The Coronavirus Pandemic has fundamentally changed our world. But it hasn’t changed the validity of fundamental economic principles.
I suggest six and a half economic principles which I think are important to bear in mind during these times. Most of them were touched on by Christoph Kuzmics in his excellent series of posts. But I thought it would be worthwhile to state them in a pointed, if slightly oversimplified, way:
- People still respond to incentives.
So, for instance, allowing small businesses to re-open earlier than large ones means there will be more small and fewer large businesses. Paying higher unemployment benefits means there will be more unemployed people. Requiring people to wear face masks when doing X, but not when doing Y, means people will do more X and less Y.
2. World output still equals world income still equals world expenditure.
If you shut down X% of the world economy, the world will produce X% fewer goods and services, will have X% less income, and will spend X% less. The idea that we can somehow preserve everyone’s income and spending while shutting down the production of (most) goods runs into this basic adding-up constraint. The recession is the price we pay for the lockdown which at the moment is the only weapon we have to fight the pandemic (until we have a vaccine or medical treatments). Government transfers can change who gets to consume the goods, but they don’t change the amount of goods there are. (But also see principles 4 and 6 1/2!)
3. The price mechanism is still the best way of allocating scarce resources.
If the demand for toilet paper exceeds the supply at the current price, there are two options: either you let the price of toilet paper rise or you create a shortage. Allowing a higher price is by far the better option. A higher price gives producers of toilet paper an incentive to produce more of it and gives consumers an incentive to use it more carefully and economically. The same applies to face masks, ventilators, and yes, even to hospital beds.
4. Economic inequality is still best addressed by lump-sum transfers.
The pandemic will lead to more economic inequality, because the poor are hit much harder both by the disease itself (low income correlates with worse health conditions) and by the lockdown (most low-wage jobs can’t be done from home). The best way to address this is to give an unconditional transfer to all households (a.k.a. „basic income“) financed by a tax on something that is in fixed supply (at least in the short run): a once-off wealth tax for example. The second fundamental theorem of welfare economics still applies: we can achieve any desired allocation of scarce goods (including toilet paper, face masks and hospital beds) by lump-sum taxes and transfers while letting the market do its job.
5. The government budget constraint still exists.
Every euro the government spends needs to come from any of three sources: from taxes, from borrowing, or from printing money. But in the end, these are all just different forms of taxation. Government borrowing is delayed taxation: the government will need to pay back the debt with future taxes. Printing money is a tax on nominal wealth.
6. Public goods problems still exist.
Enforcing the lockdown requires the threat (and sometimes use) of force. (That’s why it’s called enforcing). Staying at home is a prisoner-dilemma situation. If nobody is policing the lockdown, going out of the house is a dominant strategy (i.e. it is best irrespective of whether other people stay at home or go out). Social stereotyping of defectors (public shaming corona-party-goers, for instance) can go some way, but is also just another kind of force. Some civil liberties won’t be upheld during the lockdown.
6 1/2. Government spending still has a multiplier effect (but it is probably small).
If the government buys more goods, some otherwise unemployed workers will be employed making those goods. Those workers will themselves be able to buy more goods, creating further jobs for otherwise unemployed workers, and so on. However, the multiplier logic doesn’t work quite as well during the lockdown, because some workers simply cannot go to work. Government spending can help prop up demand in those sectors that aren’t shut down, but as long as many labor-intensive industries such as construction are closed, the multiplier will be only slightly higher than 1.