One of the main policy responses to the coronavirus pandemic has been to curb economic activity as a way of reducing the contagion’s spread. I would characterize this policy as a decision to reduce U.S. and world GDP in the short run by roughly 20 percent. In essence, this is a voluntarily implemented negative supply shock, akin to a sudden loss in productivity. The world’s annual GDP today is around $100 trillion, so a 20 percent cut sustained for a year would be about $20 trillion, roughly the annual GDP of the United States. For the moment, I assume that it is a good policy choice to engineer this reduction in GDP by $20 trillion worldwide, $4 trillion of which is accounted for by the United States.
What are reasonable monetary and fiscal responses to this fall in GDP? The usual idea would be to consider forms of economic stimulus that raise aggregate demand and, therefore, offset the fall in GDP during a recession. But this reasoning does not apply here because we have already determined that a sharp, short-term reduction in GDP — for example, by 20 percent for a year — is a good idea. From this perspective, it is puzzling that the Federal Reserve recently cut its main short-term nominal interest rate to zero and also implemented large-scale asset purchases. If the Fed’s actions stimulate the economy and, thereby, offset the fall in GDP, we would not regard that as a good thing, because the resulting increase in economic activity would presumably lead to an increase in the virus’s spread. Moreover, the present environment contains a serious threat of inflation — from the negative supply shock — and the Fed’s expansionary response will exacerbate that threat.
The only way I have come up with to rationalize the Fed’s rate cut is that a sharp rise in disaster probability has dramatically lowered safe real interest rates, manifested in the fall in yields on U.S. Treasuries throughout the range of maturities. From this perspective, the drop in the overnight rate on federal funds is just following the general decline in market nominal interest rates on U.S. Treasuries.
Various forms of expansionary fiscal policy are also being considered worldwide. In the United States, Congress’s recent package includes the federal government’s giving most adults a check of $1,200. To the extent that this kind of policy succeeds in raising aggregate demand and, thereby, GDP, it raises the same problems as the Fed’s aggressive monetary policy. In the current environment, we do not want to offset the 20 percent fall in GDP through inflationary fiscal policies; we want to stop the virus’s spread.
The threat of inflation is especially worrisome because, if it finally returns, it could well be accompanied by widespread price controls even worse than those of the early 1970s. One can just imagine politicians, starting with the president, complaining about the injustice in companies’ raising prices during an emergency and insisting that the federal government will not allow them to do so.
A smarter policy response would aim to prevent individuals who lose jobs from having little income to use for basic purchases. One reasonable way to do that is strengthening the existing social safety net. Notably, it makes sense to increase accessibility and benefit levels for programs such as unemployment insurance, food stamps, and Medicaid. These program expansions, some of which are in the massive relief package that just passed Congress, are much more targeted to the needy than the policy of passing out $1,200 checks to everyone.
It also makes sense that the recent package includes various policies aimed at limiting the permanent disappearance of businesses that would be productive absent the ongoing crisis. And it’s critical for the Federal Reserve to prevent major disruptions of financial markets, which it is already aggressively attempting to do.
As for the question hanging over all of this: Is it wise to engineer a 20 percent decline in GDP under these circumstances? Two things matter here: How much does one value the potential reductions in mortality this policy could give us and how much does the policy actually succeed in lowering mortality? The Great Influenza Pandemic of 1918–1920, which had a worldwide mortality rate of 2 percent, can serve as a baseline for answering both questions. Two percent of the world’s current population is roughly 150 million people, which we can use as a very rough upper bound for the number of lives that could be saved worldwide by curbing the ongoing pandemic.
To place a monetary value on the prevention of 150 million deaths, it is natural to make use of the extensive literature on the value of a statistical life. This research attaches monetary values to safety and health measures that reduce expected mortality, giving particular weight to the wage premium that workers require to accept riskier jobs. Typical recent estimates for the United States are around $10 million per life, but much lower numbers, around $1 million, apply in poorer countries. Even at the lower figure of $1 million, saving 150 million lives is worth $150 trillion, about 1.5 years’ of world GDP. In contrast, a 20 percent fall in the world’s GDP — if sustained for a year — is only about $20 trillion. So if the policy of cutting world GDP by 20 percent actually saves 150 million people, then it is more than worth the cost.
Much harder to know is whether the ongoing policy of constraining economic activity will actually hold back the spread of the pandemic and lead, thereby, to saving that many lives. The answer to that question should become a lot clearer in the weeks ahead, as we learn more about the dynamics of the coronavirus’s spread.