April 11, 2010
Congress has authorized over 2 trillion dollars (so far) to help those harmed by the partial shutdown of the economy undertaken to slow the spread of the SARS-CoV-2 virus, and to facilitate its rapid recovery when it is safe for people to return to work. The idea is that as the government has requested/mandated non-essential workers to stay home, and non-essential companies (restaurants, theaters, bars, hotels, etc.) have chosen to close temporarily or have been forced to by risk averse customers or government mandates, the government has an obligation to compensate them for their lost income. Above and beyond the requirements of fairness, such financial assistance should help prevent permanent damage to the economy from something that is meant to be a temporary interruption in its operation. No good economic purpose would be served, for example, by lenders foreclosing on mortgage and other loans to workers sheltered in place at home with no income with which to service them. Some of the increased spending quite rightly will go to improve our ability to deal with covid-19 directly (expanded hospital capacity, virus testing capacity, vaccine research and development, etc.)
Obviously, it will be impossible to prevent some amount of waste and corruption from such a huge increase in expenditures. Every rent seeker on the planet has been lobbying Congress to get a piece of the action. In the design of these support programs every effort should be made to carefully target them on the people and activities appropriate to the “above objectives, to remove them and their associated distortions of economic resource allocation when the crisis has passed (i.e., keep them temporary), and to provide watchdog oversight of their implementation. Unfortunately, President Trump is already undermining such oversight. “How-trump-is-sabotaging-the-coronavirus-rescue-plan” Nonetheless, the objective of minimizing the economic damage of a temporary forced shutdown of a significant part of the economy is appropriate.
The question explored here is who will pay for it and how. The entertainment output of the economy (restaurants, movie theaters, hotels, vacation travel) is to a large extent non-essential, at least for a few months. If those are shuttered, about 20 percent (my guess for purposes of this analysis) of our economic output and the incomes of those producing them will be lost for the duration of the shutdown. A central goal of the “Coronavirus Aid, Relief, and. Economic Security Act” (CARES Act) is to prevent this necessary shutdown from killing that part of the economy and from spilling over into others. The goal is to enable it to restart as quickly and easily as health conditions permit. Thus, idled workers who would not be able to pay their rent/mortgage, or electric bill, or buy food without help should not be evicted for temporary nonpayment etc. The government might pay them for their lost income directly (unemployment insurance) or it might pay their employer to continue paying their wages for non-work under one program or another, thus continuing their health insurance and other benefits. These details are important but not the subject of this note. The simplest assumption is that they all receive cash payments sufficient to see them through the shutdown (universal basic income, guaranteed minimum income or whatever you want to call it).
The starting fact/assumption is that the economy’s output and thus income is 20 percent or so lower for the next few months than it was a few months ago. Everyone on average has 20 percent less income, but that average consists of those who continue working as before and those sitting at home earning nothing. If those unemployed are to receive income support (UBI), those still working and those clipping investment coupons must pay for it. Paying an income subsidy to the unemployed does not create income, it redistributes it.
The $2 trillion plus authorized by Congress for these purposes will be debt financed, i.e. the government will borrow the money (adding to its deficit of $1 trillion for 2020 already budgeted). So, to examine who pays for this program we must start by asking who will buy this additional debt? In the past the Chinese and Germans funded an important part of our debts (via their trade surpluses with the US. “Who-pays-uncle-sam’s-deficits” China’s current account surplus with the U.S. is now negligible and it and most every other country in the world will have the financing of their own covid-19 expenditures to worry about. Those purchasing the additional Treasury bonds will thus be largely Americans who must shift their spending from other things (other investments or consumption) to the bonds and thus to the incomes of the unemployed these programs are supposed to be helping. To the extent that new bond buyers are diverting their spending on other financial instruments interest rates on such instruments will tend to rise.
