Capital Comments

Supply and Demand and the Coronavirus

The coronavirus is a world tragedy. Millions will get sick and too many will die. All of us will worry about family and friends. All of us will miss important events in our lives.

The economy will suffer too. But how much? Let’s see if we can think it through using the economists’ tools – supply and demand.

Supply is the production of goods and services, mostly by businesses. At first the news was about how the virus was disrupting supply chains in Asia. Businesses couldn’t get parts, couldn’t get products assembled, and couldn’t get them shipped.

Now, though, it looks like the main shortage will be employees. A lot of people will have to stay home sick. Without all their employees, businesses can’t deliver as many products, fully staff offices and factories, or stay open regular hours. Some will be required to close. Supply is reduced.

Demand is an even bigger problem. Demand is spending on goods and services, mostly by households. Social isolation will keep people at home. We’ll especially cut back on the goods and services we buy in the company of groups of people. Airplanes fly with few passengers.  Vacations are postponed. Sports and entertainment events are canceled. Restaurants are nearly empty or even closed. Demand is reduced.

Of course, demand increased for some goods—hand sanitizer and toilet paper, for example. This demand should slack off in relatively short order. After awhile the hall closet is bursting with toilet paper, and there’s no need to buy more.

Restricted supply and lower demand will reduce the quantity of products bought and sold. Gross domestic product will fall. Unemployment will rise. There will be a recession.

Maybe the recession will be V-shaped – a sharp decline and a recovery just as sharp. After all, the economy was in good shape. The Bureau of Labor Statistics reported that the February unemployment rate was back at 3.5%, a 50-year low. Perhaps the expansion will resume when the coronavirus fades. Businesses will get parts, their employees will return, establishments will reopen, and people will emerge from isolation and start spending, maybe a lot. Supply and demand both bounce back.

But the recession could be L-shaped – a sharp decline and then months of misery. What if businesses can’t resume production, people can’t go back to their jobs, and consumers can’t resume spending? Businesses don’t earn revenue if they can’t sell their products. If they can’t pay their suppliers or the interest on their loans, some will fail. Employees can’t go back to their jobs if their employers are out of business. Those incomes will be lost, so spending won’t rise back to where it was. And many consumers will use up savings during the isolation, and will have to rebuild their finances by spending less.

Perhaps most dangerous of all, banks and other lenders may stop lending if many borrowers default on loans, or if lenders aren’t sure about risks. Remember the financial market freeze during the Great Recession.

The recession can’t be avoided, but policy might keep it V-shaped. The Federal Reserve uses monetary policy to influence interest rates, and acts as the lender of last resort. The Fed has cut rates as much as it can. This should encourage borrowing and spending. The Fed has already provided more than $1.5 trillion in loans to financial markets, to stop them from freezing up. Most of those loans will be repaid, with interest, when the recession ends.

Fiscal policy uses federal taxing and spending. We could provide businesses and households with a bridge during the social isolation. Support revenues so businesses don’t fold. Subsidize payrolls so they can keep their employees. Support household spending so people can pay rent and utilities, do essential shopping, and so they don’t deplete their savings as much. Those are the goals; the means are a matter of debate. But don’t debate for too long!

Supply is down. Demand is down. The longest expansion in U.S. history is probably over. But if we’re lucky and smart, we’ll have a V-shaped downturn and recovery. If we’re not so lucky, or not so smart, we’ll have a longer, deeper recession.

So be smart. Keep your distance! Wash your hands!