The Economic Implications of COVID-19

In his speech and conversation with Stephanie Mehta, Paul Krugman helps us make sense of the first economic crisis driven by microbes, which does not play by existing rules.

The economic impact of COVID-19 is incredibly severe and incredibly fast. It looks like we are headed toward something that is three to five times as deep as the slump that followed the 2008 recession, and it is all moving at an incredible speed. It is also very different from other financial crises. This is the first economic crisis that is basically driven by microbes, and it does not play by existing rules. But it does not mean that we cannot make sense of it. In fact, the Economics profession has gotten together a framework for understanding it in a very short time, but it does not obey the rules of previous slumps. The speed at which it is developing, the reasons for the slump, and the way the policy works are all something that none of us have seen before. 

A recession happens when people, for whatever reasons, start spending less, there is not enough demand and businesses start laying off workers because they cannot sell enough products. In this case, that is not happening. It may happen as a consequence down the line, but the immediate cause for all these job losses is social distancing. It is that we have shut down large parts of the economy because they are things that we can live without for a while and which can serve as disease vectors. What we are going through is like a medically induced coma where doctors deliberately shut down some important brain functions in order to give the person the chance to heal from some traumatic illness. We have a large fraction of the economy into suspension, into a coma for the time being until the pandemic has subsided. It is a gigantic shock to the economy and something that we have not seen before.

Since a very large part of our workforce is out of work and several businesses are effectively shut down, the businesses and their workers will be forced to cut purchases from unaffected sectors, which would lead to a conventional recession on top.

There is a concern that we may get a conventional recession on top of that. Since a very large part of our workforce is out of work and several businesses are effectively shut down, the businesses and their workers will be forced to cut purchases from unaffected sectors, which would lead to a conventional recession on top. One of the goals of policy makers is to try and contain that, but the most important policy issue right now is to help people who are forcibly being thrown out of work and the businesses that serve those people. By and large, this recession is disproportionately affecting lower-income workers. It is the people who work in shops and in the personal service industry. It is not, by and large, the professionals as they can work from home. There are a few highly paid professionals who must be suffering but the immediate impact is on the people who are lower in economic status. It is important because these are the people whose families do not have enough money that they can live off their savings.

We are starting to get an idea of what is in store for the economy beyond this. Something like a 20-30% decline in GDP temporarily is a probable possibility. Initially, there were talks of a V-shape recovery as soon as the virus lets up, i.e., everything comes rushing back up. It could still happen, but there are a number of reasons to be sceptical about that, to the extent that there is a consensus that the recovery might look like a Nike swoosh than like a ‘V’, a long slow climb after a very steep descent at the beginning. 

The reasons for this are that the idea of surging back was based on the idea that there would be a lot of pent-up demand, something that happened in World War II. But in this crisis, the suppressed demand is not for durable goods like cars, but things like restaurant meals and ordinary shopping like clothing. A pent-up demand for restaurant meals is not the same as a pent-up demand for automobiles. It is not that people would necessarily buy enough restaurant meals to make up for the ones they did not buy during the period of quarantine. 

Meanwhile, the economic severity of what we are going through right now will probably leave a lot of damage, a hangover that will continue to afflict the economy. A lot of businesses will go under, and businesses that do not go under will be highly depleted in capital and have a hard time getting back up to full operation. A lot of households will have depleted their savings, run up debt, and when things are better, they will be trying to restore their financial position instead of spending. So, there are a number of reasons to expect a drag.

Public policy is an area of heavy concern in the US. The fact that the states are not getting remotely adequate aid means the states will be scrambling to cut spending, which will be a drag on the economy as well as be hurting services. The benefits of the stimulus also expired too soon, which means that we will be seeing a big cut-off of government-related spending just when the economy needs to be getting into recovery. Hence, all of this can amount to a sluggish recovery.

There is a consensus that the recovery might look like a Nike swoosh than like a ‘V’, a long slow climb after a very steep descent at the beginning. 

