There is widespread misunderstanding of the
economic nature of the lock-down and the effects of monetary and fiscal policy
during a lock-down . This note attempts to clarify the different elements, so
that correct policies can be devised, with particular reference to Indian
lock-down. However the analytical approach and several conclusions are equally
applicable to other countries which have imposed a lock down or Social
confinement of citizens in their homes.
Equilibrium: Essential Goods & Services
The Indian lock-down, closed all economic
activity, except Essential goods and services, through an order of the Union
Govt under the Disaster Management Act. The bulk of Essential commodities
consist of food and beverages and its entire supply chain up to the consumer
including related transport and sale. Essential services also included Government
administration, electronic communication & media services. We estimate,
that these constituted 40% of Gross Value Added and about 55% of employment.
Except for administrative glitches and minor disruptions, this part was almost
fully functional(>90%), with Demand matching Supply at approximately levels
prevailing before the pandemic. Consequently it can be assumed that both
incomes and tax revenues originating in this sector of the economy are also at
levels prevailing before the pandemic.
Equilibrium: Non-essential Goods & Services
With the rest of the economy closed there is
no production and supply of "non-essential" goods and services. With
supply zero due to Govt imposed lock-down, there is excess demand for the goods
and services in this part of the economy but it's not expressed, in the market,
because the markets are shut by Govt order. So effectively there is a
demand-supply equilibrium at zero. Note that even the govt is unable to
actualize the demand for non-essential goods and services because supply is
shut.
Assume, for the
moment that there are no legal obligations on the economic agents in this part
of the economy. Then both incomes (of workers and owners of capital) would be
reduced to zero, as would all the tax revenues of the Govt's from this sector of
the economy. Private individuals would still have to buy essential Goods and
services to survive. Those who do not have liquid funds would therefore be
desperately in need of transfers to survive. It would be the primary duty of
govt to provide such transfers to ensure survival of those with no or little
savings to fall back on. Those with accumulated savings would use these savings
to purchase essential commodities and thus become net disasters. The savings of
their counterparts in the essential goods and services sector would however
increase, because they would be unable to spend that part of their income which
they normally spent on non-essential goods and services. The net effect is
likely to be a decline in private saving rate given the relative size of the
two parts of the economy.
Govt Fiscal Balance
Govts revenues
from and expenditures on non-essential goods and services would also be zero.
As taxes on essential goods and services are generally less than on
non-essentials. On the expenditure Govt would continue to pay its govt
employees as they are considered essential. It would not, however be able to
purchase any goods and services to carry out projects and programs so these
would halt. Given the relative size of wages and commodity purchases by the
Govt, the net effect of the lock down is likely to be an increase in the
deficit from pre-Pandemic levels, but not by big amounts. To the extent,
Welfare transfers increase to ensure survival of workers and self employed in
the non-essential commodity sector, the deficit would increase further, but
there is an upper limit, given by the normal consumption of essential
commodities by the poor. Any further increase in transfers to the poor or
transfers to the non-poor will have No effect on the economy. ie fiscal
stimulus is irrelevant to an economy in lock down.
Legal Asymmetry & Force Majeure
The key problem
for the economy in lock-down is asymmetric legal contracts and Government policy
and rules which impose asymmetric obligations on employers. Examples of the
former are rental agreements, loans taken with obligation to pay interest and
repay debts. Examples of the latter are labor laws which keep employers from
reducing work hours and wages or fire them, or arbitrary decisions of State
Governments to keep paying full wages to employees who are sitting at home due
to lock-down. The lock-down therefore creates a threat of mass bankruptcy of
firms (SMEs & Household enterprises) in the non-essential sectors. The govt
must suspend such asymmetric contracts, so that mass bankruptcy is prevented.
Fiscal Policy during Lock-down
The central bank's obligation is to provide
enough short, medium term liquidity, but the Govt has to backstop this through
risk sharing and credit enhancements of lending to firms under threat of
bankruptcy. Any transfers to firms and individuals who have sufficient savings
to meet their normal demand for essential goods and services, do not have any
effect on aggregate effective demand, only on the ability to restart their
business after the lock-down is lifted.
To summarize, targeted Govt transfers to
those who do not have enough family savings to maintain their normal
expenditure on essential goods and services. Beyond this no govt stimulus is
possible. The only effect of any other govt transfers is to reduce net debt
creation and/or stave of bankruptcy of firms. The only feasible objective of
Govt during a lock-down, is to ensure no individual goes hungry and to Stave off
Mass bankruptcy in non-essential goods & services. Monetary policy has to
work closely, in tandem with Fiscal policy to achieve the latter policy by
providing enough liquidity to the banking system and securities markets that
underpin and anchor the payments and credit system and to every systemically
important segment of the financial market (NBFCs, Mutual Funds) to ensure that
liquidity problems in any institution, don't translate into insolvency and
contagion.
