Economics after the Virus

Arnold Kling

Summer 2020

The pathogen that struck the world in late 2019 is called a "novel coronavirus." The modifier "novel" indicates that humans have not encountered it before. Hence, the immunities our bodies have built up to fight familiar viruses are useless against this new threat.

This novel virus has created a novel economic predicament. In a typical recession, households reduce spending involuntarily, since they have lost income. In this case, household members have deliberately chosen not to shop or travel or seek entertainment outside their homes, even if they can afford to do so. In a typical recession, the government would like households to resume spending as soon as possible. In this case, the government has been more concerned with slowing the spread of the virus, and policymakers actually prefer to see "inessential" consumption activities curtailed. In a typical recession, construction and durable-goods manufacturing experience the sharpest declines, while service industries stay relatively stable. In this case, in-person services have been among the hardest hit sectors of the economy. In a typical recession, nearly every industry can look past the immediate troubles and foresee something close to a return to normal. In this case, retail stores, restaurants, entertainment venues, institutions of higher education, hotels, and the like foresee drastic changes even if the economy were to revive rapidly. In a typical recession, international trade, tourism, and migration continue. In this recession, they have been disrupted entirely. In our most recent recession in 2008-2009, the most important institutions that lost viability were in the financial sector. In this recession, it is non-financial firms — particularly small businesses — that are threatened with insolvency.

But instead of crafting a new strategy to respond to these unprecedented circumstances, policymakers have dusted off the playbook they used during the 2008 financial crisis. They've passed massive fiscal "stimulus" measures and adopted a greatly expanded role for the Federal Reserve in propping up financial markets. It is far from clear that these were the right plays to call in 2008; it is even less clear they are the right plays to call now.

What is clear, however, is that the Covid-19 pandemic has accelerated the deterioration of the concepts that underpin contemporary macroeconomic-policy thinking in America. That deterioration consists of a growing disconnect between the ideas that ground macroeconomic policy and the realities of the modern economy. The time has come to jettison both the Keynesian and monetarist paradigms that macroeconomic policymakers employ and to pursue an alternative paradigm more suitable to the conditions prevailing in today's economy. Such a paradigm might be best described in terms of patterns of sustainable specialization and trade, or PSST. This new model offers us a more accurate understanding of the forces at work in our economy — and a more constructive foundation for public policy — than either the Keynesian or the monetarist models do.

By considering both the older paradigms and this new one in relation to the Great Recession as well as the current Covid-19 crisis, we can begin to see a way forward for economists, for policymakers, and for a world confronting daunting economic prospects in the wake of the pandemic.


The nature of economic fluctuations has changed over the past three centuries. During the 18th century and most of the 19th century, agriculture still dominated, meaning that economic flourishing depended primarily on the state of the harvest. Booms and busts were largely reflected in land prices. Then starting in the late-19th century and continuing to around the 1980s, heavy industry dominated the American economy. Booms and busts were largely reflected in share prices of firms producing automobiles, steel, and energy. Keynesian and monetarist economists sought to stabilize this industrial economy by averting slumps in demand.

Finally, in the 1990s, important new trends in the American economy — including globalization, rapid adoption of new information and communication technology, and a greater concentration of and sophistication in finance — began to emerge. During the ensuing decades, booms and busts were largely rooted in the technology sector (especially from 1999 to 2001) and the financial sector (especially from 2005 to 2009). Together, these made the patterns of specialization and trade far more complex and opaque than those found in either the agricultural economy or even the industrial economy. For instance, until the 1990s, housing finance was relatively straightforward — most mortgages were originated and held by savings-and-loan associations. By 2005, a complex system of mortgage finance had emerged in which mortgages were pooled into securities marketed as "cash flows" and carved into different "risk tranches." In hindsight, it seems that few people fully understood the whole process.

In more recent years, very few products have been made entirely in America, or even entirely in any one country. A given product is thus likely to be produced in stages at sites in multiple countries. We have been living in an era in which business processes can be redesigned and relocated quickly and relentlessly. In a 2011 op-ed for the Wall Street Journal, technology guru Marc Andreessen proclaimed, "Software is Eating the World," by which he meant that no industry could remain untouched by the internet revolution.

