Markets, policies, and structural change during and after COVID

After the emergency responses and as the health shock appears to be under reasonable control, policy makers should turn to an evaluation of the measures that have been put in place. Some of the crisis responses, although crucial in the emergency, hamper the reallocation of economic activity across sectors and regions.

Such reallocation is now even more important because the shock is structural and likely to persist. The emergency measures have been characterized by their national character. The subsidies put in place can address distortions, such as those due to imperfect capital markets that result in liquidity constraints, but they can also distort fairness in the distribution. The response to a sudden dramatic crisis left little time to consider how they may hinder dynamic adjustment when some permanent reallocation is needed. It is now time to do so and accept less government interference in the business development.

During the lockdown, consumption concentrated on food, electronically delivered services, and home-produced leisure. Part of this reallocation will be reversed as economies recover, but some of it may well continue in the medium term. These changes will stem from households shunning certain types of expenditures because of health concerns, production costs increasing due to the need for employee and customer protection, and new business practices.

Moreover, although policies to maintain household incomes imply that aggregate consumption is recovering fast, business investment remains weak. This weakness is a combination of liquidity constraints and uncertainty about the future, and while the former may be solved relatively quickly given that investor confidence has fared relatively well, the latter is likely to remain for a considerable time since firms face increased uncertainty about both consumer demand and access to suppliers.

The drawbacks of emergency policy reactions

An aggregate shock’s welfare effects should be distributed evenly, but this is not what happened during the emergency, when the disappearance of most services markets hurt the poor the most.

The virus shock has had vastly different implications across sectors and individuals, as noted above. These structural changes have had and will likely have long-lived labor demand implications.

These policies (and similar subsidies to self-employed individuals) were useful for maintaining welfare and, potentially, expenditure during the lockdown, but clearly hamper the labor reallocation which will be needed during the recovery phase.

Undistorted market competition has traditionally been the key instrument for achieving growth. The benefits of efficient market interactions should be even more apparent after the lockdown experience, when lack of opportunities to buy and sell considerably reduced economic welfare. Banning industrial policy and state aid prevents inefficient producers backed by their governments from displacing lower-cost producers, which would increase production costs in an integrated goods market. Like doping in sports, such aid is better forbidden because if every country tries to give a competitive advantage to its producers, none will succeed, and much revenue will be wasted.

The need to reallocate out of the emergency

As economies start easing out of the emergency, two major challenges appear: reallocating labor to the “new normal” and dealing with the political economy consequences of government aid.

Another concern relates to the willingness of politicians to implement the necessary policy changes, since their actions are likely to be influenced by short-term electoral aspirations and the ease with which nationalistic instincts have risen during the crisis. For example, anti-competitive subsidies and regulations are politically more appealing when the resulting market distortions appear to damage foreign corporations (such as Amazon) and help small national producers. Politicians may try to ride on the wave of popularity that such intervention awakes, making them unwilling to remove popular but inefficient handouts.

Since monetary policy is exhausted, small appetite for consumption and investment in the private sector may call for fiscal policy. In that situation, region-specific instruments deployed to stimulate consumption and investment should not suppress the market-based reallocation that is necessary on the recovery path. Country-level policies may boost consumption without constraining the sectoral pattern of consumer expenditure.

In other words, government and the private sector have to work together to create smart decisions how to get the economy going, which means that companies have the guts to invest into their future and to hire people.

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