Rethinking stabilization policies; Including supply-side measures and entrepreneurial processes

In 2020, the world economy experienced one of its deepest economic downturns since at least the Great Depression. At that time, the downturn spiraled into an economic depression that lasted most of the 1930s. This time, it looks different, i.e., the severe recession in 2020 seems to be followed by a relatively swift recovery in 2021–2022. Uncertainty concerning the trajectory of the crisis is, however, genuine; the jury is still out. The global signs of economic recovery and optimism during summer and early autumn were hampered by an extensive and rapid second wave of the virus in the fourth quarter of 2020, followed by the third wave in February–March of 2021. The latter contained mutated and more contagious versions of the virus. Hence, cautiousness in predicting the future path of COVID-19 and its economic impacts is warranted.²

Irrespective of how the COVID-19 pandemic evolves, there are reasons to believe that it entails important lessons for how future crises may evolve and spread across countries and how to cope with them. Even though the integration of the global economy has slowed somewhat since the financial market crisis of 2008–2009, the world economy remains highly intertwined and susceptible to the transmission of shocks. Interlinked value-added production chains still account for approximately 70% of world trade, while the global population, migration flows, and the number of refugees all continue to increase.³ This suggests that future shocks could also originate in hitherto unknown causes—such as new pandemics or environmentally induced crises—and diffuse rapidly.

The COVID-19 crisis deviates from most former crises of the last century that can be traced to the financial and real estate sectors of the economy (Rheinhart & Rogoff, 2010). A typical crisis pattern is the building up of unsustainable debt among households and firms, speculation and animal spirits, bankruptcies, declining asset values, financial market turbulence, unemployment, and falling demand. The present crisis, however, took another route. First, it started with the disruption of the supply side of the economy. The fragmented and globally organized production chains that have characterized industrial production in recent decades collapsed in the initial phase of the crisis because of the enforced restrictions on mobility, travel, and trade. Second, these distortions were then transmitted to the demand side since, basically, a curfew was imposed in several countries, leading to initial decreases in employee income and the inability of firms to produce.⁴ Third, in comparison with previous crises, the COVID-19 crisis spread quickly—within just weeks or months—and it turned out to be considerably more pervasive in terms of countries, industries, firms, and individuals affected than the typical crisis. Such comprehensive crises are more likely to generate long-lasting negative effects on the economy if not mitigated through active policies and support measures (Gregory et al., 2020).

The crisis laid bare the weaknesses of the traditional macroeconomic toolbox to stabilize economic shocks, i.e., to smooth out swings in economic activity. This is evident from the unparalleled number of, and experimentally implemented, policy measures. Whereas emphasis previously has been on monetary policies, this crisis has seen not only a return to more traditional Keynesian (or neo-Keynesian) policies but also the adoption of a host of other and less conventional instruments. Previous concerns regarding budget deficits and sovereign debts, particularly among EU countries where most had already exceeded the stipulated constraints in the Maastricht agreement, vanished or were abolished.⁵ Rather, it was emphasized how low long-term interest rates constituted an opportunity to increase lending and engage in expansionary fiscal policies (Krugman, 2020).

Since expansionary monetary policies in the last decade have led to historically low, even negative, interest rates, their efficiency in stimulating demand has also withered.⁶ This provided further impetus for policymakers to shift toward fiscal policy measures such as initiating infrastructure projects (environmental and other), strengthening social security systems and automatic stabilizers, tax considerations, and a more general expansion of government expenditure. In addition, policies are, to a larger extent, characterized by microeconomic measures targeting industries, firms, and individuals directly rather than by stimulating aggregate demand through large-scale macroeconomic policies.⁷ Some of these measures have been used previously, while some are new, but their adequacy as stabilization policy tools needs to be further examined and evaluated.