The labor market no longer looks the way it did in 1960, either. Back then, male labor-force participation was high and stable, with plenty of jobs at any skill level available. Now, male labor-force participation is lower and cyclical, as workers whose skills are no longer in demand drop out and new opportunities emerge gradually, if at all. Layoffs during the '60s tended to be temporary as well, with the large industrial firms recalling workers as soon as excess inventories were worked off. Now, layoffs tend to be permanent because as soon as production processes cease to be profitable, they do not return.

These changing economic conditions have revealed the weaknesses of the 20th-century macroeconomic paradigms for explaining the conditions that dominate the modern American economy.


The older paradigms of macroeconomics — developed during the early- and mid-20th century — treat the economy as if gross domestic product were a single, homogeneous output produced in one gigantic factory. The Keynesian intuition is that this GDP factory will produce at capacity if and only if there is sufficient demand. If we are in a recession, government must inject spending into the economy so that the factory will hire more workers to raise production. Those workers will in turn spend more, thereby keeping up demand. In short, spending creates jobs, and jobs create spending.

In contrast, though based on related assumptions, the monetarist paradigm imagines the central bank fine-tuning the economy's inflation rate by altering the money supply. When it introduces more money into circulation, prices rise. Wages ultimately rise too, but at a slower rate than prices. This lag between the rise in prices and the rise in wages encourages the owners of the GDP factory to take advantage of the opportunity to profit from higher prices and lower, inflation-adjusted wages by hiring more workers.

Despite their differences, both the Keynesians and the monetarists believe in the Phillips Curve, which suggests that there exists a trade-off between inflation and unemployment. The Keynesians stress causality that runs from tighter labor markets to stronger demands for wages to higher inflation. Meanwhile, monetarists stress causality that runs in the other direction — from higher inflation to temporarily lower inflation-adjusted wages to increased hiring to tighter labor markets.

In the 1970s, however, inflation and unemployment rose simultaneously, contrary to what the Phillips Curve predicted. To explain this anomaly, the Keynesians and the monetarists tacked another factor onto their analyses — aggregate supply — and claimed that the United States was witnessing an adverse shift in this factor. In concrete terms, the cartel of oil-producing nations had cut back on the oil supply, meaning the GDP factory faced higher costs and, in response, increased its prices.

These are the analytical tools that macroeconomists brought with them to the financial crisis of 2008. Although the GDP-factory paradigm did not quite conceive of mortgage securities or financial fragility, the conventional wisdom suggested that policymakers treat the crisis as an adverse shock to demand. The Keynesian prescription was to prop up spending by directing the federal government to spend more and tax less. The monetarist prescription called for the Federal Reserve to lower interest rates. As short-term rates approached zero, the Fed pursued further monetary expansion with "quantitative easing," which meant buying long-term assets that it otherwise would not have put on its balance sheet.

As it turned out, the economic problems of 2008 and the ensuing Great Recession were more complex than the GDP-factory paradigm suggested. Despite the fiscal stimulus and quantitative easing, unemployment remained stubbornly high for several years. In fact, it took nearly a decade for full employment to return.

The old paradigms missed the causes of these problems in ways that highlight the appeal of the "patterns of sustainable specialization and trade" paradigm. Despite its seeming novelty, this paradigm is not a new theory of macroeconomics; rather, it reaches back to the roots of modern economics in the classical economists of the 18th and 19th centuries. Adam Smith and David Ricardo — two of the most prominent economists of the era — explained the benefits of trade based on specialization and comparative advantage, respectively. These concepts remain as useful today as they were when Smith and Ricardo first articulated them.

The PSST model emphatically departs from the view that the economy is like a single factory; instead, building on the theories of Smith and Ricardo, it conceives of the economy as a delicate web of connections that coordinate very refined forms of specialization. To put it in more tangible terms, the paradigm suggests that just about everything a consumer purchases — from food to smartphones to vacation experiences — is supplied by a process that requires millions of workers to perform highly specialized tasks, hardly any of which are visible to the consumer. These patterns of specialization and trade are coordinated by two systems: the pricing mechanism and the profit system. Prices are Smith's "invisible hand," telling entrepreneurs where to find Ricardian comparative advantage. Meanwhile, profit opportunities inspire new patterns, while losses signal that patterns are no longer sustainable.