At this point very little money has been disbursed under CARES and no new government bonds to finance it have been issued. As individuals and firms miss rent and debt service payments, their lenders are being squeezed for the funds with which they must service those financing them (this is why we call banks financial intermediaries). Utility companies faced with nonpayments by their customers must borrow to continue paying their own employees, etc. Scrambling for such funds would drive up interest rates in funding markets where it not for the Federal Reserve’s willingness to provide the needed liquidity. Similarly, with regard to the supply of funds to financial markets (the other side of bank’s balance sheets), normal investors are interrupting or even withdrawing funding in order to cover their own income shortfalls. This again squeezes financial sector liquidity and the flow of funds from lenders to borrowers needed to finance the remaining economic activity.
Enter the Federal Reserve. In order to supply the missing funds–the missing rent and debt service payments–needed to keep the financial system flowing and in balance–the Fed has supplied almost $2 trillion to banks over the last 6 weeks, largely by outright purchases of treasury securities, though it has also opened a number of lending facilities. Bank reserve deposits at the Fed increased about $1 trillion over this period and M2 grew by about the same amount. On April 9, the Fed announced that it was opening or expanding facilities to support CARES Act objectives with up to another $2.3 trillion (leveraged by Treasury financial support to cover losses on any Fed loans provided in support of the CARES Act). Federal Reserve Press Releases This includes support for lending by the Small Business Administration (refinancing of SBA loans), the Main Street Lending Program administered by banks, Primary and Secondary Market Corporate Credit Facilities, and the Municipal Liquidity Facility. These are dramatic expansions of Fed credit operations and the details of eligibility of borrowers and of the facilities’ administration are critically important. Ensuring that this massive government intervention in the economy creates the right incentives for a quick rebound in the economy when it can reopen and that these interventions are indeed temporary will be difficult and is very important. But the question I want to address here is whether this monetary financing on such a huge scale will be inflationary.
Simplifying and reviewing, if economic output/income falls by, say 20 percent, and the loss is shared by those working with those temporarily laid off (or idle) by workers lending money to those idled, the Fed need not be involved. However, as is often the case with fiscal policy, it is simply beyond the administrative capacity of the government to launch and coordinate such a redistribution of income quickly and smoothly enough to avoid the disruptions of credit flows described above. Instead, the Fed has printed the money paid to those idled by shuttering 20 percent of the economy. As a result, the idled workers have their regular income (more or less) from newly printed money, and the rest have their regular incomes, but the economy is producing 80 less for them to buy. The “excess” income constitutes the inflationary potential. If this income is voluntarily saved (i.e. a temporary increase in the demand for money), the increased saving would be indirectly financing the spending of the unemployed. It is not unreasonable to expect this to reflect actual behavior for a shutdown of a month or two. But should it drag on for many months the extra saving held in anticipation of a reopening of restaurants and theaters, etc. will seek other consumption outlets and prices will begin to rise.
With luck, the economy will begin to return to “normal” after a few months and the Fed will begin to withdraw its monetary injection as loans and payment delinquencies are paid off from increased output/income. The artificially preserved incomes will increasingly be spent on restored output without significant inflationary consequences.
But the CARES Act provides for the forgiveness of loans by firms that kept or that rehire their workers promptly. As the Fed sells its treasuries back to the public (or allows them to mature without replacing them), the Treasury will be issuing the additional debt needed to fund the $2 trillion plus of CARES Act expenditures, including the forgiveness of debt described above. In short, to avoid the inflationary consequences that would normally flow from the Fed’s massive increase in the money supply, the monetary financing must be replaced with fiscal debt financing. It is hard to see where the money will come from to buy such a large increase debt (some, but not much, will probably come from the foreign financing implicit in an increase in our balance of payments deficits, but the rest of the world is now being saturated with its own debt) without an increase in market interest rates, potentially a significant increase in such interest rates. To the extent that financing remains monetary and pushes up prices, the rising inflation rate will be added to nominal market interest rates compounding the pressure of expanding real debt. The long looming US fiscal debt problem may be near.
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