Some thoughts on supply vs. demand and the Covid-19 crisis, partly sparked by this very nice thread by @jasonfurman https://twitter.com/jasonfurman/status/1261750314753036291?s=20. To me, especially looking at the post-epidemic phase, a key aspect is how bad the Covid-19 shock is damaging future productive capacity
In fact, some argue that hysteresis effects are already showing up in Italy ( https://www.ft.com/content/e777c1ef-c031-42f1-8cb2-610920f7efbb). It is, however, probably early to say how large the legacy of Covid-19 on future potential output is going to be.
On the one hand, the Covid-19 recession might turn out to be short-lived, leaving a minor scar on investment. But bond markets seem to forecast a long period of slow growth ( https://twitter.com/paulkrugman/status/1259485404182560770?s=20).
Hysteresis effects might thus be larger than usual. Why is this important? Well, once the growth prospects of an economy start to crumble, agents revise downward their expectations of future income. In response, households cut back current spending – transforming the
supply disruption into an aggregate demand problem. And this is not the end of the story. Weak aggregate demand translates into lower profits, inducing firms to further reduce investment. Productivity growth falls even more, further reducing demand, and so on.
In fact, the Covid-19 shock might make this outcome even more likely, by inducing agents to coordinate expectations on a low-growth stagnation-trap scenario. All these considerations suggest that fiscal policies that mitigate the damage to future potential output are crucial
(e.g. subsidies to investment, liquidity provision to financially constrained firms, public investment programs). Not only these policies can reverse the supply-demand doom loop, but they can also ensure that expectations do not coordinate on a self-fulfilling stagnation trap.
Expansionary monetary policy can help too, but low interest rates limit its effectiveness. If you’re interested, here is a framework to think about these issues a bit more formally ( https://www.dropbox.com/s/7xmb3fpw4hg3xog/corona_board.pdf?dl=0, slides only – paper coming soon).
One last point. Risk of a stagnation trap is even higher in euro area countries worst-hit by Covid-19. The reason is that, due to high capital mobility, in the euro area financing fiscal interventions is complicated by the risk of capital flights ( https://twitter.com/LucaFornaro3/status/1255806239382044673?s=20).
You can follow @LucaFornaro3.
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