QE is the best way to go to quell the Covid-19 economic crisis
A government stimulus package that is too small will wreak far greater havoc down the road than one too big
SA faces its biggest economic crisis ever. The government’s announced R500bn package is a good start, but indications are that the stimulus is too small. A larger stimulus cannot be financed using conventional mechanisms. Instead, the government must use quantitative easing (QE), both to offset the collapse in demand and to finance government expenditure.
Interest rate cuts will help, but the response to this crisis has to be driven by fiscal policy because only fiscal policy can replace lost wages and revenue. An inadequate stimulus risks turning a recession into a depression.
How can a stimulus avoid this fate? The first goal of a package should be to reduce the negative, long-term impact of the Covid-19 crisis. A catastrophe this large will reduce the growth rate of the economy in future, possibly for decades. A response that does not mitigate this damage sufficiently will lead to a worse negative impact via the effect on balance sheets.
If household wealth decreases because of missed salaries or lost employment, there will be less to spend in the future. If businesses become insolvent they will not exist to produce goods and services in the economic upswing. This will cast a shadow, known as hysteresis, from the current downturn into lower growth in future.
This is not a normal fiscal stimulus because the root cause is an economic shock resulting from the government policy to deal with a health crisis. That imposes some responsibilities on the government. It means it should ensure households and companies do not suffer losses for the cost of complying with the coronavirus lockdown.
A small package could lead to starvation, hundreds of thousands of job losses and thousands of company bankruptcies ... If the package is too large, it would result in some inflation
The second objective of a stimulus should be that, as far as possible, both households and businesses need to be made whole. Households should not have to miss salaries or increase debt because of lockdown, and businesses should not have more debt or become bankrupt.
The third goal is that the government needs to fill the output gap, the difference between what GDP would have been without a crisis and what it is now. The government needs to respond to the output gap because the private sector will not be spending. Private companies will be trying to reduce their expenditure as much as possible because their balance sheets have suffered. Consumers, too, will be spending as little as possible because they are unsure as to how long they will be employed, or they may have already lost their jobs. Only the government can spend in this environment.
The package should offset most of the output gap. It should not be the whole output gap because spending by the government will induce some extra spending by the private sector. But the size of the output gap is unknown. The current government plan is based on an output gap of about R300bn. Recent data suggests this underestimates the impact of the pandemic.
For instance, US GDP declined 5% in the first quarter of 2020, when the full impact of the Covid-19 lockdown only occurred in two weeks of that quarter. Forecasts for the second quarter are for an annualised decline of 20% to 45%. The European Central Bank is forecasting that EU GDP will decline by 9% in 2020, with a worst-case scenario drop of 15%.
In SA, early forecasts were for a 6% decline, but more recent forecasts have been for a decline of 10% of GDP or more in 2020. There is still a lot of uncertainty around any GDP forecast because there is no clarity on how long the lockdown will last, or whether a second wave of the virus might lead to further lockdowns.
QE is the cheapest method of financing a deficit as it is free. QE has a positive impact on the rest of the government’s debt portfolio
It is difficult to know which of these forecasts is correct ahead of time, but there is a trend emerging that the scale of the contraction is so large that the current government package is inadequate. If the package is too small the economy could remain demand-constrained for years to come.
How should the government proceed, given the uncertainty about how big the stimulus should be? The risks of getting the size of the package wrong are asymmetric, and this should inform the response.
There are much worse consequences from a package that is too small compared to a package that is too large. If the stimulus is too small it will result in large declines in the wealth of households and businesses. Put differently, a small package could lead to starvation, hundreds of thousands of job losses and thousands of company bankruptcies. These problems will persist during the crisis period and in the years afterwards when the companies that should be increasing production and hiring workers do not do so because they no longer exist.
If the package is too large, it would result in some inflation. This is a much smaller problem, and it is also a problem SA, particularly the SA Reserve Bank, is adept at solving. All it would require is conventional monetary policy through interest rates and open market operations. Given the uncertainty about how large the package should be, it is wise to have a package that tends towards the too-large rather than the too-small.
The key stumbling block is funding a large stimulus, as conventional financing through government borrowing is approaching its limits. The government needs to use QE, allowing the Reserve Bank to fund government operations.
There are valid concerns about the use of QE, the primary one being that QE could result in higher inflation. Most examples of hyperinflation have involved monetisation of debt and recently QE has mostly been used to fight deflation.
The SA economy is suffering from two significant deflationary shocks from the large impact of the lockdown on demand and the fall of the global oil price. QE would be a useful tool to counteract these shocks. It is difficult to see how hyperinflation occurs when there is such a large deflationary shock.
Even though economic conditions are so dire that inflation is unlikely to be a concern, it would be prudent to guard against any large increase in inflation. QE purchases need to be in discrete amounts and take place over a period of time to gauge the inflationary response. For instance, the Bank could purchase R20bn-R30bn of bonds per week. If inflationary pressures start rising then this amount could be reduced or stopped completely. In the worst-case scenario, purchases would be stopped and effectively reversed by the Bank selling bonds, which would reduce the amount of liquidity in the market.
The Bank could also start paying interest on bank reserves. This would incentivise banks to hold excess reserves with the Bank rather than lending them out, reducing the growth in money supply. The US Federal Reserve used a similar strategy during the global financial crisis to offset the inflationary impact of QE. This resulted in excess reserves held with the Fed increasing from just more than $2bn in 2008 to nearly $1.5-trillion in 2012.
QE is the cheapest method of financing a deficit as it is free. QE has a positive impact on the rest of the government’s debt portfolio as it pushes bond yields down. This improves fiscal sustainability.
If the government does not use QE, debt levels and interest rates will be higher, and there will be real concerns about the sustainability of SA’s debt. If policymakers are too cautious it could result in dire consequences for our workers and companies, as well as place the fiscus on the path to crisis. Bold policy will save us.
• Willcox, a former National Treasury official, is a principle consultant with Oxford Policy Management. This is a condensed version of a trade and industrial policy strategies policy brief.