Fiscal responses to the coronavirus
March 31, 2020

Fiscal responses to the coronavirus

John Greenwood, Chief Economist, Invesco Ltd and Adam Burton, Assistant Economist

What’s happening now, and more importantly, what happens next will be critical in the fight to support the global economy.  

  • Progress on the virus front over the next two to three weeks in the US, Europe, and the UK will be critical
  • The shape of the infection curves will eventually determine the amounts of fiscal support each government is required to grant
  • While each economy has its own idiosyncratic features, there are numerous common elements with these sets of new fiscal plans
  • Each government has understood the imperative to act early and to act on a large scale
  • Each government has undertaken to act as a bridge to ensure funding for private sector businesses and employees so that the recovery, when it does come, can rapidly return to the pre-coronavirus status
  • But will these massive fiscal (and monetary) plans prove inflationary or deflationary?

For the short term we expect a deflationary environment to prevail, but in the longer-term inflation will be determined primarily by how the debts of the three governments are financed. If they are funded – like Japan over the past decade – mainly by private sector savings with very low rates of monetary growth, then inflation will struggle to meet the 2% target, just as it has done during the post-GFC decade.

If, however, the government deficits are funded either directly from the central banks (which we deem unlikely) or by the rapid creation of money in the banking system, then there is a greater chance of an inflationary outcome.

Given the pre-occupation of regulators everywhere with the safety and soundness of the banking system – which implies continuing to insist on numerous balance sheet restraints such as capital, leverage and liquidity coverage ratios – we thing it much more likely that economies will continue to experience sub-par growth with sub-target inflation, not the high inflation that some more excitable commentators are already suggesting.

We begin by re-stating the three broad principles that together can supply a solution to the current coronavirus pandemic and its devastating impact on financial markets and economies around the world.

First, and above all, the measures to tackle the health issue must be strong, comprehensive and science-based. Those countries that took forceful measures early on – such as South Korea, Singapore, Hong Kong, and – despite some early missteps – China, are paying a modest price; those that delayed and allowed the virus to become rampant are already paying a very heavy penalty.  So far, the response has largely been on a country-by-country basis; far more international coordination of countermeasures will be needed to ensure that the virus does not return in repeated waves.  Until the virus is under control – nationally and internationally – there will be limited prospects for a full and sustained recovery from the health crisis or the economic crisis.

Second, central banks must inject liquidity into financial markets to ensure that all the funding mechanisms needed for the economy return to normality as soon as feasible are operating smoothly. These extend from financing the huge government borrowing plans to enabling businesses and individuals in the private sector to make payments, meet obligations and receive the incomes on which they depend. These operations encompass both the traditional “lender of last resort” function of central banks (enunciated as far back as 1873 by Walter Bagehot in his famous book, “Lombard Street”) and the newer “dealer of last resort” function – i.e. restoring liquidity to markets where panic has caused spreads to widen so much that the financial plumbing was effectively blocked.

Third, the fiscal authorities need to become the “purchaser of last resort”. Only the government has the fund-raising capacity, the income transfer mechanisms and the spending-power to ensure that the bulk of cash flows in the private sector are maintained. By taking these actions, governments can largely stabilize aggregate demand or total spending in the economy. Because the shutdowns were government-mandated to save the entire community from the virus, central governments have an obligation to step in to provide funds for businesses, employees and the self-employed across the board. In addition, since many businesses could go bankrupt during the period of shutdown, the government should also provide compensation and balance sheet support to ensure that a viable private sector remains broadly intact, ready to participate in the recovery once the virus has been overcome. 

In this article we compare the fiscal responses of the US, the EU (as a whole rather than its member states) and the UK. Inevitably their fiscal plans vary much more than the monetary policies. In monetary policy the Bank of England and – somewhat later – the ECB have followed the template of large-scale balance sheet expansion initiated by the Fed. But in fiscal policy there has been a much wider variety of responses. This is due both to wide differences in tax, welfare, and other benefit systems in each economy, as well as due to the divergent priorities of the particular governments in power at the national or supra-national level.

In the United States, after days of party-political wrangling in the US Congress, Democrats and Republicans came together to approve a spending bill amounting to some $2 trillion to deal with the COVID-19 outbreak that is now rampaging across many states. The response by Congress has been relatively rapid but limited (less than 10% of GDP) and will almost certainly not match the actions of the Federal Reserve after all its programmes have been rolled out. The Coronavirus Aid, Relief and Economic Security Act creates or enhances several programmes to combat corporate cash flow problems, increases in unemployment, and tackling the coronavirus head on with more funding for healthcare initiatives. However, due to the structure of the US political system, whereby the Congress controls overall spending but the House currently has a Democratic majority, the President is unable to implement the kind of open-ended spending program that has been devised in the UK.