This complex system of sustainable-specialization and trade patterns operates with minimal friction when households and businesses carry little in reserve for emergencies. Households can obtain houses and durable goods on credit without having to accumulate much in savings. Similarly, firms can carry inventories and expand by issuing debt rather than financing these activities out of retained earnings.

In a minimal-friction economy, the household sector and the business sector alike issue many risky long-term liabilities and hold low-risk short-term assets. The financial sector accommodates this activity by doing the reverse. As a result, the patterns of specialization and trade in a minimal-friction economy are fragile, with the fragility particularly concentrated in the financial sector.

The 2008 financial crisis exposed the fragility of the financial sector, thereby disrupting many patterns of specialization and trade. In an environment with a contracting financial sector, businesses that seemingly had nothing to do with housing or housing finance were no longer viable. There was no GDP factory simply waiting for demand to appear, no way to make the old patterns sustainable — we simply could not have put Humpty Dumpty back together again. The recovery came only gradually, as new and existing businesses groped through a process of trial and error to discover new patterns of sustainable specialization and trade.

Financial fragility is the Achilles' heel of the minimal-friction economy. The patterns of specialization and trade that emerge are very efficient as long as everything is going smoothly. But such patterns are not robust, as circumstances change and their financial underpinnings start to unravel.


The pandemic has forced a near-term shutdown of much economic activity. Although people often casually attribute this to government lockdowns, much of the economic contraction came from private decisions rather than government restrictions. After being made aware of the dangers posed by the virus, household members became reluctant to shop, to enjoy live entertainment, to travel, or to work outside their homes. Firms, concerned with the safety of their employees, frantically tried to reduce the need for personal contact in the process of organizing, orchestrating, communicating, and conducting their business. Educational institutions, both public and private, became unwilling to risk in-person instruction, which hurt the ability of parents to handle the demands of their employers.

The Keynesian and monetarist paradigms do not have a clear way to picture this kind of scenario in economic terms. Because these circumstances involve a reduction in the capacity of businesses to operate, they seem to indicate a supply shock. But in their rhetoric and response, policymakers have treated it as a problem of inadequate demand that requires more government spending to stimulate.

Of course, economists realized from the outset that there was (and still is) something different going on. Some spoke of authorities as trying to deal with the virus by putting the economy into an "induced coma" or a period of "hibernation" to reduce social contact. The problem with these metaphors is that financial obligations do not sleep: Firms still have to make payroll, households still have to pay rent, and everybody has to pay interest on debt.

One way of solving the financial-obligations problem might have been for the government to provide banks with the backing to give each household and business account a credit line equal to its deposits for the first two months of the year. In that case, it would have been up to the owner to decide whether to tap the credit line. Instead, Congress passed bills such as the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which provided various forms of grants and loans to individuals and businesses but also made allowances for people to avoid having to pay mortgages or rent. Congress also authorized the Federal Reserve to inject trillions of dollars into the financial sector, including through the purchase of private securities.

This was the 2008 playbook revisited — on a much larger scale. In 2008, Congress passed the $800 billion Troubled Asset Relief Program, or TARP. The program was originally pitched as an effort to buy up toxic assets in order to cleanse the balance sheets of major financial firms. But as legislated and implemented, it became a grab-bag of expenditures primarily involving the government injecting capital into banks. In 2009, Congress passed the American Recovery and Reinvestment Act, which was a mix of spending measures intended to lead to a Keynesian economic revival. Meanwhile, the Federal Reserve undertook various measures to shore up particular firms in the financial industry and various segments of the financial sector, such as the mortgage-securities market.

In 2020, the Keynesian spending packages were larger — over $3 trillion as of this writing. As for the Fed, its interventions were broader — extending to the corporate-debt and municipal-bond markets. And both the policy response to the pandemic and the surrounding rhetoric employed the old GDP-factory framework. Politicians, economists, and the press spoke of a plan to "re-open the economy" as if it were just a matter of turning a key or flipping a switch. The implicit assumption was that once the lockdowns were lifted, everything would return to "normal," and people who had been temporarily laid off would return to their jobs.

The PSST framework provides a deeper insight into the nature of the problem we are now facing. According to this model, the economic shutdown is not simply a supply shock or a demand downturn; it is a disruption of patterns of specialization and trade. People have changed their behavior — in some ways for just a few weeks, in others likely for a few years. In still other ways, these behavior changes may be permanent. Just as it was after the 2008 crisis, the challenge for today's economy is to go through the trial-and-error process of discovering new patterns of specialization and trade.

