AN APPRAISAL OF POST-COVID ECONOMICS
Peter Nicholson
The following is Peter Nicholson’s abridged summary of an original July 25, 2020 article by editors of The Economist: Starting Over Again. This important article puts in context the intellectual and policy disarray in macroeconomics, already evident before the pandemic, in view of the persistence of historically low interest rates and the deflationary bias of the advanced economies. A change is underway in our understanding of how the economy works—the fourth such re-evaluation since the 1930s—and the direction of macroeconomic policy will depend on its still uncertain conclusion.
IN THE FORM it is known today, macroeconomics began in 1936 with the publication of John Maynard Keynes’s “The General Theory of Employment, Interest and Money.” Its subsequent history can be divided into three eras.
Keynesianism: The era guided by Keynes’s ideas began in the 1940s but by the 1970s had encountered problems (notably stagflation) that it could not solve.
Monetarism: In the 1980s, the monetarist era began and inspired Fed Chairman, Paul Volcker, to crush inflation by constraining the money supply.
A Hybrid: In the 1990s and 2000s economists combined insights from both monetarist and Keynesian schools and recommended a policy regime loosely known as “flexible inflation targeting”. The primary tool of economic management was the raising and lowering of short-term interest rates. The job of fiscal policy was to keep public debts low, and to redistribute income to the degree and in the way that politicians saw fit.
The late 2010s were simultaneously the new 1970s and the anti-1970s: inflation and unemployment were once again not behaving as expected, though this time they were both surprisingly low. This threw into question the received wisdom about how to manage the economy. Central bankers faced a situation where the interest rate needed to generate enough demand was below zero. Now, in the wreckage left behind by the coronavirus pandemic, a new era is beginning. What does it hold?
Economists and policymakers can be divided into three schools of thought, from least to most radical: (a) which calls merely for greater courage; (b) which looks to fiscal policy; and (c) which says the solution is negative interest rates.
a) The proponents of the 1st school say that so long as central banks are able to print money to buy assets they will be able to boost economic growth and inflation. Their critics doubt that central-bank asset purchases can deliver unlimited stimulus, or see such purchases as dangerous or unfair—perhaps, for example, because buying corporate debt keeps companies alive that should be allowed to fail.
b) Most central bankers have gravitated towards the 2nd school. Better for the government to boost spending or cut taxes, with budget deficits soaking up the glut of savings created by the private sector. It may mean running large deficits for a prolonged period, something that Larry Summers has suggested. This view does not eliminate the role of central banks, but it does relegate them. They become enablers of fiscal stimulus whose main job is to keep even longer-term public borrowing cheap as budget deficits soar. They can do so either by buying bonds directly, or by pegging longer-term interest rates near zero, as the Bank of Japan and the Australian central bank currently do. Those influenced by the Keynesian school want the monetary financing of fiscal stimulus to become a stated policy—an idea known as “helicopter money”. When interest rates are zero, there is no distinction between issuing debt, which would otherwise incur interest costs, and printing money. In fact, central banks can continue to finance governments so long as inflation remains low, because it is ultimately the prospect of inflation that forces policymakers to raise rates to levels which make debt costly.
c) The third school of thought, which focuses on negative interest rates, worries about how interest rates will remain below rates of economic growth. Its proponents view fiscal stimulus with some suspicion, as it leaves bills for the future. A further concern is that governments will face still more pressure on their budgets from the pension and health-care spending associated with an ageing population, investments to fight climate change, and any further catastrophes like Covid-19. The best way to stimulate economies on an ongoing basis is not to create endless bills to be paid when rates rise again. It is to take interest rates negative. Some are already marginally negative—e.g., the Swiss National Bank’s policy rate is -0.75%. But Kenneth Rogoff of Harvard University, for example, envisions interest rates of -3% or lower—a much more radical proposition. This would discourage saving—in a depressed economy, after all, too much saving is the fundamental problem. Many people would also want to take their money out of banks and “stuff it under the mattress” in order to avoid paying for safe-keeping in a bank! Making negative interest rates effective would require sweeping reform. The brute-force method is to abolish at least high-denomination banknotes, making holding large quantities of physical cash expensive and impractical. Mr Rogoff suggests that eventually cash might exist only as “weighty coins”. Several factors make the economy more hospitable to negative rates. Cash is in decline. Central bankers, meanwhile, are toying with the idea of creating their own digital currencies which could act like deposit accounts for the public, allowing the central bank to pay or charge interest on deposits directly, rather than via the banking system.
Policymakers now have to weigh the risks to choose from: (a) widespread central-bank intervention in asset markets, (b) ongoing increases in public debt, or (c) a shake-up of the financial system. Yet increasing numbers of economists argue that deeper problems exist which can only be solved by structural reform.
One target is inequality since it saps demand from the economy. Just as inequality creates a need for stimulus, stimulus eventually creates more inequality. This is because it leaves economies more indebted, either because low interest rates encourage households or firms to borrow, or because the government has run deficits. Both public and private indebtedness transfer income to rich investors who own the debt, thereby depressing demand (because the rich tend to consume a lower proportion of their income) and interest rates still further. The secular trends of recent decades, of higher inequality, higher debt-to-GDP ratios and lower interest rates, thus reinforce one another. Escaping the trap requires consideration of less standard macroeconomic policies, such as those focused on redistribution or those reducing the structural sources of high inequality.
Larry Summers, for example, blames workers’ declining bargaining power. This can explain all manner of American economic trends: the decline (until the mid-2010s) in workers’ share of income, reduced unemployment and inflation, and high corporate profitability. Business owners may be more likely to save than workers, so as corporate income rises, aggregate savings increase. Summers favours policies such as strengthening labour unions or promoting “corporate-governance arrangements that increase worker power”. Another is to strengthen the safety-net, which would increase workers’ bargaining power and ability to walk away from unattractive working arrangements.
These ideas will compete for space in a political environment in which change suddenly seems much more possible. Owing to mass Covid bail-outs, the role of the state in the economy will probably loom considerably larger.
The rethink of economics is an opportunity. There now exists a growing consensus that tight labour markets could give workers more bargaining power without the need for a big expansion of redistribution. A level-headed reassessment of public debt could lead to the green public investment necessary to fight climate change. And governments could unleash a new era of finance, involving more innovation, cheaper financial intermediation and, perhaps, a monetary policy that is not constrained by the presence of physical cash. What is clear is that the old economic paradigm is looking tired. One way or another, change is coming.
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Peter Nicholson - Born in Halifax, Nova Scotia and educated in physics (BSc, MSc, Dalhousie University) and operations research (PhD, Stanford), Peter Nicholson has served in numerous posts in government, business, science and higher education. His varied public service career included positions as head of policy in the Office of the Prime Minister, the Clifford Clark Visiting Economist in Finance Canada and Special Advisor to the Secretary-General of the Organization for Economic Cooperation and Development (OECD) in Paris. His business career included senior executive positions with Scotiabank in Toronto and BCE Inc. in Montreal. He retired in 2010 as the founding president of the Council of Canadian Academies, an organization created to support expert panels that assess the science relevant to issues of public importance. Peter Nicholson has been awarded five honourary degrees and is a member of both the Order of Canada and the Order of Nova Scotia. Fun Fact: Elon Musk credits Peter in his biography as giving him his first job.
The views expressed belong to the author.
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