The major provisions in the bill can be grouped into five key areas:

  1. Support for households via direct payments – payments will be made directly to US households from the US Treasury: $1,200 per adult, $2,400 for each couple, and additional payments for children. These payments phase out for adults earning over $75,000 a year, or $150,000 a year for a couple. The total amount earmarked for this scheme is around $300 billion (1.4% of GDP).
  2. Support for businesses via bailouts/loans - $500 billion (2.3% of GDP) has been earmarked for specific businesses affected by COVID-19. Passenger airlines will receive $25 billion, cargo airlines will receive $4 billion, and companies that are “critical to maintaining national security” will receive $17 billion. The other $454 billion (2.1% of GDP) is for the Exchange Stabilization Fund (an entity operated by the Treasury) which in turn will effectively provide indemnities to the Federal Reserve against losses on loan or purchase schemes that have already been announced. The mechanism will enable the Fed to lend up to 10 times this amount ($4.5 trillion) to Special Purpose Vehicles (SPVs) that it will create to buy corporate bonds, support the municipal bond market, buy bond ETFs and lend to small businesses who have suffered from cash flow problems as a result of the COVID-19 outbreak.
  3. Increasing unemployment insurance - $250 billion (1.2% of GDP) has been earmarked for additional unemployment insurance payments. While it was expected that unemployment would rocket as the US economy is locked down, initial unemployment claims jumped from 282,000 to the astonishing figure of 3.3 million in the week ended March 21 (compared with the consensus estimate of 1.64 million), the most in history. Payments per person will increase by $600 per week for four months, with each state also contributing to the additional unemployment benefits.
  4. Increased funding for healthcare – through state and local governments, an additional $150 billion (0.7% of GDP) will be made available to fund hospitals, healthcare equipment, testing supplies, and increased hiring/training of medical professionals.
  5. Small business aid – loans and grants totalling $367 billion (1.7% of GDP) will be made available for businesses with fewer than 500 employees.

In the Eurozone, the fiscal response to the health crisis is somewhat similar in terms of principles to the US plan in the sense that specific and limited sums are authorized for targeted sectors. Again, there is no authority to spend “whatever it takes” as in the UK.

Thus, the member states have agreed to increase spending on health care systems, to allocate designated amounts for relief of sectors or firms, and to grant wage subsidies for workers. Together these two so far amount to about 2% of Euro area GDP.  (Note, however, that since this calculation includes the ½%-of-GDP easing of fiscal restraint that was included in last year’s budgets, the true amount is nearer 1½% than 2%.) In addition, the European Commission has agreed on government guarantees for bank loans to firms amounting to about 13% of GDP.

This so far rather restricted framework originates from the Euro area’s 20-year history of efforts to ensure that the budget deficits and sovereign debt of member states were in line with the Maastricht Treaty guidelines and its replacement, the Stability and Growth Pact (SGP). Although the European Commission formally suspended the SGP at the start of the week to deal with the coronavirus, the core ideology of the EU – the belief that all the member states must eventually conform to rules and norms set collectively in Brussels – remains strong. This is what has so far prevented the kind of open-ended spending that is possible in a unitary state like the UK whose fiscal policy is not subject to EU rules.

No doubt individual states will argue for special exemptions due to special factors or local circumstances (as Italy already is doing), and there will be pressure to provide funding to individual countries through collective mechanisms such as the European Stability Mechanism (ESM). Moreover, in the heat of the crisis the spending plans will grow: the loan guarantees are already higher than the 10% set only a week ago. Moreover, the larger member states such as Germany and France are setting their own course. In addition, both France and Germany have significantly increased their previous spending plans.

It should also be mentioned that the support that comes from the “automatic stabilizers” as economic activity weakens (i.e. the unemployment benefits and other supplementary income support measures which automatically kick in when economies fall into recession) will add to the total amounts spent. This spending could amount to another 2-3% or more of GDP, giving overall budget deficits of up to 5% of GDP.

For the EU as a whole it seems highly likely that these limited spending plans will need to be substantially revised upwards later this year, especially if the economic damage turns out to be greater than currently forecast and economic recovery proves elusive.

In the UK, the approach of the government has been drastically different to that of the US, or the Euro area. The UK government is adopting a much more flexible, “do whatever it takes approach” in fighting the malicious effects of the COVID-19 pandemic. Unlike in the Euro area, which is bound by several public spending rules (most notably the often-broken Fiscal Compact), the UK has no such binding fiscal framework and can react much more nimbly and robustly. In comparison to the US, the political situation in the UK is also much more straightforward; the Conservative party now enjoys a large majority to push through legislation effectively, whereas in the US the Democrats control the House of Representatives whilst the Republicans control the Senate, meaning any action from the authorities can be plagued with setbacks and delays.

Key provisions already put forward by the UK government are as follows:

  • £330 billion (15% of GDP) in state-backed loans for all businesses through the banking system with the help of the Bank of England, ranging from £25,000 up to £5m. There is also £20 billion in other aid available, as well as a business rates tax holiday (for this year). Key sectors being targeted are retailers and pubs, with help for airlines being considered.
  • The Treasury is to pay up 80% of wages for employees, covering wages of up to £2,500 per month. In tandem with this, there is a planned annual increase of £1,000, or £83 a month, in the basic allowance for a single person claiming under universal credit. Those who are self-employed can receive a taxable grant worth 80% of average monthly profits of up to £2,500 per month, in an attempt to replicate the scheme available for business employees. This is intended to be targeted support for businesses with trading profits of up to £50,000 per annum, which will affect around 95% of the 5 million self-employed population. Tax payments for the self-employed due in June can be deferred until January 2020.
  • Cash grants of up to £25,000 for small businesses.
  • Covering cost of statutory sick pay of up to two weeks.
  • Three-month mortgage holiday from lenders.

The government has also promised to increase funding for hospital beds, front-line medical and care services and supporting personnel. The UK government has said repeatedly that “whatever funding the NHS needs, they will get”.

Footnotes

  • Image: Visualspectrum/ Stocksy

Investment risks

  • The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Important information

  • Where John Greenwood and Adam Burton have expressed opinions, they are based on current market conditions, may differ from those of other investment professionals and are subject to change without notice.