from central banks and adding credit mechanisms.

The ECB had few weapons after years of expansionary policy with interest rates below zero and the Asset Purchase Program already working since 3Q2019. The ECB had to inject €360 billion into the European economy in March 2020. A program that increased liquidity in the Eurozone by €40 billion per month, half of the monthly amount injected during 2016 and 2017. A new stimulus plan was announced shortly, adding €750 billion until end of 2020.

The Federal Reserve also approved an unlimited quantitative easing program, aimed at widening the asset purchase program to include municipal bonds and increasing the size of its balance sheet to record levels.

Regarding fiscal policy, the most widely used is being non-contributory transfers, included in 150 programs in 84 countries according to Gentilini, U. (March, 2020). Other common measures to tackle Covid19 are:

  1. Increase in health spending. All countries are experiencing an unexpected expenditure due to Covid19 treatment and social care needs related to containment measures.
  2. Exemption and deferred taxes. Most economies understood that companies, especially SMEs, are facing a liquidity crisis. That is why they are financing working capital with taxes, focusing on VAT or social contributions. As I already noted, this is the most effective policy to maintain employment. In the case of self-employed workers, social security contributions have been deleted during 2 or 3 months.
  3. Unemployment insurance where it has not been yet established (such as the USA and Canada), and more flexibility on their conditions in the European countries.
  4. Concessional loan facilities at 0% interest rates and public guarantee schemes. Liquidity in markets is guaranteed by monetary policy. With these schemes access to funds is ensured, where public guarantee schemes are probably more useful for corporates, and concessional loan facilities through public banks will be used by SMEs that don’t have counterparts.
  5. A relaxation of capital requirements and permits for high-quality liquid assets below the minimum liquidity coverage ratio requirement.

There has been an important movement towards labor market flexibilization. In countries such as Germany, where it is already flexible, main labor policies have been reduced to financing partially the difference between full-time salary and part-time wage received by workers. But in other rigid markets, such as the Spanish, more flexible schemes have been introduced (ERTEs, or temporary job restructuring plans where the government pays part of wages for six months under a commitment from the company to re-hire the worker once the period ends) to try to keep employment when the economy restarts.

Countries such as the United States, Canada or Japan have already noticed the high impact of Covid19 and started to implement plans that add to up to 10% of GDP combining fiscal measures with monetary policies.

It is undeniable that these efforts will lead to high deficits and an increase in public and private debt in 2020. Fiscal responsibility during expansionary years may reduce the long-term impact. The incidence of Covid19 on public spending and the increase in automatic stabilizers may strain public accounts significantly. The key issue is to use the fiscal space to strengthen the recovery and preserve the business fabric as well as understand that supply measures can reactivate the economies rapidly and help recover the financial health in most countries. That is why governments should be careful and selective about demand-side policies and disincentives to private activity which could lead to a prolonged time of recession or stagnation. 

What is important is that this public fiscal space is helpful to restart the economy and allow businesses (especially Small and Medium Enterprises, SMEs) to stay alive.

Some governments, like the United States administration, are combining both demand and supply-side measures. Others, like most of the large eurozone economies except maybe Germany, are only focused on policies driven to provide credit relief and increased spending.

With these measures in mind, and considering the slump in economic activity, corporate profits, wages and tax revenues that will be generated, global debt is likely to soar. This means that the vast majority of the stimulus packages will be aimed at financing higher debt created by government non-economic-return current spending and hibernating large companies, while small and medium enterprises, which have little access to debt and maybe no assets to leverage, simply disappear. Start-ups and small businesses may face a double negative of zero access to equity as well as collapse in sales.

The evidence shows that the global economy has recovered in a much slower and indebted way from each of the past crises. However, none of the crises of the past 50 years have been remotely like this one. We have never witnessed a global shutdown of the entire economy, and policymakers may be unaware of the mid and long-term ramifications, that is why doubling-down on debt and liquidity measures should, at least, be carefully monitored.

The main risk we see from unprecedented demand-side stimuli in a forced shutdown comes from a deflationary period followed by stagflation. The process that policy makers should avoid could be as follows:

The crisis is created by the pandemic and the subsequent closing of entire economies in a domino effect, causing strains on supply chains as well as a wave of credit events in highly indebted sectors.

Governments would subsequently bail out the large and strategic sectors as well as citizens with massive loans and grants and fiscal measures but may leave behind the preservation of supply chains at a global level. As the crisis deepens and lasts longer, governments could decide to take protectionist and interventionist measures that further erode supply chains. This period would be deflationary because money velocity would collapse, investment stops, consumption is weaker, and citizens try to hold on to the little savings they have.

The deflationary and indebted spiral would be addressed with even more liquidity and more debt, but by that time the supply chains may have been irreparably damaged and interventionist measures would add to rising inflation in essential goods and services. This can lead to an economy that remains in stagnation, but prices creep up.

This chain of actions and reactions can be avoided with the right combination of supply-side measures, policies that support the business fabric and demand-side measures. The Korea example shows that health and the economy are not mutually exclusive.

Some European countries such as Spain or Italy are not doing the necessary fiscal efforts to tackle Covid19. Furthermore, some of their measures are going in the wrong way like banning lay-offs or placing private property rights at risk, which may make it more difficult to restart the economic activity due to a loss of confidence both of domestic and international players. Some of the most effective measures, such as tax exemptions, are likely to be implemented, in order to avoid a loss in the production system in addition to the already high impact on the labor market. Without tax exemption policies, it may be more difficult to recover employment in the country and achieve a rapid economic recovery.

About Daniel Lacalle

Daniel Lacalle (Madrid, 1967). PhD Economist and Fund Manager. Author of bestsellers "Life In The Financial Markets" and "The Energy World Is Flat" as well as "Escape From the Central Bank Trap". Daniel Lacalle (Madrid, 1967). PhD Economist and Fund Manager. Frequent collaborator with CNBC, Bloomberg, CNN, Hedgeye, Epoch Times, Mises Institute, BBN Times, Wall Street Journal, El Español, A3 Media and 13TV. Holds the CIIA (Certified International Investment Analyst) and masters in Economic Investigation and IESE.

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