Supply-Side Perspectives On The Economic Impact Of COVID-19

Most of the discussion on the economic impact of COVID-19 has focused on demand destruction. Yet two recent academic papers, COVID-19 Is Also a Reallocation Shock and US Unemployment Insurance Replacement Rates During the Pandemic, provide an important supply-side perspective. They argue that the recovery will entail substantial reallocation of labour and that the current policy response hinders this reallocation, and they propose changes. Their views help assess the likelihood of a V-shaped recovery.

In the first paper, the authors argue that COVID-19 has led to a spike in labour reallocation, a process that goes on even under normal circumstances. They cite the following key evidence:

• The Atlanta Fed Survey of Business Uncertainty, a monthly US-wide survey that asks business executives for a subjective one year ahead forecast of their own capex, employment, and sales. Based on the survey, the authors construct an index of labour reallocation and show that it has spiked in April. They also estimate that, so far, there have been 2.7 hires for every 10 COVID-related layoffs.
• Dispersion of listed firms’ monthly equity returns that spiked in March 2020.

The authors further argue that even if COVID-19 turns out to be a short-lived medical crisis, elevated reallocation will continue. The reasons: some of the shifts in consumer and business spending are likely to persist; small firms lose out to bigger, deeper pocketed ones; and the demand shock cleanses out marginal firms.

They then stress that reallocation takes time. In the adjustment of the manufacturing sector to the oil shocks of the 1970s and 1980s, ‘the destruction side of reallocation preceded the creation side by 1-2 years’. This is due to frictions such as ‘the time needed to plan new enterprises and business activities, to navigate regulatory hurdles and permitting processes, for capital formation, and for forming new relationships with suppliers, employees, distributors, and customers’.

As a result, even under an optimistic medical scenario where an effective vaccine is deployed in 12-18 months, they expect the recovery to be slow: ‘US real GDP may not surpass its 2019 level until the latter half of 2021 or later, and the return path to full employment is likely to take even longer’.

The role of policy, then, is to facilitate the reallocation of labour, and in this respect they see current policies as lacking. They believe the Paycheck Protection Program (PPP) – SME loans that get forgiven if firms retain the workers on their payroll – will keep workers in firms that may be unviable. They instead favour low interest loans without forgiveness provision to discourage unviable businesses from applying, and they support the reallocation of labour.  They also see existing restrictions on land use, occupational licensing, and other regulatory barriers as slowing labour reallocation and preventing a speedier recovery.

But their greatest concern around policy inefficiencies surrounds the high unemployment benefits voted by Congress, which is the focus of the second paper. The second paper conducts a detailed analysis of the impact of the supplemental unemployment benefits voted by Congress on income replacement ratios.

As part of the response to COVID-19, Congress has voted a $600 weekly additional unemployment insurance (UI) payment designed to replace 100 percent of the mean US wage when combined with mean state UI benefits.

The authors start by stressing that the distribution of workers’ earnings is right skewed (i.e. the median is below the mean). As a result, because the additional UI payment is targeting mean earnings, low paid unemployed workers are likely to get benefits well in excess of income lost.

Figure 1: Median Benefit Replacement Rates by State

Source: Page 6 of “US Unemployment Insurance Replacement Rates During the Pandemic“

The authors then show that ‘68% of workers have replacement rates above 100%. The median replacement rate is 134%, and workers in the bottom 20% of the income distribution have replacement rates above 200%’.

They further show that ‘lower wage jobs effectively have much higher replacement rates than higher wage jobs, often substantially above 100%’. Moving on to states, ‘while there is substantial variation across states, the median replacement rate in all states is well above 100%. Maryland has the lowest median replacement rate at 129% of lost earnings, and New Mexico the highest at 177%’.

They then highlight efficiency and equity implications. ‘This system essentially pays bonuses to some workers who are laid off but provides no additional pay for otherwise similar “front-line” workers. For example, unemployed janitors who worked at businesses which are closed can get UI benefits equal to 158% of their prior earnings, while janitors who continue to work at increased health risk in businesses deemed “essential” have no guarantees of any hazard pay or increased earnings’.

In addition, ‘Paying very high UI benefits to low-income households helps provide support for these vulnerable households, but it can also deter beneficial labour reallocation. Labour supply disincentives from high replacement rates are likely to become more important as the public health threat diminishes and businesses again look to hire’.

The authors conclude by suggesting policy options to improve the trade-off between UI efficiency and equity. They suggest replacing the current $600 fixed payment that expires at the end of July in such a way as to target a median replacement ratio no higher than 100%. They believe the administrative complexities involved are limited and that states would have until the end of July to get ready to implement the new formula.

While the two papers take a supply-side perspective, they are not arguing that demand-side policies are ineffectual. Rather they seem to view both types of policies as complementary: with more efficient UI benefits, for instance, there will be less of a need for demand support (i.e. monetary and fiscal support). Alternatively, this could be read as: more monetary and fiscal support can offset supply-side inefficiencies.