Policymakers: Pulling Out All The Stops

In the face of the most serious global health crisis in more than a century, fiscal and monetary policymakers around the world will very likely have to pull out all the stops in an effort to prevent what currently looks like an inevitable recession from turning into a depression, and to stop financial markets from shifting from a drawdown into a meltdown.

The (relatively) good news is that governments and central banks are on the case and have started to respond more forcefully to coronavirus-related stresses this past week. Importantly, seeking to underpin markets and ultimately the economy, the Federal Reserve on Sunday (15 March) ­announced a comprehensive easing package including near-zero policy rates, large-scale purchases of U.S. Treasuries and mortgage-backed securities (MBS), lower rates on currency swaps, and regulatory relief for banks. This is about as close as it gets to “whatever it takes.”

Still, a global recession in response to a combination of supply disruptions and a sudden and drastic drop in demand for (mostly) services appears to be a foregone conclusion. Against this backdrop, the task at hand for governments and central banks has been and continues to be to ensure that the recession stays relatively short-lived and doesn’t morph into an economic depression – loosely defined as a combination of a prolonged slump in activity that lasts longer than just a few quarters, a very significant rise in unemployment, and mass business bankruptcies and bank failures.

First and foremost, averting this outcome will require a very large fiscal response to support individuals and businesses that are adversely affected by the crisis. Such a response is now underway in many countries. Tax relief, transfers to individuals, and subsidies to firms will increase current budget deficits significantly. Moreover, government guarantees for bank loans to companies (as announced by several European governments over the past few days) will increase implicit government liabilities and may lead to higher future deficits in the case of losses. Thus, one consequence of this crisis will likely be (even) higher levels of public sector debt in the future.