While the world is undergoing its worst economic shock since 1929, policymakers are turning to John Maynard Keynes (1883-1946), founding father of the welfare state, who devoted almost his entire life to understand how to tackle such a situation. Firmly opposed to the neoclassical liberalism that didn't take into account life vagaries such as wars and pandemics, Keynes was skeptical that letting the markets running their course in recession periods would allow the economy to restore to a prosperous equilibrium and to achieve full employment. According to him, when people feel uncertainty, they tend to save more, leading to a demand fall and an economic contraction. In response, Keynes promoted the demand-side economics where governments should actively intervene in the economy borrowing and spending money to offset the lowering population consumption in order to keep the economy back on track. These large spendings intend not only to restart growth but also to make people regaining confidence in the future. Such measures are carried out by monetary creation, government debts and entail a deepening budget deficit by the same token. However, Keynes argued that we should first worry about people’s confidence and that debt should come upstage. At the Great Depression time, politicians didn't seem to feel the same way. Indeed, countries only began to apply Keynesian principles after WW2 - Marshall’s plan.
Nevertheless, how effective are these Keynesian measures? Under what conditions are they justified? Are they sustainable in the long term? This is what we will try to answer throughout this article taking first its theoretical analysis, then the current Keynesian policies put in place by governments. We will finally see the virtues but also the dangers they entail taking into consideration our very particular situation.
The Theoretical Keynesian analysis:
To understand how a pandemic-related depression generates a supply collapse, reduces the labor supply and how the state intervention is meant to spur the economy, let’s consider the Keynesian macroeconomic model. For this purpose, we will use two directly related graphical tools.
The first one is the AS/AD model. The basic idea is to take the intersection of the Aggregate Supply curve representing the GDP and the Aggregate Demand curve - including consumption, corporate investment and government demand- to achieve the economic equilibrium. Both describe the evolution of the GDP/income (Y) as a function of the price level (P).
The second one is the IS/LM model underlying the Aggregate Demand curve. It describes how the economic goods market interacts with the money market to balance the interest rates and the total output. The graphical representation shows the evolution of the interest rates (i) as a function of the GDP (Y).
IS curve reflects the interest rates and output balance needed for corporate investments and consumers savings to be equal. LM curve refers to investors demand for liquid assets and the money supply in the banking system. IS curve goes downward because lowering interest rates prompts companies to invest more. For its part, LM curve slopes upward because the higher GDP/income(Y) is, the more inclined central banks are to raise interest rates to encourage bonds transactions.
Following the containment measures, labor supply has fallen sharply resulting in a supply collapse. The aggregate supply curve subsequently shifts downwards. It thus pushes up the price level of goods and services as the output and income decrease such as shown in the figure below.
Figure 1*(Forbes): Shows how the supply drop negatively impacts the equilibrium between price level (P) and the total output/income(Y)
In response to this negative supply shock, companies reduce their corporate investments and consumers cut their expenses back at the same time shifting the IS curve leftward for a fixed price P (Figure 2). Income and output (Y) consequently decline along with the interest rates (i). While the income and corporate investments keep decreasing, consumption drops even further. This is translated in the Aggregate Demand Curve downward shift. (Figure 3). These are the consequences of the economic downturn.
Figure 2*(Forbes): Following the supply shock, consumption and corporate investment decline and IS shifts leftward
Figure 3*(Forbes): Shows the downward shift of the Aggregate Demand Curve following the supply Shock
"Though stimulus aim to boost consumption, lockdown measures strongly limit their virtuous effects of increasing real output. The risk is now to see price level soaring while keeping a low production level."
To tackle this kind of economic contraction, two options are available. On one hand, governments can resort to fiscal policies by increasing spendings such as the current unprecedented stimulus packages we will discuss later in this article. These will push the IS curve back to the right. And on the other hand, monetary policies undertaken by central banks aim at shifting LM curve to the right. Indeed, when central banks inject liquidities, it fosters investors to switch from cash to bonds without necessary increasing interest rates. Both these actions are meant to push the Aggregate Demand curve back up.
We notice that given the recession situation we are currently into, we are located in the upward zone of the Aggregate Supply curve. Though stimulus aim to boost consumption, lockdown measures strongly limit their virtuous effects of increasing real output. The risk is now to see price level soaring while keeping a low production level. Thereby, we notice that we need to find out a recovery plan which is neither too weak to entail deflation nor too strong to bring inflation. Thereafter, once the containment is lifted, the Aggregate Supply curve should recover. However, it will not necessarily mark the end of depression as long as the Aggregate Demand remains low. That is why Keynes already thought at the time that The Great Depression was rather due to a negative shock on the Aggregate Demand curve than on the Aggregate Supply curve.
