Optimal economic policy during COVID-19

One of the questions students ask me is about the optimal economic policy response to the COVID-19 crisis across different countries. Speaking about optimality in economics involves thinking about the main tradeoffs that policymakers encounter. In the context of the current pandemic, the most relevant decision margin is between the number of lives saved and the economic cost of social distancing measures. These two objectives are in direct opposition to each other, which is precisely why the optimality question is so compelling to the pundits of the dismal science.

Unpleasant tradeoffs for fiscal authorities in advanced economies

While the virtue of saving lives is—at least one would hope it to be—self-explanatory, the not-so-obvious insight that economics brings to the table is that averted deaths come at a steep financial and human cost. As a consequence, both benefits and costs need to be taken into account when designing policy. Life is priceless; nonetheless, decision-makers are expected to contemplate implicit tradeoffs when deciding, for example, the duration of a lockdown or the amount of precious fiscal resources dedicated to supporting struggling households and firms.

The fiscal outlook is further complicated because, during lockdowns, governments must allocate limited resources across many competing needs.  The allocations that end up materializing depend on the valuation that policymakers give to different societal needs. What data has revealed thus far is that the priorities of most fiscal authorities revolve around keeping healthcare running and minimizing job losses and firm bankruptcies during the crisis.

In countries with advanced economies, government implementation and expansion of a variety of fiscal policy measures reflects these priorities. Substantial investments in hospital equipment and infrastructure, testing, and subsidies for the development of a low-cost vaccine reveal that healthcare is at the top of the list. Likewise, the implementation of direct cash transfers, unemployment benefits, tax credits, and direct loans to struggling firms shows that preventing household income losses and firm bankruptcies is another clear priority.

An increase in taxation—whether it targets the wealthy or not—looms for countries where growth has proven elusive.

The implementation of such measures places severe pressure on government budgets. Fiscal pressure has already led to massive deficits, (i.e., differences between expenditure and tax revenues). To finance these deficits, governments in advanced economies have responded by issuing new debt by selling treasury bonds in their own currency, since the painful memory of austerity and spending cuts after the 2008-09 financial crisis is still too fresh in society’s collective mind. In turn, treasury bonds have been on high demand in capital markets because international investors are willing to give up the relatively higher returns offered by stock markets for the safety granted by government securities. Hence, debt-to-GDP ratios are projected to rise sharply over the coming year.

This increase should not be a problem for those countries that are well-positioned to grow over the medium-run and enjoy the privilege of advantageously low interest rates. Although unintuitive, this famous “debt dynamics” insight follows because future growth in GDP stabilizes the above ratio by making the denominator increase at a faster pace than the numerator, effectively preventing the real burden of debt from spiraling upwards, in the same way as a successful professional can pay her student loans after a promotion. In contrast, an increase in taxation—whether it targets the wealthy or not—looms on the horizon for countries where growth has proven elusive. In the latter case, the implicit tradeoff for policymakers is between current livelihoods and future financial well-being.

Besides these tradeoffs, governments face the unaccustomed challenge of keeping essential public services running, including trash collection, public transport, police, fire, and emergencies. These services are usually the responsibility of local governments, which currently cannot afford to raise property taxes or parking fees without exerting undue pressure on local economies. Inevitably, local treasuries will have to borrow and issue new municipal and state bonds. Therefore, it will prove crucial for federal governments and monetary authorities to establish effective coordination with these lower government levels, especially in the short-run, when financial commitments are harder to modify.

Monetary authorities providing liquidity and financial stability

The list of available policy levers is not limited to the fiscal side. Monetary authorities incentivize commercial banks and other non-bank market participants, such as investment funds, to provide loans to struggling companies through a variety of policy tools, including lowering the policy rate, purchasing bank assets, and procuring stability in financial markets.

The policy rate is the short-term interest rate at which banks and other depository institutions can borrow from other banks to meet reserve requirements. These requirements, set by regulation, are the percentage of the deposits owed by a commercial bank to its customers that must be kept overnight in the central bank. Lowering policy rates helps commercial banks borrow reserves and extend credit to more firms without infringing regulations.

The role of central bankers in guarding financial stability is hard to overstate.

These days, policy rates are already at the zero lower bound (policy rates lower than zero would imply a secure loss for lenders). Therefore, central banks provide additional support to financial markets by purchasing assets from banks, such as bundled mortgage securities and private company bonds. These purchases act as immediate “liquidity” injections to financial markets, while central banks keep assets that mature in the long-run. This policy measure is not the same as monetization, the simple act of printing money to finance the needs of the public sector—a practice long-abandoned by advanced markets but still somewhat frequent in fragile economies.

Finally, the role of central bankers in guarding financial stability is hard to overstate. Official communication has literally prevented the meltdown of financial markets. The act of communicating the state of the economy and likely future course of monetary policy to market participants is known as “forward guidance.” Competent central bankers provide guidance even in times of extreme uncertainty, such as the current COVID-19 crisis.

Key challenges in developing countries

The complexity of the fiscal and monetary outlook is a heavy burden for advanced economies, but the delicate act of balancing policy priorities is even more challenging to handle for emerging economies. In particular, developing countries face three key challenges to overcome that are absent in advanced economies: lack of access to international credit markets, labor informality (i.e., non-compliance with labor regulation and income taxation), and stunning drops in the prices of the goods and services they provide.

