Tyler Cowen has a short paper on the topic.

The key point is that in the short run we want economic activity to fall in ways that will curb the spread of the virus. In the long run, we want economic activity to come back.

In my view, the primary channel by which a short-term reduction in economic activity leads to a long-term decline is the financial channel. I have an essay on that, which I will post below the fold.

The Government as Financial Intermediary Responding to the Virus Crisis

by Arnold Kling

I remember reading once that it is still not understood how the giraffe manages to pump an adequate blood supply all the way up to its head; but it is hard to imagine that anyone would therefore conclude that giraffes do not have long necks.

–Robert Solow, “On Theories of Unemployment.” American Economic Review. March, 1980

Economists “see” the economy through the lens of simple mathematical models. Robert Solow saw a danger of this. When reality and one’s preferred model conflict, the temptation to nonetheless stick to the model can make an economist dangerous. I worry that mainstream economists are guilty of this, trying to apply a model of “aggregate supply and demand” inappropriately to a complex economy.

The direct effects of the virus crisis on GDP are relatively small. The sectors that are most affected are travel and entertainment, and the output lost in these sectors is temporary. It is the indirect effects, multiplied by the financial sector, that create the potential for a massive economic collapse.

In other words, in the absence of financial risk, the economic damage of the virus crisis would be minor. The main macroeconomic policy issue raised by the crisis concerns what to do about financial risk. Unfortunately, mainstream economists do not have a “go-to” model of financial risk. Instead, they face the choice of using the misguided “aggregate demand/aggregate supply” model or remaining silent on policy.

Models are metaphors, and “aggregate supply and demand” is a particularly weak metaphor. But rather than critique this metaphor, what I will do here is propose an alternative metaphor for navigating the virus crisis: government as a financial intermediary.

What Financial Intermediaries Do

As individuals, we prefer to issue risky, long-term liabilities and to hold riskless, short-term assets. The financial sector accommodates this by issuing riskless, short-term assets liabilities backed by risky, long-term liabilities assets.

This process takes place in layers. For example, suppose that a firm creates a risky, long-term asset by starting a new project. The firm finances this project in part by issuing debt, which is somewhat less risky and not as long-term. A bank invests in the debt, and the bank issues checking accounts which are riskless, short-term assets to households (liabilities to banks).

The foregoing description is greatly simplified. In modern finance, there are many layers in the middle of transforming the risky, long-term liabilities created at the edges of the nonfinancial economy. These layers include exotic financial instruments, such as options and other derivatives. The layers involve many institutions, including nonfinancial corporations, mutual funds, pension funds, insurance companies, investment banks, and commercial banks.

Governments participate in the financial intermediation process. They issue fiat money, which is a riskless, short-term instrument. But they also bolster the other layers in the financial system, by issuing loan guarantees and subsidizing particular forms of credit. For example, when the government provides deposit insurance, this helps banks to present their short-term liabilities as riskless, even though deposits are backed by risky, long-term assets.

Financial Crisis

A financial crisis occurs when there is a widespread, cascading loss of confidence in what were formerly considered riskless financial assets. For example, if people were to lose confidence in bank deposits, there could be a “run” on banks. That in turn would require banks to shrink, which would mean that firms that depend on bank loans could not continue to operate.

The virus crisis threatens to cause a financial crisis. For example, airlines are heavily financed by debt, and the sudden, sharp drop in travel means that they will not be able to meet the payments on that debt. That in turn threatens the banks or other financial intermediaries to which the airlines owe money.

The government can intervene in a financial crisis, using a variety of financial instruments and offering them to a variety of layers. For example, in the case of airlines, the government could offer direct cash assistance to the airlines so that they can meet their debt payments. Alternatively, the government could offer loan guarantees to the airlines. This would force the shareholders of airlines to bear losses, but it would protect banks and other lenders. Alternatively, the government could allow banks to write down the loans to airlines, letting bank capital fall below regulatory standards but continuing to insure bank deposits. I term this latter approach “forbearance.”

Picking Winners and Losers

One concern that the government faces is that it must preserve its own credibility as a financial intermediary. If bondholders lose confidence in the financial soundness of the government, then they will charge a high interest rate, and this may make it infeasible for the government to borrow. The government will then have to print money to pay its bills, a process that risks hyperinflation. To avoid these scenarios, the government must be judicious in choosing how to backstop the financial sector.

The government cannot afford to meet every desire for financial assistance. Government intervention in a financial crisis inevitably involves picking winners and losers. In the airline example, if the government offers cash assistance, then airline shareholders are winners. If the government offers loan guarantees, then the creditors of airlines are winners, but airline shareholders may be losers. If the government offers forbearance, then banks are winners, but they may choose to let the airlines go under, making other creditors of the airlines losers.

With government acting as a financial intermediary, future taxpayers may be losers. For example, if the government issues debt to fund cash assistance to airlines, then future taxpayers will have to pay higher taxes in order to repay that debt. If the government instead uses loan guarantees, then if some airlines go bankrupt, future taxpayers will have to make good the losses. If the government engages in forbearance but the banks eventually become insolvent, then taxpayers will have to help bail out the deposit insurance fund.

Offering guidelines

The process of picking winners and losers is bound to be discretionary, and it is bound to be political. There are no clear rules. At best, economists can offer guidelines.

One classic guideline comes from Walter Bagehot, who said that a lender of last result should lend freely, against good collateral, at a penalty rate. Unfortunately, this guideline is of little help in today’s economy. Are the assets of a struggling airline good collateral? If not, then are the outstanding loans made by a bank to an airline good collateral for lending to the bank?

Instead, let me propose the following:

It is in the public interest to try to maximize the way that assistance helps to re-start economic activity. Instead, assistance which primarily serves to make whole the losses of particular constituents is simply a wealth transfer, not an economic stimulus. This suggests giving assistance that either directly or indirectly provides working capital to firms. Loans to financially strapped households also may fall in this category.

The approach that seems most likely to serve these purposes is to offer forbearance to banks, while “jawboning” them to provide working capital to nonfinancial firms and consumer loans to households. As banks deplete their capital, the risk to the deposit insurance fund will grow. But this approach probably offers the greatest potential for improving economic activity with the smallest burden on taxpayers.

Note: Kevin Warsh is thinking along similar lines. His proposal has the Fed participating in bank lending, rather than my combination of forbearance plus jawboning. Either way, banks would be involved in the decision of who to save and how to save them.