The Grumpy Economist: Corona virus monetary policy

A colleague and I were discussing the question, should the Fed lower interest rates in response to the corona virus?

More generally, suppose a pandemic gets serious and either by choice or by fiat a large swath of the economy is shut down for a few weeks or months. What should the Fed, or other economic policy do about it?

My first instinct was that the Fed should not lower rates. This is a classic supply shock, and there is nothing more demand can do. What’s the point of encouraging more spending if the stores are closed? Even giving people money doesn’t do any good if the stores and factories are closed. The first job of a central bank should be to ask “is this a supply shock or a demand shock” and respond to demand shocks, not supply shocks. This is like stoking demand at night or over the weekend.

But supply and demand aren’t so neatly distinguished. Maybe a supply shock creates its own lack of demand. And a pandemic has demand effects too. People hunker up at home and don’t want to go buy a new boat.  One job of the central bank is to spy what the natural real interest rate is, and move the nominal rate accordingly so there is no force unsteadying inflation. Well, if the economy shuts down, people don’t want to spend, since the stores are closed, so by definition they save. (Unless income is shut off). People don’t want to borrow (except to roll over) for the same reason. The marginal product of capital is nothing. So that argues for a pretty sharp fall in interest rates.

But as I think about it, the right answer is that this is the wrong question, and aggregate supply and demand is the wrong framework for thinking about it. What happens if the economy shuts down for a few weeks or months, either by choice or by public-health mandate? Shutting down the economy is not like shutting down a light bulb. It’s more like shutting down a nuclear reactor. You need to do it slowly and carefully or it melts down,

I can see huge financial problems. The store and factory may shut down, but the clock still ticks. Businesses must still pay debts, with nothing coming in. They likely have to pay wages — otherwise, what will people do to buy food? People have to make mortgage payments and rent, likely with no income coming in. Left alone, there could be a huge wave of bankruptcies, insolvencies, or just plan inability to pay the bills. A modestly long economic shutdown, left alone, could be a financial catastrophe.

The problem would be mitigated if we could count on the lost GDP coming back. Then we just need loans against the future output. But the GDP won’t come back.  The level of GDP should return quickly — if these financial problems don’t wipe out a segment of the economy. But the GDP not made is not made for good. If you make one pair of shoes a day, when you get sick you don’t make shoes. When you get better you can make one shoe a day again, but not two to make up for lost time. Some demands may accumulate, there is some ability to run above capacity for a while, but it’s not a one for one gain. So the money needed in the interim cannot be borrowed against future incomes, even if banks would lend it.

In free market nirvana, I guess we would all have pandemic insurance to give us a flood of money in this event, and the pandemic insurers would not go bankrupt on this by definition nondiversifiable event. But that hasn’t happened.

In second-best free market nirvana, we would each have recognized that at any moment the economy could shut down for a few months, and each of us — and every firm — has enough liquid savings to last, say, six months of expenses with no income. Precautionary savings should do the trick. Paradoxically, though many economists diagnose a «savings glut,» that glut is not widespread and there are many hand-to-mouth consumers and highly leveraged companies around. In the old days, when crop failure, famine, pestilence, war, and just plain winter were common, the general reaction was to try to keep enough grain around to get through it. That didn’t always work and not for everyone.

So back to the Fed. Absent precautionary savings, one might imagine something like a switch turning off financial claims. But we can’t just shut down the whole economy — people need food, heat, electricity, Netflix, hospitals, and so forth.

In sum, then, I think we need a detailed, pandemic-induced financial crisis plan, that forestalls bankruptcies and insolvencies where possible,  without causing downstream crises among people who were counting on being paid back, and floods the country with money in the right spots, as insurance would do, but not too many of the wrong spots. Yes, you heard it here, judiciously targeted bailouts are really the only way I can think of to keep businesses and people from going bankrupt given the absence of pandemic insurance.

We need a detailed pandemic response financial plan, sort of like an earthquake, flood, fire, or hurricane plan that (I hope!) local governments and FEMA routinely make and practice.

Is there any such thing? Not that I know of, but I would be interested to hear from knowledgeable people if I am simply ignorant of the plan and it’s really sitting there under «break glass in emergency» down in a basement of the Treasury or Fed.  Without a pre-plan, can our political system successfully make this one up on the fly, as they made up the bank bailouts of 2008?

Then we have to figure out how to prevent the atrocious moral hazard that such interventions produce. Pandemics are going to be a regular thing. Ex-post bailout reduces further the incentive for ex-ante precautionary saving. Too good a fire department and people store gasoline in the basement.

This starts down the same bailout and regulate road that suffocates our debt-based banking system. I welcome better ideas.

One might say a rate cut can help provide such liquidity. But the level of the overnight rate is a very small issue to a business that needs a loan to keep up with mortgage or rent, payroll, electric bill, debt payments, there is absolutely no money coming in, can’t buy supplies if there were, and the bank is refusing (rightly) to make such a loan at any rate. So, yes, this dark view does argue for a sharp rate cut when serious economic disruption hits. But it’s a very small salve to the fundamental problem.

So, as I consider the potential chaos of a reasonably long economic shutdown, monetary policy is about 10th order and the level of overnight rates about 100th order. A detailed financial disaster plan is about 3nd order. Getting people to stockpile enough liquid assets ahead of time is second order.  Public health plans, also apparently being made up on the fly, are first order. My guess is that our government has even more drastically underinvested in the financial pandemic plan than it has in the public health pandemic plan.

Corona virus may seem small. «Only» 2% of people die from it. If it sweeps the planet unchecked, that’s 150 million people, on the order of WWI, WWII, Stalin, Hitler and Mao put together, though less concentrated and somehow, as in 1918, less vivid. And corona virus is our Bear Stearns. We’ve had SARS, MERS, Ebola, various flus, and now corona virus. Globalization leads to pandemics. Remember 1350 and 1492 as well as 1918.  There will be more. In the next 100 years there could easily be one with  20% mortality that shuts down the economy down for a year.  Can our economic and political system handle that? Are we faintly prepared? People who say climate is the worst problem facing civilization have a remarkable lack of imagination in my view. Maybe we should be spending 1/1000 of the resources that go in to energy policy on pandemic prevention.

John H. Cochrane

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me «the grumpy economist,» and hence this blog and its title. In real life I’m a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I’m also an adjunct scholar of the Cato Institute. I’m not really grumpy by the way!