To Treat COVID-19’s Economic Impact, Start by Keeping the Lights On

The figure displays a version of a well-known circular money flow diagram used in economics textbooks. In simplified form, households own capital and labor, which they sell to businesses, who use it to make things that households then buy with the money businesses gave them, thereby completing the circuit and keeping the economy ticking over.

The key point is that the economy continues running only when the money keeps flowing around the circuit. Roughly speaking, a flow disruption anywhere causes a slowdown everywhere. The diagram here adds in a few more complications by allowing for a government and foreigners. It also separates consumption expenditure and investment expenditure.

The red starbursts show where the three types of shocks can disrupt, or are disrupting, the flow of money—the economic dynamo, as it were. Starting from the far left and moving clockwise:

Households that don’t get paid may experience financial distress or even bankruptcy—especially in the US, where medical bills are a major source of people going broke, according to bankruptcy statistics published by Debt.org. This reduces spending on goods, and thus the flow of money from households to the government and firms.

The domestic demand shocks hit the nation’s imports and thus the flow of money to foreigners. This doesn’t directly hit domestic demand, but it dampens foreign incomes and thus spending on the nation’s exports. This can slash the flow of money into the nation that used to be coming from export sales. In the 2008–09 global financial crisis, these two strike zones were particularly important, leading to what came to be known as the Great Trade Collapse.

The drop in demand and/or direct supply shocks can lead to a disruption in international and domestic supply chains. Both lead to further reduction in output—especially in the manufacturing sectors. The hit to manufacturing can be exaggerated by the wait-and-see behavior of people and firms. Manufacturing is especially vulnerable since many manufactured goods are postpone-able—things you can wait for without huge costs for at least a few weeks or months.

Businesses are forced into bankruptcy. Many businesses have loaded up on debt in recent years, according to the Bank for International Settlements’ 2019 Annual Economic Report, so they may be vulnerable to reductions in the cashflow. The bankruptcy of the British airline Flybe is a classic example. This sort of shutting down of firms creates further disruptions in the flow of money. Creditors don’t get paid, and workers often don’t get paid fully, and in any case become unemployed. To the extent that the firms that go under are suppliers to or buyers from other firms, the bankruptcy of one can put other firms in danger. This sort of chain-reaction bankruptcy has been seen, for example, in the construction industry during housing crises.

Labor is disrupted by layoffs, sick leaves, quarantines, or leaves to care for children or sick relatives. This is the last but perhaps most obvious of the strike zones. When workers lose their jobs—even when they have unemployment insurance or other income support—they tend to cut back spending on less necessary, more postpone-able items. The precautionary motives may be less evident for workers who keep their jobs but are taking leave, but as mentioned, this sort of leave is not recompensed in all G7 nations, or not for very long.

What should governments do?

The basic principle should be: keep the lights on. The COVID-19 crisis was sparked by a medical shock that will dissipate. It does not seem to be an especially deadly pandemic, so although many will die and each death is a tragedy, it is not like the plague; the workforce will not be reduced significantly on a permanent basis. The key is to reduce the accumulation of “economic scar tissue”—reduce the number of unnecessary personal and corporate bankruptcies, and make sure people have money to keep spending even if they are not working. A side benefit of this would be to subsidize the sort of self-quarantine that is needed to flatten the epidemiologic curve.

A number of excellent plans have already been proposed. My favorite, by Paris School of Economics’ Agnès Bénassy-Quéré and her coauthors, was posted on VoxEU.org on March 11.

Richard Baldwin is professor of international economics at the Graduate Institute, Geneva; founder and editor-in-chief of VoxEU.org; and former president of the Center for Economic and Policy Research.

This article originally appeared on VoxEU.org. VoxEU’s coverage of the COVID-19 crisis, which can be accessed here, includes two free e-books: “Economics in the Time of COVID-19” and “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes,” which explains the fiscal response the crisis demands.