Network News

Home News Network News Debating government financial intervention during a pandemic

Who to contact

Have a question?

Network News • 02-02-2021

Debating government financial intervention during a pandemic

Author: George Mangion
Published on The Malta Independent on Tuesday, 2 February 2021

It comes as no surprise that various governments have dug deep in their pockets (and borrowed hard) to help their economies during this pandemic. Is the government’s financial intervention aimed to give a stimulus to certain sectors a sign of rampant protectionism?

Economics lecturers remind us about John Maynard Keynes who was a prominent economist advocating government intervention particularly in extreme cases such as the Great Depression of the 1930s. Keynes advocated a demand-side theory calling for expansionary fiscal policy to stimulate aggregate demand and hence pull the global economy out of the depression.

More specifically, Keynes argued that in order for an economy to improve its conditions, greater government expenditure (injections to the economy) is required while simultaneously reducing the leakages within the economy by reducing taxes. Does this seem similar to what President Joe Biden is proposing with the US Senate for a $1.9 trillion treasure chest?

The policy is to donate a cash sum of $1,400 to every US citizen and help fund many start-up companies. Ex-US president Donald Trump had even lowered corporate taxes (from 35% to 21%) and promised greater government expenditure to rebuild the ailing infrastructure. Back to the Keynesian model, it believes that as the money in circulation increases, households and firms are able to spend and invest more money, hence stimulating aggregate demand.

Consequently, this higher spending generates higher levels of economic activity such that more output must be produced to meet the new higher demand, such that the demand for employment increases as well. In Europe currently, there is talk about fixing a universal living income that can guarantee workers a decent living threshold for all.

The theory goes to argue that as employment levels increase, people’s disposable income increases, which can be used to further increase one’s consumption and hence further stimulate economic activity. In short, Keynes proposed that government’s intervention is essential especially during times of crisis, such as the pandemic, which forced countries to order lockdowns and curfews, because through expansionary fiscal policy the government can stimulate aggregate demand and hence stabilise the economy.

Economists argue that Keynes’ economic reasoning contradicts that proposed by Adam Smith and other classical economists. The latter contend that economic cycles and fluctuations in employment and output would be modest and self-adjusting via market mechanisms. But such a theory did not function well during the recent financial crash of 2007/8.

Many observed that this self-regulating mechanism would not be enough to stimulate economic recovery and even stated that the rigidities and characteristics of market economies would exacerbate economic weakness and cause aggregate demand to plunge further.

In fact, during the past decade, the global economy (baring China) faced sluggish growth and relatively low-interest rates commingled with low inflation (under 2%). Here one may reflect that the Keynesian theory did not prove to be 100% correct even though it dominated the first half of the 20th century.

The next winner of the coveted trophy for the practical economic model was Milton Friedman. Friedman developed his theory, called Monetarism, which unlike Keynes’ theory emphasised the importance of monetary policy and free-market regimes over fiscal policy to stabilise the economy. Friedman argued that Keynesian economics focuses on short-term implications rather than on the long-term inferences of such policy actions.

As proven by past experiences, higher government spending will lead to short-term economic prosperity, but in the long run, it will result in higher inflation levels and eventually higher unemployment, hence the government’s actions would be futile and self-destructive.

This emerges because as the government undertakes expansionary fiscal policy, more money is being injected into the economy. As the amount of money available increases, money starts to lose its value, that is, gives holders a lower purchasing power (inflation).

As inflation increases, the Central Bank intervenes to bring the inflation rate back to its intended target by increasing the policy interest rate and hence discouraging investment and interest rate sensitive consumption. This then reduces economic activity, which eventually leads to unemployment.

Therefore, the initial government injection would defeat its own purpose in the long run, as it would lead to higher unemployment and lower output. The monetarism theory worked well for the latter part of the 20th century (except for stagnant growth in Japan) but not for the global economy, which suffered an unprecedented financial loss during the last recession of 2007/8.  Simply put, Friedman argued for free trade, smaller governments and a slow steady increase in money supply in growing economies.

On the contrary, the 2007/8 global financial crisis contradicted the criteria brought forward by the economic thoughts discussed in the aforementioned paragraphs. The crisis was preceded by long periods of rapid credit growth, low-risk premia, abundant liquidity, strong leverage and build-ups of asset price bubbles.

All these factors rendered financial markets and institutions vulnerable to even marginal fluctuations and when the asset price bubble burst in 2007, (sub-prime lenders started to default on their loan obligations) within a few months, the US financial markets started to collapse (remember Lehman Bros?).

Due to the high degree of the interrelatedness of banks and other financial institutions, this situation quickly spread throughout the global financial markets, leading to the worse crisis the world had experienced since the Great Depression of the 1930s. To this end, during the last decade, central banks turned to unconventional monetary policy tools, namely the Asset Purchasing Programme (APP), better known as Quantitative Easing (QE).

This technique was mainly adopted by the Fed., the ECB and the Bank of Japan. The medicine did not work and in 2021 global interest rates remain at their all-time lows, with some countries even registering negative rates. Despite the very low and negative interest rates, inflation has remained stagnant. In conclusion, during 2020 most governments joined in a race to the bottom by borrowing to the hilt.

The debt was used to finance jobs with a wage supplement under a nationwide furlough scheme. Such emergency funds did not come a moment too soon and one hopes that normality reigns once, at least, 70% of the global population is inoculated by the end of the year. Hopefully, demand picks up and firms start looking for new export orders.

Can AI come to our rescue to usher innovation and new growth? Governments are calling for a disruptive yet effective way for a post-Covid-19 Renaissance – one that unlocks creativity while building a supply-side revival. 

Author: George Mangion
Published on The Malta Independent on Tuesday, 2 February 2021
Get in touch:

See more Network News items