Macroeconomic policy rethinks after a pandemic

The government and central bank policy response to the pandemic was large and unprecedented.

In the United States, the Federal Reserve Bank invested $ 3 trillion in strong funding between March and June 2020. This is the same funding for the first 100 years, 1913-2013.

In the UK, the Prime Minister requested Parliament to approve £ 40bn deficit spending in March 2020, borrowing £ 400bn over the next 12 months, 92% funded by the Bank of England. I did.

Does this “unorthodox” policy response justify a rethinking of macroeconomics?

Keynes established macroeconomics, the study of the economy as a whole, as a clear subject of economics.

During the Great Depression of the 1930s, Keynes conceived in his famous work “General Theory” that the key to full employment was sufficient demand to maintain all the resources available in a fully employed economy. Introduced.

Government spending provides the additional demand needed for full employment, as personal consumption and investment, along with net exports, are not guaranteed to generate sufficient demand to ensure that all products produced are sold. There is a possibility.

The availability of government budgets as a means of economic policy was a revolutionary concept at the time.

This gave rise to the idea of ​​anti-circular fiscal policy, which became the main macroeconomic policy framework from the postwar period to the 1960s.

By the 1970s, confidence in fiscal policy had been shaken. Long, fluctuating delays before affecting the economy, and politics that hindered sound finances, were seen as the cause of instability.

Meanwhile, a group of economists at the University of Chicago, led by Milton Friedman, have developed an alternative macroeconomic framework that focuses on the money supply as a major determinant of economic activity.

The 1970s was characterized by the last serious inflation episode (to date).

World and US demand was supported by the Vietnam War and US fiscal spending on the great world.

At the same time, OPEC’s oil crisis and strong trade unions have pushed wages into a wage-price spiral.

Lowering the resulting inflation required sharp rises in interest rates and a severe recession.

The experience of “stagflation” in the 1970s helped weaken Keynesians and strengthen monetarist approaches to macroeconomic policymaking.

Since the mid-1980s, trade and capital movement liberalization and globalization have promoted productivity growth and curbed inflation.

The significant increase in the global workforce has reduced the cost of goods and wages in developed countries, resulting in price stability for 40 years. During the same period, interest rates have fallen steadily.

Along the way, interest rates fell below the growth rate of the world economy. This is important for debt sustainability.

However, monetary policy cannot stimulate the economy because interest rates are at the effective lower limit (that is, interest rates cannot be lowered any further), and fiscal policy plays an important role in maintaining its potential. Played.

This theoretical consensus for increasing reliance on fiscal policy was first tested during the global financial crisis.

The severe recession of 2008 caused by the 2007 GFC required a coordinated global response.

Fiscal expansion

At the G20 meeting in London in 2009, Gordon Brown secured such an agreement for coordinated fiscal expansion.

This eased the decline in economic activity, but as many countries were already in debt, it led to further deficit spending and a sharp increase in public debt.

The statement that “the debt threshold must not be exceeded” was strong enough to create a reversal of fiscal expansion coordinated at the 2010 Toronto G20 meeting.

The period of austerity, which had a negative economic and social impact, continued.

“Austerity” has influenced policy making during the eurozone crisis, especially in Greece, where economic and social impacts were unnecessarily serious.

With today’s thinking about public debt and central bank support for government deficit spending, the eurozone crisis could have been dealt with in another way.

The limited fiscal expansion during the Great Recession of 2008 meant that recovery from the financial crisis was slow. Austerity delayed recovery as many countries addressed the high debt heritage and concerns about maintaining sufficient ammunition to cope with the next crisis.

The next crisis happened in an unexpected way.

With the outbreak of the pandemic, a more positive and collaborative response has become more positive.

There was an immediate and substantive financial response to protect income and employment and keep the company alive.

The macroeconomic policies implemented globally during the pandemic are of the general macroeconomic legitimacy of (a) no major deficit spending and (b) no central bank funding of government debt. It violated the two most basic norms.

Both conditions were set aside significantly during the pandemic.

We are now in the post-pandemic period.

Is a new macroeconomic story emerging in the aftermath of a pandemic?

High inflation

The response to the pandemic was a significantly expanded fiscal and monetary policy.

The focus has shifted from concerns about an increase in the debt-to-GDP ratio to the potential impact of pandemic stimuli on inflation.

Is there any high inflation we are currently experiencing due to the pandemic stimulus?

In traditional macroeconomic thinking, this was the expected result of excessive deficit spending funded by central banks during a pandemic.

However, the double supply shock of the pandemic and Russia’s invasion of Ukraine has led to sharp rises in energy and commodity prices, complicating the debate over the causes of high inflation experienced by the world.

Economists are divided into those who focus on supply constraints and those who blame excessive pandemic spending.

Initially, the central bank considered inflation to be a temporary phenomenon and took no action.

Simultaneous supply and demand shocks pose a serious dilemma for central banks. In order for central banks to show independence and take seriously to avoid runaway inflation, they need to fix inflation expectations by quickly normalizing monetary policy, which carries the risk of a recession. ..

The goal is a “soft landing,” or lowering inflation without causing a recession, but if it’s too low now, it could require a larger monetary contraction and a significant rise in interest rates if inflation gets out of hand. There is sex.

The likelihood of this happening depends on the state of the labor market in each economy.

Wage-price spirals only occur if workers have sufficient bargaining power to boost wages in anticipation of future inflation.

Since the beginning of the 1930s, macroeconomics has gone through several stages, including a major rethinking of macroeconomic theory and a fundamental shift in the direction of macroeconomic policy.

The latest example of this process is the “unorthodox” policy pursued during the pandemic.

Are these policies seen as a temporary departure from the “normal business” of dealing with unprecedented emergencies, or do they lead to a more radical rethinking of the macroeconomy?

If these policies can deal with the crisis without causing runaway inflation, why can’t they be used to prevent a crisis such as climate change?

The answers to these questions depend heavily on the current verdict on the cause of inflation.

Time tells us how much we need to rethink macroeconomic policy.

Meanwhile, the central bank has begun the process of raising interest rates, so it hasn’t missed an opportunity.

Former Cyprus Finance Minister, Michaelis Salis

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