This post takes another look at the GEM contribution to understanding the sort of macro instability produced by COVID-19 pandemic. Some months ago, this blog summarized the newly constructed model. This reiteration has two parts. First is a brief summary of how the Project’s extreme instability model, rooted in the generalization of rational exchange from markets to information-challenged workplaces, was adapted to the circumstances of the pandemic. Shani Schechter and I constructed the original model in 2009 to help advise the Fed on its response to the Great Recession. Second is a repeat look at effective stabilization policy in the pandemic.
GEM Extreme Instability Modeling in the Pandemic
Macro shock. The central problem in the 2008-09 crisis was collapsing effective demand. By contrast, the current episode of extreme instability began with collapsing effective supply. Mitigation of the contagious coronavirus quickly shut down a great deal of the economy. The evolving containment strategy produced huge involuntary job loss and lost production.
Shock propagation: Barriers to effective supply. Three interrelated components are most significant. First is the absence of effective virus protection of workers and customers. Full opening of the economy awaits the mass distribution of credible vaccines or the development of powerful therapeutics. Second are breakdowns and the time needed to reconstruct global supply chains. Third is the incidence of bankruptcy that diverts the macro recovery into the deliberate justice system, producing serious structural delays in restoration dynamics.
Shock propagation: Barriers to effective demand. Permitting widespread bankruptcy to result from the mandated shutdown is a double whammy. Added to its contemporaneous restriction of aggregate supply is its damage to the capacity of aggregate demand to recover sufficiently to prevent a prolonged weak recovery in employment and production. Moreover, uncertainties about the prospects for effective therapies and vaccines discourage consumers’ propensity to spend and business plans to invest.
Difficulties in restoring normal economic activity will be aggravated by the reluctance of the most vulnerable populations to emerge from isolation. (The model is rooted in rational behavior and notably predicts that effective mitigation will become increasingly concentrated in the most vulnerable populations.) Also important are powerful multiplier effects from initial shock. Shock propagation is where GEM modeling contributed to our understanding 2008-09 crisis and where it most contributes today. We know that aggressive monetary policy was the key to preventing depression in 2009. We also know that, as a result of Congressional inability to rise to the challenge, fiscal policy provided unreliable help.
What is today’s greatest economic policy risk to sufficient demand? If the 2008-09 crisis is a useful guide, the most damaging problem will be the reluctance of Congress to spend enough, getting bogged down in its quest for partisan advantage. Meanwhile, the Fed is demonstrating that it learned the lessons from 2008-09 well.
GEM Model Stabilization-Policy Priorities
The interrelated stabilization strategies most critical in the extraordinary circumstances of the pandemic are:
- The U.S. Treasury should replace wage income lost to the Pandemic.
- Deep-pocket public subsidies should further be used to prevent business bankruptcies in response to the pandemic.
- Stabilization authorities – the Federal Reserve, Congress, and the Executive Branch – should adhere to the principal lessons learned in 2008-09. Go big and go fast.
- All of the additional federal debt resulting from the massive government efforts to mitigate the human and economic cost of COVID-19 should be purchased and held by the Fed.
GEM modeling indicates that those objectives, if successfully pursued, effectively manage pandemic stabilization risks. Consider each in turn.
First, replacement of wage income is a no-brainer. It is both ethical and provides a good deal of the support for aggregate spending sufficient to stabilize the economy.
Second, mass liquidity bankruptcies would grievously damage lifetime financial paths of millions of people as well as disastrously forcing recovery dynamics to accommodate the painfully slow, painfully arrogant justice system’s liquidation processes. In circumstances of extreme instability, debt dominos do double duty. The immediate effect is to aggravate the collapse of total nominal spending. Subsequently, as already noted, the resumption of growth is badly hindered, similar to the drag experienced in the aftermath of the Great Recession, by the extent to which bankruptcies and associated debt problems are slow to be resolved.
How well we achieve income replacement and bankruptcy prevention will greatly influence the course of the post-vaccine economy. At the onset of the pandemic, fiscal and monetary policymakers assigned high priority to both. It would be extremely irresponsible to lose that focus in the remainder of the pre-vaccine period.
Third, the U.S. central bank can create money. In the circumstances of any extreme instability that threatens depression, that is a super power. The GEM Project has identified the Fed’s crucial responsibility to prevent a breakdown of the financial system’s capacity to support aggregate demand when confronted with nonstationary contractions of total spending.
The fourth priority is particularly relevant in a pandemic. If successfully pursued, it avoids trillions of dollars of federal debt being sold to domestic or, worse, foreign investors. The structural risks that the proposed Fed buy-and-hold strategy would be dealing are obvious, including – at the most benign – the eventual crowding out of important safety-net and other social-service spending.
Blog Type: Policy/Topical Saint Joseph, Michigan