Throughout my life (or so much as I can remember) Monetarism has been prevalent. It, in the form of Mrs. Thatcher and Ronald Reagan, rescued us from the failed Keynesian 1970s. Taxes dropped, border tariffs dispersed and the international free markets boomed. It enriched the world as its population exploded. Greed was good. Then, in 2008, we had a banking crisis which started a move to a more controlled financial environment supported by central banks, that said the free market was still king, despite creeping protectionism and nationalism (see the rise of Trump and Brexit).
But this world has hit the buffers. Left to the free market, the world economy may have gone into a death spiral which would have made 2008 and 1930 look like a small blip. As its stands, we are still likely to be at the beginning of the largest recorded recession despite unprecedented interventions and stimuli.
Covid-19 is an unusual combination of supply and demand shocks. These shocks propagate through supply chains, causing different sectors to become demand-constrained or supply-constrained. David Baqaee (UCLA) and Emmanuel Farhi (Harvard) have used a disaggregated Keynesian model to identify the shocks, classify the sectors, and draw implications for policy. Negative sectoral supply shocks and shocks to the sectoral composition of demand generate more than 7% inflation, and this inflation is kept in check by a large negative aggregate demand shock. There is considerable slack in economy, with 6% Keynesian unemployment, but it is concentrated in certain sectors. As a result, untargeted aggregate demand stimulus, while desirable, is less effective than in a typical recession.
Their paper looks at how reductions in supply and demand lower real GDP. However, for policymakers, separating demand shortfalls from supply constraints is important because they require different remedies. Treatments for inadequate demand – such as lowering interest rates or increasing in government spending – exacerbate problems of inadequate supply, leading to shortages and inflation. Similarly, treatments for inadequate supply – such as relaxing lockdowns or providing liability exemptions – applied to demand-constrained sectors are ineffective at restoring activity.
The paper is short, but pretty academic, and outlines some key issues. Governmental responses have been applied equally to all sectors. However some sectors are already at capacity and these sectors could see significant inflation, look at share price inflation against yields for the big 5 in the S&P500. Other sectors are stuck in the doldrums and may in effect never return to pre-Covid levels.
We are in the middle of a huge economic experiment. Let us hope we avoid some of the old Keynesian issues such as inflation or worse still stagflation.
Treatments for inadequate demand – such as lowering interest rates or increasing in government spending – exacerbate problems of inadequate supply, leading to shortages and inflation