Lastly, a two-part question is should we be worried about the amount of debt that will have been run up after the pandemic is over, and will we be concerned about it? The answer to the first part is we probably should not. The reality is that the US has a huge borrowing capacity, and basically investors have been begging the federal government to borrow money. There is no hint of a serious debt problem, either in the data or in the experience of other countries. So, the US will be coming out of this with a huge debt but we can still go on just fine. The answer to the second part is that very likely we will be concerned. It is almost a certainty that a lot of politicians will be demanding cuts in social programmes after the crisis has subsided.

The basic picture is that we have an unconventional slump. The most appropriate response is disaster relief. The US is doing nearly the right thing but on an insufficient scale, with insufficient duration, and with sluggish implementation, so that people are not going to be getting relief soon enough and there is going to be a lot of economic suffering on top of the toll of the disease itself. We will fully recover but it may not be as fast as the people hope.

Stephanie Mehta in Conversation with Paul Krugman

Stephanie Mehta: In your book, you say, “I’m not a health care economist but I play one on TV.” You’ve written extensively about the Affordable Care Act, the opposition to the Affordable Care Act. Shifting slightly to the health care response that we are seeing, do you think a more full-throated embrace of the affordable health care act could have resulted in different health outcomes during the crisis we are facing right now?

Paul Krugman: It’s more about what will happen next, and so far, the worst of the crisis has come to New York City and then to a more limited extent, some other big coastal cities, and those happen to be Blue states that did fully embrace the Affordable Care Act (ACA), so people in New York are at least not losing health insurance. There is a pretty robust program in there and it is probably one of the states that have reopened Obama Care enrollment so that we are in a position now where the people are somewhat cushioned from the loss of health insurance that comes with losing jobs, or the people who suddenly become more aware of their mortality and realize they really should have health insurance are in a position to do that. As it spreads to other parts of the country then it has become a real issue. Many of the southern states of the US refuse to expand Medicaid under Obamacare, so we have a very weak social safety net in large parts of the United States, and as the health and economic impact spread to those areas it is going to be a really big deal, and even to the states that are relatively rich like Florida. Florida has not expanded to Medicaid, has a totally overwhelmed unemployment system, and they have been making it hard to collect unemployment benefits in Florida. The state’s economy is heavily dependent upon exactly the kinds of things that have been shut down, like tourism, cruise ships, etc. There is going to be a lot of suffering and we’re are going be seeing the costs of a weak social safety net a lot more than we did a few months ago.

Stephanie Mehta: What positive do you think can come out of this? After 2008, we quickly went back to doing the business the way we did before, so can this be different?

Paul Krugman: I’d like to hope it’ll be different, but then if you would have asked me in 2008 I’d have expected to see a much bigger change than we did. Nevertheless, we may at least get some appreciation that we need to be better prepared for bad things to happen, and one of the jobs of the society is to provide a safety net – both physical in terms of things like health care but also financial, for when bad things happen. We may therefore have some change, maybe we’ll get Medicaid expanded, maybe this will provide an impetus for getting something like an Obamacare 2.0, which is much more comprehensive and effective than what we have now. I’d like to think people will also feel greater concern for their fellow human beings even though I’m a cynic about that after everything we have seen these past 10 years.

Stephanie Mehta: The economic engine has many moving parts. Do you have a picture you can paint on how it gets started again and what part needs to start moving first?

Paul Krugman: I think it is pretty clear that we just need to reopen. It’ll have to come in phases depending upon what is the least sensitive in terms of infection, but as you reopen business and make it possible for people to go shopping for things besides groceries and to restaurants, people will come. Three-quarters of the population still have money and jobs and their spending is only suppressed because they cannot buy the things they want to buy. Even the other quarter that is desperately affected by this is receiving relief aid so that the demand is there. Thus, if we reopen customers will arrive and that will get the economy restarted.

Stephanie Mehta: What is your view on the moves in the stock markets?

Paul Krugman: Firstly, the stock market is notoriously driven by sentiment, so it is obviously not responding to the state of the economy. The stock market does its thing and doesn’t necessarily tell you much about the economy. Also, the stock market is based upon the long-run profitability of the companies, and since this will not go on forever, the stock should reflect what one thinks the profit is going to be over the next several decades. It shouldn’t be that much affected even by very severe downturns, so even if the economy is down 30%, it doesn’t mean that stock should be down 30%. They should be down something less than that because the future will not be as grim as the present.