People are going to be conscious of the novel coronavirus for quite a long time. Households, businesses, and other institutions will not go back to doing things the way they had been doing them before the virus hit. People will continue to try to avoid crowded indoor settings — restaurants, malls, airports, indoor sporting and concert venues. Firms will continue to encourage remote work and seek out alternatives to in-person meetings and business travel. Educational institutions will attempt to find ways to operate that are comfortable for teachers and professors who may not be sufficiently young or healthy to feel safe around younger students and staff, who are more likely to be asymptomatic carriers of the virus.

Fear of the virus will cause some activities to be curtailed dramatically. Business sectors that are complementary to the curtailed activities will shrink — one can imagine a much smaller hotel industry, for example. Meanwhile, business sectors that provide substitutes for curtailed activities will expand — there will likely be an increase in demand for firms that provide services like software and support for online education, for instance. In short, the impetus in the private sector will be to shift resources out of patterns of specialization that are no longer profitable and into new patterns that are.

The government, on the other hand, will feel pressure to do the opposite. Policymakers will be inclined to prop up troubled sectors, since those sectors will be pleading for help with the loudest voices. As failing firms beg for "stimulus," Congress will tend to give them what they want. This attempt to revive unsustainable patterns of specialization and trade will occasionally succeed, often fail, and certainly prove very costly.

Some of the loudest pleading will come from the financial sector. Already, the Fed has responded to what it deems distress signals in municipal-bond and corporate-debt markets. It has already purchased some of these debt instruments and signaled a willingness to purchase more if market conditions require it. In the process, the Fed is not just serving as a lender of last resort; it has become a buyer of last resort. This has the effect of steering capital into sectors that are failing rather than allowing capital to flow to the sectors that need to expand.

The PSST framework asserts that propping up economic sectors that have lost viability as a result of the pandemic is not the way to heal the economy. The pandemic is not an echo of the 2008 financial crisis. Problems are not spreading outward from the financial sector to the rest of the economy; instead, problems among firms and individuals hurt significantly by the virus will create troubles for financial firms exposed to those areas.

The PSST framework helps us recognize that bailing out these financial firms will do nothing to help funnel capital into the businesses that have the opportunity to expand in a virus-conscious environment. Instead, government ought to be encouraging the transition to new activities that are profitable in a virus-conscious economy. One way to do so would be to pay businesses a wage subsidy to hire workers. Another method would be to cut the payroll tax. An economy-wide incentive to add workers would have more bang for the buck than a costly effort to keep uneconomical businesses afloat.

The PSST framework also predicts that the decline in economic activity will likely be steep and prolonged. As governors have gradually lifted their statewide lockdowns, some Americans are eagerly taking the opportunity to return to pre-pandemic activities. But many are proceeding with caution — wearing masks, making efforts to take activities outdoors when possible, and avoiding crowded indoor places where they are most susceptible to catching or spreading the virus. Those most at risk of death from Covid-19 — namely the elderly and those with conditions like diabetes and heart disease — will likely continue to self-isolate. Given these changed behaviors, the economy is not going to snap back to where it was in January; instead, the economy is going to reshape itself, and be reshaped, over the next few years.

The Keynesian and monetarist attempts to spur spending will take place in the context of this decline: The stimulus will inject more spending into the economy, while reduced economic activity will mean fewer goods and services will be produced. Goods and services that are still in demand in a virus-conscious economy will tend to see prices rise. Workers who find their jobs "essential" will start to demand higher pay. A return to significant levels of inflation is possible.

If inflation does return, it will be difficult to snuff out. The old monetarist paradigm treats inflation as a phenomenon that the central bank can address by fine-tuning the money supply. But prices are set based on what people expect money to be worth in the coming months. And in recent years, people have come to have confidence that prices will be fairly stable. This becomes a self-fulfilling prophecy: If people are confident that the prices of the goods they buy will be the same next month as they are now, then they can keep the price of what they sell steady as well.

But in the years ahead, heavy deficit spending financed by the Fed rather than through taxing or borrowing from the public risks changing the very norms and expectations that have stabilized prices. Once inflation becomes noticeable, higher expectations of inflation become self-fulfilling: Workers demand cost-of-living raises, forcing firms to raise prices in response, which in turn makes it more difficult for people to afford the cost of living.

