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This Isn't Your Usual Demand-Shock Recession.

  • Capital Consumption

Tags InflationMonetary Policy

In the last month, the coronavirus pandemic, known officially as COVID-19, has caused social and economic havoc in the US and the rest of the world. Last month, the US economy lost a total of 701,000 jobs while the unemployment rate shot up to 4.4 percent from 3.5 percent. The decade-long trend of job gains has come to an end, but one question remains: are these signs of a typical recession? The answer is complicated, unfortunately.

Austrian economists have long warned that a recession has been inevitable ever since the Federal Reserve began its quantitative easing program following the 2008 financial crisis. However, while we may be in the midst of a reduction in what mainstream economists call “aggregate demand,” we are also seeing a significant supply-side shock. The former typically has deflationary tendencies, while the latter causes price inflation. A supply shock is simply an event which impedes the ability for supply chains, or the structure of production, to maintain the allocation of capital and labor so that they can produce a given level of output.

What began as a reduced supply of imports to the US from China has developed into an even deeper supply-side issue, with government-enforced shutdowns for “nonessential” businesses, rising domestic unemployment, and reduced production as a record 6.6 million Americans filed for unemployment benefits in the last week of March.

Economists believe that when aggregate demand falls a central bank should lower interest rates and increase the supply of money to prevent unemployment from rising and a recession from occurring. As Brendan Brown, senior fellow at the Hudson Institute said last month, “The rationale for a monetary response according to central bankers is to counter supposed demand depression stemming from the original supply disruption.” This is precisely what the Fed has done recently with a $2.2 trillion stimulus package to businesses and individuals. Should the monetary authorities print money to offset rising unemployment due to the forced closure of businesses even though spending doesn’t necessarily fall alongside it?

With the Federal Reserve's current inflation target of 2 percent, this would pose a problem arguably worse than just a typical monetary response to an adverse demand shock. Economist David Beckworth illustrates this using an oil supply shock as an example:


While not an Austrian model, the aggregate demand-aggregate supply (AD-AS) model demonstrates the nature of the problem. On the left graph, a sudden and unexpected decrease in short-run aggregate supply (SRAS) causes the price level to rise and output to fall, requiring the Fed to lower it back to 2 percent in the graph on the right by tightening its monetary policy in accordance with its inflation target. As Beckworth states in his example,

Consider first a negative AS shock due to say a temporary disruption of the oil supply. Given the temporary nature of the shock, the short run AS (SRAS) curve would shift left.

The negative AS shock causes inflation to increase to 3% and slows down real growth to 2%. Under pure inflation targeting, Fed officials would see the pickup in inflation and respond by tightening monetary policy to bring inflation down to 2%. As the second figure above shows, though, such a response would slow AD to a 2.5% growth rate and only further weaken the economy.

In the current situation, if the central bank allows prices to adjust to the supply shock without using monetary stimulus, real GDP will fall and unemployment will continue to rise. This is the natural outcome of a supply shock due to a natural disaster or a virus in this case. As we can see, this is not a typical economic downturn like the one in 2008. Aggregate demand doesn’t seem to have fallen. It is possible that crises such as COVID-19 can cause a fall in spending in the short run due to pessimism and fear, but not necessarily so. In fact, there have been reported shortages of food, toilet paper, and other essential goods all over the nation, which indicates that spending isn’t falling. If this continues, the structure of production will flatten, and the economy will go into “regression.” Jesús Huerta de Soto gives a historic example:

According to John Hicks, Giovanni Boccaccio, in an interesting passage in the Introduction to Decameron, written around the year 1360, was the first to describe, in rather precise terms, a process very similar to the one we have just analyzed when he related the impact the Great Plague of the fourteenth century had on the people of Florence. In fact the epidemic caused people to anticipate a drastic reduction in life expectancy, and thus entrepreneurs and workers, instead of saving and “lengthening” the stages in their production process by working their lands and tending their livestock, devoted themselves to increasing their present consumption. After Boccaccio, the first economist to seriously consider the effects of a decline in saving and the resulting economic setback was Böhm-Bawerk in his book, Capital and Interest, where he explains in detail that a general decision by individuals to consume more and save less triggers a phenomenon of capital consumption, which ultimately lowers productive capacity and the production of consumer goods and services, giving rise to the generalized impoverishment of society.

A lack of real savings and resources means that increases in consumption from stimulus spending will reduce our living standards even further than if the monetary authorities did nothing. In other words, the Federal Reserve is damned if it does, and damned if it doesn’t. It is now attempting to increase aggregate demand (shifting it to the right in the graph above), which will only serve to further aggravate rising inflation. With a dwindling supply of goods and services, rising unemployment, and the increased spending from the $2 trillion stimulus package, the economy will likely experience something akin to the stagflation of the 1970s. Although the economic outlook seems bleak, there is a solution that could end the pain of unemployment and price inflation sooner rather than later: the productivity norm. The Federal Reserve should not be trying to target inflation when the production structure changes. George Selgin explains:

in reality productivity is constantly changing, generally for the better. In the real world, a little secular deflation, along with upward movements in the price level mirroring adverse supply shocks, would be better than zero inflation.

Thus, the solution here is twofold. First, the government should not so sloppily be enforcing its will on businesses whose livelihoods depend on their willing consumer base to purchase their products. Reducing this would at least partly ameliorate the supply-side problem. Second, the trend of prices in the economy should be allowed to change with changes in demand and supply. Prices will therefore reflect real-world scarcities, as they should. Otherwise, the “Corona Shock” will become an afterthought in the event of an even worse crisis: severe stagflation.


Michael J. Hoffman

Michael Hoffman is the author of Monetary Kaleidics: Reflections on Money Illusion and the War on Cash.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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