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And now? It’s getting much more complicated,

especially in the EU

June 9, 2020




With hindsight, economic policies seemed to have been easy during the lockdown period. As lockdowns come to an end, the challenge rises. Lockdown was primarily a supply shock (production was shut down), now we face a massive demand shortfall.


During lockdown, economic policies had a clear purpose: prevent a meltdown on the economic fabric. People were compelled to stay at home. Those could not work from home could not work at all and needed income support. Non-essential firms that rely on workers’ physical presence had to shut down, as did those that were not allowed to function (stores, hotels and restaurants, airlines, etc.). With no revenues and costs still running, they too had to be allowed to survive. Governments in developed countries rushed to provide support while central banks were busily prevented a financial crisis.


As lockdowns are lifted, we are hoping for a quick recovery (the V-shape hypothesis) but it will not happen spontaneously for at least six reasons. First, the virus is still around. Until a vaccine is available, there can be no return to normalcy. Various protective measures will have to remain in place, which will hamper economic activity and raise production costs. Second, people have saved quite a lot during the lockdown period. Would they now rush to make up for lost time, we would indeed have a V-shaped recovery but there are many indications that this is not happening. There is ample evidence that people are scared by the virus and they want to keep saving as a precaution. Third, governments have allowed their budgets to go into deep deficits, rightly so. But now public debts are surging. Many of them will feel constrained and some may be unable to borrow much more. Austerity would abort any potential recovery. Fifth, asset prices have risen after the initial deep drop. Forceful interventions by central banks are one reason. Anticipation of a speedy recovery might be another reason. If the recovery is slow, instead, asset prices might drop again. Sixth, the recovery cannot be achieved at the national level. The whole world has plunged in a deep recession and a successful recovery must be global.


The broad implication is that pandemic-related fiscal policies must now be redesigned. They must shift from damage control, which has generally been successful, to more classic forms of expansionary actions. Central banks must keep stabilizing the financial markets and also support the recovery. It may look simple, but it is not.


To start with, fiscal policy typically is slow to put in place, in part because it always is controversial, and its effects are rarely immediate. Governments should move immediately after the end of lockdown to help recovery in the second half of 2020. Most of them (Germany is one shining exception) are struggling to decide a strategy when they do not rush to take poorly thought-through tactical actions. They face contentious issues. Should they raise spending or cut taxes? Should they aim at particular sectors? Should they also try to kill two birds with one stone by simultaneous advancing other objectives like climate change, inequality, health or industrial policies? How long can they keep their budgets in deep deficits?


The main principle that should drive any government is to stay focused on the need for a rapid recovery and to make it simple to be understood and effective. Fiscal policy action must be seen as a one-off extraordinary step to meet an extremely rare historical event. Fiscal discipline, which only makes sense in the long run, should not be an issue, wherever possible. The adopted measures must be both very strong and strictly temporary, just one burst of the famed bazooka. Mixing up all kinds of objectives is a sure way to violate the temporary nature of policies and, therefore, to prevent a timely reduction of deficits. Multi-year programs are the exact opposite of what is to be done. We need to boost consumption, now.


Scared consumers will not be easily convinced to spend, especially if they feel the threat of unemployment. That means that the various measures that have replaced firing with furloughs must stay in place, transparently until the recovery is well under way. It also means that consumption must be encouraged through various and easy to understand actions. Temporarily reducing consumption taxes (VAT in most countries) is a good starting point. Easy access to cheap credit is another obvious mean. Temporary deferrals of due taxes and loan repayments have a role to play too. Morale boosting would also be good, if possible. At the very least, people must not feel overly stressed about the on-going presence of the virus. Smooth talking will not be enough, health policy must be quickly expanded. Hospital beds, and the associated professional support and equipment, must be expanded fast. Testing and tracing is needed to quickly circumscribe infection hot spots as they emerge. The overall goal is to convince people that another massively costly lockdown can be avoided.


A second principle is to recognize that that public spending is usually ill-suited to quickly trigger a rapid recovery. This is specially the case of programs that are unrelated to the issue, the classic example being spending on climate change, for three main reasons. First, almost by definition, these are not temporary commitments as they often end up being considered as entitlements. Second, they take time to be put in place and are spread over time. Finally, they often are chosen in response to intense lobbying by interest groups that see that the public purse is largely open. The famous counter-example of public works in the US after the Great Depression is not easily reproduced today given the considerable administrative delays that they entail. Cutting taxes, or delaying tax collection, can be decided and implemented in no time.


Sadly enough, these principles do not seem to be guiding actions in the EU. Even in Germany, where the VAT will be reduced temporarily during the second half of 2020, large amounts of the announced package are dedicated to specific industries and to “good causes” unrelated to the recovery, including climate change or artificial intelligence. Elsewhere, governments seem to be moving slowly, as if they could not have anticipated the end of lockdowns. More worrisome is that many governments are contemplating higher spending on “good causes” or on chosen sectors deemed important for the country or on national champions such as the national airline. 


The announced Recovery Fund proposed by the European Commission sets up transfers, from countries that can borrow easily because of their low indebtedness to countries whose ability to borrow is constrained. As such, it represents a significant, potentially historical achievement. The proposed use of funds, however, compounds misleading steps. It relies largely on public spending and not at all on tax cuts, for the simple reason that there are no EU taxes. It focuses heavily not on immediate recovery but on “good causes” – dubbed “next generation EU” – and disbursement is to be spread over several years. The Commission very much hopes that this massive enlargement of its budget is, at least partly, permanent. The idea of enhancing consumption is essentially absent. The stated objective of alleviating borrowing constraints could be easily achieved by issuing Eurobonds but it is not politically acceptable. The Recovery Fund is a roundabout alternative to Eurobonds, but a highly ineffectual one. 

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