Phased Unlocking: Transition From Lockdown To Normalcy
While phasing out
the Lock-down the most important distinction to keep in mind, is between
individuals as consumers and individuals as workers, professional service
providers, mangers and owners of businesses & companies. It is possible to
minimize transmission of Corona Virus while speeding economic recovery, by a
combination of quicker freeing of production and supply and slower
normalization of interpersonal and social freedom.
The second important dimension, which is
critical to efficient and cost effective transition, is that between Contact
Services, which contribute about 10% of Gross Value Added (GVA) and employment, and
Manufacturing, mining, construction & allied services(MMC&AS) , which
contributes 50% of GVA and about 35% of employment. By their very nature,
former involve mass contact with many other individuals in confined spaces,
while in the latter, supply chains are fragmented and spread out
geographically. A similar two speed approach to these two sub-sectors of
non-essential G&S, is necessary to optimize the trade-off between health
and income. The overall goal is to minimize spread of virus through social
contact while resuming economic & income generating activity while taking
all necessary and feasible precautions at the workplace, in transport of
workers and in sale of goods.
The third dimension of the transition is the
definition of confinement/quarantine zones which must be isolated, red zones in
which all Contact services must remain locked down even as MMC&AS is freed
to ensure that supply chains function smoothly and orange zones where social
activity remains severely constrained eg by night curfew and green zones where
even personal services can be liberalized.
Given some
version of these policies, what is the economic nature of the transition? While
the problems of personnel stress among the poor and the threat of mass
bankruptcy among in business and trade begins to ease it does not disappear;
the latter becomes less widespread but more acute in selected industries,
requiring a narrower focus. The new problems relate to the fragmentation of
supply chains, and divorcing of workers from workplace, resulting in local
and/or regional pockets of demand-supply imbalances in markets for goods, labor
and working capital. While RBI has to focus attention on working capital &
credit, the Union Govt has to focus on smoothening inter-state flow of goods
and allied services and the State's on ensuring the intra-State flow of goods
& services(within State), with close cooperation of the Union Govt on both
matters.
With lockdown
remaining in contact sectors, the question of stimulating demand in this sector
does not arise. Demand & supply are both closed by Govt intention and feat.
The critical issue in MMC&AS, is one of fragmentation of demand and supply
and not of a shortage of aggregate demand. The aggregate imbalance will become
clear, only after national supply chains in all industries are functioning
smoothly will the aggregate demand picture become clear.
During this
period Governments normal project, program & developmental activities will
and must resume. However, it's unclear to what extent these need to be stepped
up beyond levels budgeted in February. By the nature of the transition outlined
above, there will be much greater need for flexibility on the part of both
State and Union Govt. There would be a need for speeding up projects in certain
geographies where there's excess supply and to slow down activities in
geographies where there is excess demand, to smooth imbalances instead of
aggravating them.
Fiscal Stimulus Post-normalization
We can however,
anticipate the nature of the aggregate imbalance, which will need to be acted
on as supply chains start functioning normally. This is the sharp reduction of
income in the contact sectors, and its effect on demand in the MMC&AS. Thus
the issue of fiscal stimulus will become relevant as the issues arising
directly from the economic lockdown are resolved.
Govt should
prepare a three pronged strategy. One is revenue-negative tax reform which
gives a boost to demand in short term, raises entrepreneurial optimism and the
buoyancy of the tax revenues. This can be done jointly with States through the
GST council by simplifying and reforming the GST and by the union govt alone by
simplifying and rationalizing the Direct Tax Code. Both these will immensely
benefit the SME sector which faces the greatest thereat of bankruptcy during
the transition. Replacement of the entire subsidy system by an Aadhar linked,
mobile payment based Direct Cash Transfer system, will greatly enhance the
ability of the Union and .state governments to ensure that those most effected
by the Pandemic receive the most assistance form the government in the most
timely manner. The third leg of the stimulus will be targeted expenditures and
short term subsidies for those contact services, in which fears of contagion
continue to depress demand, even after lockdown has been completely lifted.
These subsidies should provide capital assistance for creating a new
environment of safety to calm fears of consumers.
Conclusion
Economists should be very careful in
prescribing or demanding a Fiscal stimulus which will have no positive outcome,
but can do great harm by diverting Government's attention from problems it must
address during a lockdown and while phasing out the lock down and transitioning
to normalization. Once the economy returns to a semblance of normalcy normal
fiscal issues return to the fore, and will have to be addressed along with
critical need for reforming the fiscal system to promote growth recovery and
return to its potential.
