Nurturing a feel-good factor

It comes as no surprise that various governments have dug deep in their pockets (and borrowed hard) to help economies during this pandemic. Is this government intervention aimed to give a stimulus to certain sectors a sign of rampant protectionism? Economics lecturers remind us of John Maynard Keynes who advocated heavy government intervention (particularly in extreme cases such as the Great Depression of the 1930’s).

Keynes promoted a demand side theory calling for an 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 managed to fight for a $1.9 trillion treasure chest? Consequently, this higher spending generates higher levels of economic activity leading to more output to meet a higher demand. As can be expected demand for sustainable employment increases. In short, Keynes proposed that government 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 render themselves self-adjusting via market mechanisms. But this 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 (barring China) faced sluggish growth and relatively low interest rates commingled with low inflation (under 2%).

Here one may reflect that Keynesian theory did not prove to be 100% correct even though it dominated the first half of the 20th century. The winner of the coveted trophy for 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.

A successful revival strategy must incorporate six factors. Economic recovery is the process of reallocating resources and workers from failed businesses and investments to new jobs and uses after a recession. The recovery usually leads. towards a new expansionary business cycle phase. It can be compared to a healing process analogous to the body heals by breaking down and reusing dead and damaged tissue. Naturally, self-indulgent politicians can interfere with this process in a similar way that certain drugs interfere with the body’s healing process.

Closer to home, higher government spending on furlough schemes will eventually lead to higher taxation even though such a policy will not be ushered in at a time so close to a general election. The NSO said public finances registered an unprecedented deficit of 12% as government expenditure shot up to cushion the impact of the coronavirus pandemic.

Another huge investment in road building has kept the employment barometer especially in the construction sphere to register a shortage of workers. As can be expected, economists fear that inflation in Malta will return once the pandemic subsides.

Back to the discussion on global economic theory, the monetarism creed 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 increase in money supply.

On the contrary, the 2007/8 global financial crisis contradicted the rationale discussed in the aforementioned paragraphs. The 2007/9 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 collapsed (remember Lehman Bros). Due to the high degree of interrelatedness of banks and other financial intuitions, 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 Program (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 consequently this year global interest rates remain at their all-time lows, with some countries even registering negative rates.

In conclusion, due to the pandemic most governments joined in a race to the bottom in borrowing to the hilt. Debt was used to finance jobs with a wage supplement under a nationwide furlough scheme. Such plans did not come a moment too soon and one hopes that normality returns at large once 70% of global population is inoculated.

Hopefully demand picks up and firms start looking for new export orders. Unfortunately, dishing out cash vouchers to all (costing over €100 million) may end up propping zombie companies. Such practices can also do permanent damage to society by encouraging people and businesses to continue to think that pennies from heaven will continue to fall from the sky.

Closer to home - can the hon Dr Owen Bonnici, minister for Post-Covid recovery come up with a concrete revival plan? Surely this calls for a disruptive yet effective way culminating in a post Covid-19 Renaissance - one that unlocks creativity while building a supply side revival.