The best kind of stimulus

No sooner was the ink dry on the March 27 $2 trillion stimulus package than Washington began work on the next stimulus. This is the right thing to do. Deficit hawks who worry about the debt-GDP ratio should want it, because without further stimulus, the debt-GDP ratio will soar because of crumbling GDP.

Both President Trump and Democrats are talking about infrastructure spending, although it is not clear they can agree on details. Infrastructure spending is clearly needed. But the overwhelming economic worry is that massive firings and bankruptcies will impose a deep and enduring drag on our economy long after the coronavirus public health crisis is over. Thus, the main aim of stimulus must be to promote firm solvency and job preservation. We simply need to protect the productive capacity of the economy, so that it can quickly rebound, once this medically induced economic coma is removed.

We have long held that mainstream macroeconomic models underappreciate the role of finance. Today’s crisis is a brutal case in point. Imagine all firms were debt free. How would they respond to today’s COVID-19 lockdown? Almost no-one believes that over the next 10 years, lockdown will be the rule. We can argue about 60 days or 3 to 6 months, but if you have going concern with a 20 year horizon, you could hammer out a strategy to get through the brief brutal fall for revenues, assured of a rebound when the Faucis of the world give the all clear.

In capitalist economies, however, capital structures have a habit of dominating in a crisis. Awash in debt, a company knows that even 60 days of de minimis revenues guarantees bankruptcy. Radical action, wholesale firing, is the only means by which a leveraged company can slash outlays and perhaps meet debt service needs. The impossible to fathom jobless claims data of the past two weeks makes it clear that this dynamic is in full force.

Just as stripping away finance can give a more sanguine picture, so to can one underappreciate the consequences of such firing, if one assumes frictionless markets. Companies fire amid the virus. They hire everyone back, once the virus is gone. Not in the real world. Not by a long shot. If we allow the jobless rate to soar to 20% in 6 months, the notion that it will retrace back to 3.5%, amid safe coronavirus news is comical. Hysteresis is a well known economic issue in labor markets

Thus, for this specific purpose, infrastructure spending does not seem the most natural choice. Rather we would look to several European countries which have offered to cover the wages of all employees (high wages excluded), as long as workers are not laid off. Companies can save cash as if they had fired their employees, providing the same improved opportunity to service debt. Workers are consumers and so this supports consumption. Workers don’t have to file for unemployment insurance which is putting strain on the unemployment insurance infrastructure. Most importantly, they can seamlessly resume their work and their spending when the crisis passes, making something of a V shaped recovery more plausible.

Indeed the US did something like this in the March 27 stimulus by making loans to small businesses that convert into grants if they avoid layoffs. But it only applies to a small part of the labor market.

Direct labor market support of this sort would be the best fiscal stimulus to pass at this point. The standard economists’ view is that the best thing is to let firms fail and support the unemployed workers instead. Supporting the failing firm, we normally think, prevents the recession from having its cleansing effect. But in the face of a once in a century pandemic, this is categorically the wrong approach. Clearly the lion’s share of the many firms and jobs that would be destroyed are perfectly viable in the long run. But for them to survive in the long run, the government must act forcefully and quickly.