Category: Policy Solutions

The Corona Shock is Different from other Supply Shocks

The coronavirus pandemic constitutes an economic shock, specifically a supply shock. In contrast to demand shocks, supply shocks cannot be offset by monetary policy. A supply shock will lead to a temporary reduction (or slow-down of growth) of output (Real GDP) and therefore a temporary reduction (or slow-down of growth) of consumption and living standards.

While the central bank is not able to prevent a supply shock from having a negative effect on RGDP, it is usually able to prevent secondary effects such as, for example, an increase in unemployment.

Supply Shocks – the Normal Case

A supply shock reduces the productive capacity of the economy. As a result workers need to accept lower real incomes. If nominal wages were fully flexible, they would adjust downwards. The number of jobs would stay the same. In reality, nominal wages are very sticky, so instead the number of jobs adjusts downwards unless the central bank keeps nominal spending stable.

If the central bank stabilizes aggregate demand (i.e. nominal spending), real wages will (as a result of price rises) fully adjust to the diminished productive capacity of the economy. Unemployment will stay the same. Only the composition of Nominal GDP (NGDP) growth will temporarily change (more inflation, less real growth).

The Corona Shock

The corona shock is also a supply shock but one which does not permanently reduce the productive capacity of the economy. Basically, the corona shock constitutes a temporary shutdown of large parts of the economy. There is, in principle, no need for real wages to adjust to a new reality of a less productive economy.

The goal should be to enable businesses which had to shut down temporarily to start right up again once health experts have given the green light for that to happen. What you don’t want is such businesses running out of cash before the restart of the economy. One way of doing this would be for businesses to put employees on temporary unemployment. The temporarily unemployed could then be supported by checks from the government or from the central bank during the time of the shutdown.

Furthermore, the central bank should make sure that businesses have access to credit to stay afloat during the shutdown. If banks don’t provide (enough of) such access, the central bank may even lend money to businesses directly.

The Simple Way to Avoid any Disruptions to the Flow of Imports to Britain after a No-Deal-Brexit

The deal negotiated by Theresa May is dead. The EU is not going to yield so there will not be a new deal. Hence, many now see a No-Deal Brexit as the most likely outcome. And it seems that much of the British political establishment and the population at large is suffering from a severe panic at the thought of the impact of such a No-Deal Brexit on the flow of imports to Britain. 

The important thing to understand is that, when it comes to the flow of British imports, the big distinction is not between Brexit with a deal and Brexit without a deal but between

    1. a deal that would keep Britain in the European customs union
      and
    2. a No-Deal Brexit or a deal that would not keep the customs union intact. 

Let us for a moment imagine that Britain had achieved a complete free-trade deal (i.e. zero tariffs) with the remaining EU. Would such a free-trade agreement avoid any disruptions to the flow of imports to Britain after its exit from the EU? The answer is “No” – if the British government did not also commit to zero tariffs on imports from the rest of the world.

Here’s why: the EU is not a free trade agreement like NAFTA; it’s a customs union, setting common external tariffs, which means that once you’re in, you’re in: once goods are unloaded at, say,  Hamburg they can be shipped on to anywhere within the customs union without further customs checks.

In the case of Britain leaving the EU with a free-trade agreement EU products could enter Britain tariff-free. But if Britain charged tariffs on products from (all or some) non-EU member countries, this would mean that EU goods entering Britain would still have to face a customs inspection in order to make sure that they were actually produced in an EU member country rather than, say, Chinese goods unloaded in Rotterdam or Hamburg and shipped across the border to bypass British tariffs. So there would be much more friction compared to today.

And frictions, not tariffs, constitute the greatest concern for British businesses relying on supplies from the EU. The risk of customs delays would make “just-in-time” production infeasible for British companies currently relying on prompt arrival of parts from Europe. They would have to maintain higher inventories, which would substantially raise costs.

Furthermore, in the short run things may turn quite ugly. After almost half a century in the customs union Britain does not have in place the infrastructure needed for the customs inspections mentioned above. Hence the fear of massive delays and of shortages.

However, there is a simple way to avoid any disruptions to the flow of imports to Britain after Brexit with or without a deal: unilateral free trade.

In this case the tariff would be the same for all imports regardless of where they come from: zero. Customs inspections would be unnecessary. Brexit – with or without a deal – would not lead to any friction regarding imports.

Anti-Corn_Law_League_MeetingA meeting of the Anti-Corn Law League in Exeter Hall in 1846