Stephanie Mehta: What changes do you see on a global scale such as change of power, trade patterns, and trade restrictions?

Paul Krugman: There might be more protectionist policy. I think we have learnt the importance of having some domestic capacity to produce medical equipment, so that has been added to the list of national security things we want to maintain some domestic capacity for. As for globalization, it has depended a lot upon movement of people. An important part of organizing all of this has depended on the ability to have people go back and forth for meetings, but maybe we can replace all of that with Zoom. Nevertheless, I think it will be inhibited and we are not going to see airline travel come to where it was for a very long time. People are now going to be much more aware of the risks, so it might put a crimp on globalization. In terms of actual global hard powers, the US military is still the strongest in the world and the Chinese economy is still huge and fast-growing relative to ours. I do think America has taken a hit in terms of soft power. The fact that we have handled this so badly and China, after a bad start, has handled it more effectively has been influencing people to question what is so great about the US.

Stephanie Mehta: What do you think about bailing out industries like aeronautics, airlines, auto, etc. versus just paying a pay check to every tax payer over the next ‘x’ number of months? In other words, should the focus be on people or businesses?

Paul Krugman: My instinct is to say people, not businesses, but there are pretty strong arguments for keeping businesses in existence. Once a company has gone into liquidation, it is very hard to get it going again or for somebody else to step into its place. There’s a reason we did a bail-out of the auto industry back during the Obama years and not just payments to auto workers. The policy makers correctly concluded that keeping the auto companies in businesses is important. The small business loans that are a big component of this stimulus bill are based on that view and they also act indirectly as a way of supporting people’s income. A lot of other countries are giving money to companies to meet payroll but it is intended to maintain the companies and the links with their workers in existence. Now, if there’s a lot of money, there’s a big bail-out, then you need to bail out the company, not the stock holders, so we really should have the kinds of things we did in the last crisis even though this crisis looks different in many ways. Taxpayers got large ownership stake as a condition for bail out so that is the way to be going. I’d like to be a purist and say, “No, help the people, never mind the corporations,” but in the real world, I think sometimes you do have to help the corporations too.

Stephanie Mehta: Are we at risk of a bank crisis or banks collapsing, possibly starting with Italy?

Paul Krugman: Italy is possible because Italy is a country where the government itself has financial constraints in the way the US government does not. They have higher debt and that too in Euros whereas the US can borrow enormously in our own currency. If you look at the borrowing markets, they’re now feeling fairly reassured about investment-grade companies, partly because the Federal Reserve is stepping in there to buy that debt. I’d say Italy is a big worry but the emerging markets are an even bigger worry; their currency is falling and they have a lot of debts in dollars or euros. Our main line commercial banks are fine, they don’t look to be all that stressed, but as we have learnt a dozen years ago, there may be some fall out in the long run.

Stephanie Mehta: Is the US economy sufficiently resilient to survive a second wave of COVID or something similar before it recovers from this one? 

Paul Krugman: I think a lot depends on policy. Advanced countries are incredibly resilient under stress provided that you have an active and effective government. The most amazing thing about the economics of WWII is that all of the combats managed to keep themselves going under incredible stress. There were blockades and bombs, and dislocation of raw materials, and pretty much everybody’s GDP continued to rise through the war, until maybe the very end for Germany. We certainly have the capacity. If we had the Federal government step in and actually behave as if we are facing something like the economic equivalent of a war, which it should be, I think we can roll with it. The resilience of a country like the United States is enormous, but we are a deeply divided partisan country that may not be able to respond in the ways it has in the past.

Stephanie Mehta: Do you see a scenario similar to the one that ended the first gilded age which ushered in the progressive era?  

Paul Krugman: The first gilded era was pre-WWI, and some things changed, but really major equalising movements have only happened in the aftermath of major wars. A lot of us hoped that the 2008 crisis would lead to a lot of changes in policy and reduction in inequality, but it didn’t. It appears that mass mobilisation is what does that, and we don’t see that happening right now.