"In order to reach full employment while keeping the price level stable, workers have to accept low real wages"
Now let’s take an insight towards the future and consider we are in recovery. When economic activity picks up, unemployment rate declines and prices start to increase. In response, workers ask for higher nominal wages to compensate their purchase power drop. This leads the Supply curve to move rightward lowering production and rising price level. Governments should here intervene to shift the aggregate demand curve rightward as well. Consequently, we notice on the figure below that this mechanism brings us back to the pre-crisis output level but at a higher price level though. Therefore, we can easily see that maintaining a high output and a high purchase power at the same time lead to an everlasting inflation. We conclude that in order to reach full employment while keeping the price level stable, workers have to accept low real wages.
figure 4*: Inflation scenario (Forbes)
Current Keynesian policies:
Now let’s focus back to less theoretical aspects and first take a look at what governments have done so far and what conclusion can we draw from the Keynesian theory. After all, we live in reality, not in a magical tale. As soon as the covid-19 damage on the entire economy started to be felt, governments have forthwith and legitimately applied Keynesian policies in order to relieve individual and households hardships as well as to cushion the economic disruptions. They have indeed loosened their fiscal policies and unveiled unprecedented stimulus packages. Even Donald Trump seems to be inspired by the european social model. After the BCE decided to buy eur900bn in extra bonds, UK promise a £350bn rescue package to help companies going through this period. For its part, France has vowed to spend up to eur300bn and Germany has agreed to take on eur750bn in new debt. The UK have announced to rise its public borrowing at its highest level since 1992 and to allocate three times more in public spending than the average of the last 40 years in order to finance public-works projects which would create new jobs.
The money injected in the economy is indeed earmarked to finance social spending, to help self-employed people, to bolster lending bank to provide low cost commercial papers, to support companies cash grants but also guarantees. Keynesian trend thus seems to be unanimous. It is indeed obvious that in order for the economy to go back on track after the crisis, it is essential to prevent it to collapse meanwhile. However, the resulting rise of states indebtedness comes at the expense of the public accounts and we know the consequences of such Keynesian measures. The Banque De France governor estimates a 3% recession cost and 2% additional deficit per month of confinement. But let’s be clear, a highly indebted country is a weak country and this weakness consequences are even more glaring in such a crisis time. While Germany has a debt of 64% of its GDP and is in budgetary surplus, France's is stalling well above at 98,4% with a 3,9% deficit. The crisis could even lead France’s debt to reach 120% in the aftermath. This explains why Germany is in a much better position than Frances’s to tackle the issue and to buy enough tests, reanimation beds, masks and respirators and how the lack of liberalism considerably undermines the ability to resist an economic shock. At the european scale, according to the IMF’s Fiscal Monitor forecasts, eurozone would see its debt reaching 100% of its GDP, straining the euro area countries. Indeed, states with the highest level of indebtedness such as Italy and Greece could top 155% this year while France, Portugal or Spain will exceed 100%.Therefore, in the post-crisis phase, these countries will face serious structural difficulties to invest in a strong recovery and to response to the increasing demand of welfare state, protection, and relocation.
On another note, while we are in a war against an invisible enemy and that wealth producers are confined, boosting consumption could cause inflation as seen in the Keynesian Theoretical analysis above. Therefore, it would rather be wiser to redirect our public spendings towards health sector first.
"Lastly, we will have sooner or later, or, would I say, as soon as the pandemic will be behind us to resort to a period of austerity mixed with a Schumpeterian economy to prevent our entire system from further suffering"
Finally, we have seen that Keynesian policies are undeniably justified in the current context and without states intervention the whole economy could likely collapse. They are useful in that we help companies not to go bankrupt, to pay their employees on short-time working and that we provide support for the self-employed. By after, we thoroughly need to be careful to prevent inflation and not boosting consumption too much as long as we are forced to stay at home. Instead, we should rather use state intervention to considerably improve the health care system to cope with the massive influx of patients in order to lift the containment measures as soon as possible and allow economic activity to resume. However, when this crisis is over, states will find themselves burdened by debt and budget deficit. Especially countries such as France, which were already in a bad position, will be particularly hard hit. Unfortunately, the risk is that it be households and businesses who will pay the price. It is also relevant to note that to avoid inflation in the aftermath, workers will have to accept a low real wage. Lastly, we will have sooner or later, or, would I say, as soon as the pandemic will be behind us to resort to a period of austerity mixed with a Schumpeterian economy to prevent our entire system from further suffering. Remains to be known whether some countries - such as our douce France- will dare to free themselves from the excessive bureaucracy and fiscal oppression that overwhelm them. This will enable them, in the event of a new crisis, not only to be better prepared but also to have more room for manoeuvre to use possible and Keynesian measures and tackle the issue properl...
Edouard Wauquier - Head of Corporate Finance