The PSST paradigm sees money and prices as arising from social norms. In other words, what people use as money varies depending on technology and circumstances. The great monetarist economist Milton Friedman defined money as currency plus the value of checking and savings accounts. But people do not need currency or checks to conduct transactions nowadays; they can use credit cards, debit cards, or mobile-pay systems. If inflation were to reach the point where people see currency and deposits declining in value rapidly, many of us would seek to minimize the size of our currency holdings and our bank balances, using other means of payment and stores of value instead. The Fed might be trying to cut the supply of currency and deposits, but the drop in demand and the shift to other means of payment would confound its efforts to slow spending.


Looking beyond this crisis, if economists and policymakers want to ensure that we are prepared for the next one, they need to consider the problem of economic fragility.

Both in 2008 and in 2020, the lack of a financial cushion in many households, businesses, and especially the financial sector greatly amplified economic problems. If we lived in a society in which every household and business had enough savings to cover six months of expenses, we could endure these kinds of crises without suffering an economic calamity anywhere near the magnitude of the one we are experiencing now. If we lived in a society where levels of debt were much smaller, we would have a smaller financial sector, and the Fed would have to do much less emergency lending. If we lived in a society in which pensions — including state- and local-government pensions — were fully funded under conservative assumptions, state and local governments would not require bailouts. If we lived in a society that, during good economic times, balanced the federal budget or had a budget surplus, we could respond to these crises by borrowing in the credit market without having to ask the central bank to purchase the debt that the government issued and run the risk of setting off an inflationary spiral.

Instead, we have fallen into a habit of enlarging the financial sector and running up very large debt levels during good economic times. As noted, this has some advantages in terms of efficiency. Households are able to enjoy greater amounts of durable goods, and businesses are able to operate with a higher return on equity than they would otherwise. But this high-leverage, minimal-friction economy greatly amplifies adversity — when something goes wrong, the repercussions spread much wider and last much longer than would be the case if habits had differed.

We have arrived at this state of affairs because of the incentives embedded in the financial sector and in public policy. The financial sector operates in an environment in which its profits are privatized and its risks are socialized. During good times, financial firms can pay generous salaries, bonuses, and dividends. During bad times, they become too big or too significant to fail.

After the 2008 crisis, the federal government set out to assure the public that the financial sector would never receive another bailout. Officials promised to use regulation to make sure firms are sound from the start; and if it turns out some firms are not, they promised that their shareholders — not taxpayers more generally — would be the ones who suffered. The Dodd-Frank Wall Street Reform and Consumer Protection Act, for instance, states that the Fed will only protect systematically important financial institutions that have passed certain stress tests, and directs banks to create "living wills" that will allow regulators to break up banks should they start to fail.

But stress tests on paper are meaningless when real stress occurs. During a crisis, the only will that stands out is the regulators' will to ensure that no major financial institution has to be restructured on their watch.

Going forward, then, we must find the will to restructure our social incentives. We could develop a tax system that discourages households and firms from using debt-based finance, or at least one that offers less incentive to do so. We could have state and local government adopt norms, or even constitutional mandates, that require states and localities to fully fund pensions. We could similarly have the national government adopt norms or a constitutional requirement to avoid deficit spending except in an emergency. We have plenty of tools at our disposal to make these adjustments — all we lack is the will to follow through.


The novel coronavirus has revealed an urgent need for economists and policymakers to bury the GDP-factory paradigm. Instead, they need to think about the economy in terms of patterns of sustainable specialization and trade. And they should pay particular attention to the word "sustainable" in that phrase, which will require a significant reduction in the role of debt — and hence the size and fragility — of the financial sector.

Such a paradigm would help us make much better sense of the economic conditions of 21st-century America, which the profession of economics has struggled to understand and explain. It would also serve us well in thinking through the difficulties our country will confront in the wake of the pandemic, in assessing the tools available to policymakers, and in addressing the decisions that confront workers, employers, consumers, and investors in a challenging new economic environment.

Arnold Kling is an adjunct scholar with the Cato Institute and a member of the Financial Markets Working Group at the Mercatus Center at George Mason University.


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