Access to international credit markets varies widely in the developing world. Most mid-income countries can issue debt, albeit at relatively higher interest rates and generally worse credit conditions than advanced economies. Institutions like the International Monetary Fund [IMF] will help countries repay what they owe— although this type of help may not be of the kind needed to fund essential healthcare. Still, despite the sizable credit facilities at their disposal, some previously-stable economies will enter financial distress, and some already distressed economies will likely default over the coming years, ultimately leading to abrupt declines in capital inflows and income. Some other countries do not even enjoy the confidence of international investors and will have to scratch with their nails, so to speak, and resort to excruciating spending cuts in priority areas like education.

World demand for the commodities most commonly exported by developing countries—metals, rubber, and other materials needed for industrial production— has plummeted.

Labor informality is an especially tricky obstacle to overcome because it makes the traditional social insurance systems that provide healthcare, disability, and unemployment insurance impossible to implement. Informal firms and workers do not pay income taxes and, therefore, do not exist in revenue administration databases. In turn, unregistered workers who operate below government radars forego unemployment benefits (as well as regulation and taxation). The severity of this matter is further complicated because most informal workers live on their daily income. In response, some governments have resorted to beneficiary lists from their own anti-poverty programs to channel cash transfers, although with little success, since beneficiaries do not always have taxpayer identification numbers, and not all affected workers receive poverty alleviation transfers.

To make things worse, world demand for the commodities most commonly exported by developing countries— including metals, rubber, and other materials needed for industrial production— has plummeted over the past few months, resulting in severe price reductions. The same has occurred with oil prices, owing to the decline in driving and other forms of fueled mobility, as well as the reduced tourist trade. These severe demand contractions translate into a tax revenue downfall in sectors that traditionally comprise a large share of the budget in developing nations.

Structural change

Beyond these short-term fiscal implications, we appear to be entering a deep global recession. The initial consensus between economists around the forecast of a momentary interruption to economic activity and a v-shaped recovery seems to have lost ground against the alternative of a long-lived crisis and u-shaped recovery. Therefore, the design of long-term fiscal policy is becoming a central issue. In particular, a lesson that emerges from the crisis is the need for some form of universal social insurance. At the very least, the now-uncontestable observation that the groups at a high risk of contagion include mostly low-income individuals and wage workers makes the case for universal healthcare insurance stronger than before. Long-term expansions of social insurance systems may have to enter public budgets in the future.

Financial support to all struggling businesses may cease to be a feasible option.

Another implication of a long-term crisis is that the economic shock no longer represents a temporary fluctuation in the business cycle but begins to be viewed as part of a structural and permanent shift in economic activity. Therefore, universal countercyclical measures such as unemployment insurance and loans for small businesses, primarily aimed at cushioning the impact of a cyclical and temporary downfall, lose attractiveness relative to targeted policies designed to help economic agents adjust to the “new normality.” Stated bluntly, financial support to all struggling businesses may cease to be a feasible option, and those not projected to be profitable in the medium-run may have to be allowed to exit the market.

In turn, the process of Schumpeterian “creative destruction”—admittedly more destructive than creative in the short-term—may result in innovation by reallocating valuable human and physical assets into entirely new activities. These projections are particularly valid for sectors currently posed to suffer sizable losses given the current state of affairs, such as restaurants, entertainment, hospitality, and travel.

Good policies

In this context, three especially compelling policies come to mind: financing the expansion of digital technologies, online higher education, and support for first-time job seekers. Leveraging digitization means expanding the essential infrastructure for broadband internet, such as 5G towers and internet balloons, as well as developing FinTech innovation. Undoubtedly, internet access will help bridge the technological divide that currently exists between and within countries. In contrast, FinTech innovation will help both new businesses to reach more customers through electronic payments options and governments to reach vulnerable sectors of the population.

Online higher education is perhaps the single most beneficial revolution that could come out of COVID-19. The past few economic crises have had a disproportionately detrimental effect on low-skilled workers, and technological progress threatens to erase many of the jobs that require only secondary education. While online higher education may provide an affordable alternative for low-income individuals to invest in human capital, universities that find the most attractive online platforms early in the race will raise their revenues by alluring new students into their courses.

Support for first-time job seekers is also emerging as an area that, if left unattended, may represent a severe threat to society in the near and distant future. Economic research shows that workers that start their career on the “wrong foot” have trouble getting back on their feet. Beyond the damage done to the lives of the cohorts at risk of starting a less-than-impressive “career,” lengthy unemployment spells are fertile ground for political radicalization and divisiveness.

Bad policies

As bewildering as this may sound, uncertainty has become the new constant. We are uncertain about the prevalence of the infection and the future course of the pandemic. This situation opens the door for unwisely conceived and hastily implemented policies that could backfire in the long run. The weakening financial health of the overall economy is prompting leaders to reopen the workplace.  In an uncertain environment, however, it is vital to act with caution. Sudden reopening is an audacious bet; consequences could be dire. Risk-averse leaders may find it wise to prefer gradualism over cold-turkey strategies.

In spite of significant disagreements over timing, all agree that reopening is necessary to avoid further economic damage. That said, policymakers should reject blunt instruments in favor of intelligent reopening plans that take account of the many possible contagion channels. After all, it never pays to be penny-wise but pound-foolish.


Alejandro Estefan is assistant professor of global affairs at the University of Notre Dame’s Keough School of Global Affairs. His research focuses on development economics, labor economics, public finance, and macroeconomic policy.

This article is part of a series of blog posts published by the Keough School of Global Affairs. Dignity and Development provides in-depth analysis of global challenges through the lens of integral human development.



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