Will The Covid-19 Response Bring Inflation or Higher Taxes?

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Economists estimate that for every month of lockdown an economy shrinks 2.5%. That makes a two-month lockdown equal to the 5% fall in output from the financial crisis (in the case of the UK) and more severe if it stretched out to three months or longer. Double-digit budget deficits for the UK and the US would be unavoidable under this scenario.

This will leave administrations with some very tough choices. Politics in both countries have already taken a populist turn as a result of the austerity and the fallout from the financial crisis. It will be very difficult politically to make further cuts in public services or welfare payments to restore the health of the government’s balance sheet.

But the only other easy options are direct financing by the central banks or raising taxes. As reported in the Financial Times, the UK has become the first country to use monetary financing of government as a coronavirus response measure. Bank of England governor Andrew Bailey says this is a temporary measure and has rejected long-term monetary financing for the very reason that it would “damage credibility on controlling inflation”.

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Raising taxes is a fine idea but the large companies and wealthy individuals that governments would like to pay them are very mobile these days and difficult to pin down. Increasing taxes on the middle classes is electoral suicide.

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There could be one final and better option. Now might be the time to do what left-of-centre politicians and economists have been advocating for some time, and that is carry on spending. The UK government would keep the economy on a ‘war footing’ even as the coronavirus epidemic retreats and redirect the spending on wage and business support to productive investment. The goal would be to restructure the economy, which in the UK’s case is long overdue, and not to worry if the debt-to-GDP ratio goes north of 150%.

Done right it could set the course of the economy for a generation and bring in the revenues to pay back the debt.  The other choices are more austerity or high inflation.

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