Stephanie Mehta: What are your views on the economic effects of negative real interest rates?

Paul Krugman: I don’t think there are any problems with negative real rates. A lot of countries have, but the United States has not gone for negative nominal rates, because the Federal Reserve doesn’t think that is a good idea. They think the damage to the functioning of financial market outweighs any benefits, and I think they are probably right about that. The fact that people who lend their money to the federal government are going to see it eroded by inflation faster than they gain from interest payments. It is a poor investment but no one is forcing people to do that, so I don’t see the negative real interest rates as a problem over and above the other problems we have coming out of this situation.

Stephanie Mehta: Do you have a take on whether Universal Basic Income (UBI) might have provided some cushion for people, particularly for those who are more vulnerable?

Paul Krugman: What we are seeing now actually is a demonstration of the case against the UBI. We have a quarter of a workforce suddenly without income and people have debts and bills to pay. Those people need as close as we can get to a full replacement of their income. Three-quarters of the workforce is not facing any financial stress. If we were sending everybody a cheque, no conditions attached, either those cheques would be grossly inadequate for the people who have suddenly seen their monthly income disappear or it would be wildly expensive or both. So we are actually seeing the reason why people who are sympathetic to the idea that everybody should be guaranteed a decent standard of living think that a universal income that is not contingent upon economic circumstances is just not what you need. 

Stephanie Mehta: The US has large debt levels and Keynesians typically recommend paying this down during booms, which we haven’t done over the last decade after leaving the last crises. Combine that with importing surplus and our bonds being owned by foreign countries, what are we relying on to balance our budget? What does the victory path look like from here?

Paul Krugman: All of the major economies have the same thing we do, which is, that interest rates are less than growth rates. We don’t have to pay off debt, we can just let it erode relative to the economy. That is by and large the way we have done it in the past. So, even if we come out of this with debt that is 130% of the GDP, we don’t have to pay that down. We just have to run budget deficits small enough that debt grows more slowly than the economy and it slowly comes down over time. The next time we have a genuine boom, we could pay down some debt, but it doesn’t seem like an urgent issue at all right now.

Stephanie Mehta: Do you have a take on what kind of inflation we could experience?

Paul Krugman: We are contracting the economy’s productive capacity in a way because of the shutdown, but we are also suppressing demand. While there may be some redirection of consumer spending, like spending on alcohol because you are not able to go to a baseball game. That seems to be outweighed by the spending cuts by the people in the affected sectors. As for printing money, we are in a liquidity trap. The interest rate is basically zero and the quantity of money doesn’t matter at all, so inflation worries are just about as misplaced now as they were in 2008-09.

Stephanie Mehta: Are there any countries you have seen that are doing a good job providing relief?

Paul Krugman: The Danes are doing it right. They are providing very broad-based subsidies to employers, 75% of wages on the condition that they maintain employment, so they are in effect, providing relief keeping workers from being laid off and maintaining their ties to their employers so they are well-positioned to make a comeback. By and large, North-West Europe is doing a better job than the US, because they are managing to deliver relief in a way that also maintains workers’ links to companies. There are issues around dealing with self-employed, gig workers, and freelancers and I am not at all clear on what Denmark is doing on that. The Germans are apparently doing a spectacular job of delivering relief there.

Stephanie Mehta: I’d request you to make a few closing remarks and sum up your comments on where we will be going in the next several months.

Paul Krugman: This is an unprecedented crisis economically as a consequence of the health crisis. We have severe economic contraction but for the most part, what’s happened so far is desirable, given where we are in terms of the pandemic. This is like a medically-induced coma that is very unpleasant and may inflict some long-term damage, but it is a lot better than not doing it. We are following policies that are very far from ideal but are actually not nearly as bad as I thought it would be. We are providing at least some of the relief to afflicted workers and businesses. My bet is that we’ll have a slower recovery than people are hoping for, but I’m not sure of that. A lot depends upon how much damage is done, but we should already be thinking about what is it that the policy needs to do to get us back on track as quickly as possible, once the pandemic threat has ended. Lastly, we’ll have a big increase in the debt number in the end, but it is unlikely to cause any real problems.