The need for economic theories and policy in the present crisis

According to traditional market-based economic theory, the economy within an economic system functions when there is free flow of information with full bargaining power.

This leads to efficient allocation of resources and maximization of producer and consumer surplus and maximization of welfare in the society. The market delivers efficiency and believes in minimum government intervention.

During the Great Depression of 1930, Keynesian theory identified the lack of aggregate demand in marketplace as the leading obstacle to growth. When effective demand is low in the market, exogenous stimulus, which can come from government intervention, can help generate drivers of production.

Covid-19's effect on market function?

In the Covid-19 scenario, state intervention has become the primary order and has stopped the function of the free market system by putting an artificial blockade on effective demand through supply chain regulation.

In such scenario, aggregate supply is also slashed due to immediate shutdown of the production process in all the sectors. This artificial drastic cut in demand and supply has led to a very low level of equilibrium, lower GDP and lower employment.  

Hence, the contraction in both the supply side and the demand side forces has led to a drastic fall in economic activities in all sectors. The full employment equilibrium is beyond reach and efficiency of market has also been killed.

Illustration: Foreign Policy

What next in this unprecedented scenario of economic downturn?

Usually, the economy goes through phases, but the Covid-19 left no time to prepare for this downturn. Consequently, economic activities have been hit by waves of uncertainties.

Can Keynesian prescription, like in the time of the Great Depression, be followed in the current scenario through fiscal incentives, when the problem is not one of lack of effective demand? If demand management policies are not a solution, then can supply side policies be an option for economies?

The supply side policies are effective in the long run. It requires government stimulus and planning for a positive shift in supply and overall capacity building.

Building up human capital and social capital in digital platforms will be suitable for specific sectors and certain groups in the economy.

But the majority population will be excluded from such benefits and this will not lead to a massive shift in capacity building in the developing economies.

In case of these economies, where the informal sector is no less a contributor compared to the formal sector, it is all the more important to build up a support system for the informal sector for their bare survival.  

To tackle the problem in the short run, the government cannot override the necessity of restricting human movement in the local territory and global borders to maintain social distancing. Hence, there is going to be immediate supply shock and demand shock afterwards.

Due to imposed supply shock, there is a forced lack of aggregate demand that is accompanied by high purchasing power in the economy.  In such an economic downturn, people with lower purchasing power also tend to save more as a precautionary step towards future uncertainty.

We are heading towards a consequence envisaged in economics as "Paradox of Thrift".

This internal demand shock will be further multiplied with less external demand, and less export income will create more burden on the economy. But import will be slashed as well because of closure of international borders.

Our trade balance shows more import expenditure than export income. Hence, this can be a new opportunity for a new pattern of economic growth for countries like ours, focusing on import-substituting industries and generating internal demand as masses still have the demand for quality products.

Hence, shifting focus from external trade, remittance, external aid, towards a thriving domestic economy and a strong incentive for financial capital to find new investment opportunity within the country, and region, will pave the way forward for handling any such crisis in future.

The writer is Assistant Professor at the Department of Economics, East Delta University