Based on the experimental policy approach featuring the present crisis and the obvious need to reconsider or complement traditional policy measures, the objective of this article is to present a modified and more comprehensive stabilization policy framework to counter large-scale and pervasive crises. More specifically, one prime and two secondary issues will be pursued. First, the importance of including the supply side and coherently aligning macro-policies targeting aggregate demand with supply-side microeconomic measures will be emphasized. Second, I will argue that a properly designed and cohesive strategy to stabilize the economy is compatible with improving the prerequisites for long-term growth,⁸ in addition to facilitating structural adjustment of the economy.

An efficient transmission of policy measures targeting the aggregate level requires that the microeconomic structures of an economy are taken into account. Entrepreneurial processes, either within incumbents (intrapreneurship) or in the form of new ventures, will be critical in restructuring and restarting an economy. Incentives that foster knowledge upgrading related to digitization, sustainable production systems, and resilient internationalization structures constitute one crucial element to accomplish this transformation. Such measures will also serve to strengthen employees’ and the business sector’s competitiveness and deepen the knowledge base of the economy.

The most important supply-side policy instruments at the micro-level are claimed to be knowledge upgrading/accumulation, taxes, access to finance, labor market flexibility, competition, and insolvency institutions. The composition and level of implementation can be expected to vary across countries and regions. Some of the suggested proposals are short term and temporary (taxes, financing, training, and knowledge upgrading), aiming to bridge swings in the business cycle and prepare economic agents for a turnaround in economic activity. Others serve to enhance the efficiency of short-term policies in the somewhat longer run (functioning labor markets, competition, and insolvency institutions).

Moreover, since crises tend to be characterized by different phases, policies need to adapt over time. The immediate “whatever it takes” strategy in the COVID-19 crisis was appropriate for the first phase but is not necessarily adequate in the subsequent stages or if a similar shock appears in the future. An excessively extensive policy agenda of subsidies and support schemes risks stifling the necessary restructuring of the economy and hampering the introduction of new firms, new business models, and innovations, while instead nurturing so-called zombie companies.⁹ A flexible approach may be needed where strategies change according to the different stages of the crisis.

A number of important issues, for instance, related to sustainability aspects, fall outside the scope of this paper.¹⁰ Such aspects should be integrated into crisis policies; while my analysis does not in any way hinder that, how and through which means is not explicitly elaborated in this study. In the somewhat longer run, it may serve to create significant competitive advantages for businesses.¹¹ Another area that is not considered refers to the tensions between rural and metropolitan regions, which may be affected by crises differently for several reasons. Rural areas often see a strong concentration of industrial production, whereas services are more spatially distributed (e.g., tourism), implying that the crisis strikes differently depending on the pattern of specialization.¹²

In what follows, I will first give a brief account of the policy responses to the crisis and the different support schemes introduced in the EU and a number of countries. The subsequent Sect. 3 discusses the strengths and weaknesses of traditional macroeconomic stabilization policies, how they evolved over time, and why they need to be redesigned and complemented with other measures. Section 4 presents how micro-level supply-side policies could be better realigned with macroeconomic measures to boost the effectiveness of stabilization policies. The final Sect. 5 concludes and summarizes.

A wide array of policy measures have been undertaken in most countries to mitigate the COVID-19 crisis. The OECD (2020b) has carefully documented the support measures implemented at the national and regional levels. Similarly, the effects of the crisis have also been reported on an ongoing basis, mainly based on surveys conducted in a large number of countries. During the second quarter of 2020, basically all of these surveys revealed sharp falls in employment and turnover, financial difficulties, and an increase in closures and bankruptcies (Bartik et al., 2020). In an analysis of 17 countries, Gourinchas et al. (2020) conclude that the average failure rate is expected to increase by almost 10% during the crisis, with certain sectors being considerably harder hit (recreation, travel, etc.). However, during the following third quarter, which was characterized by a decline in the spread of the virus and a lifting of different lockdown measures, economic activities bounced back, albeit not enough to compensate for the earlier decline. Notably, including the fourth quarter, bankruptcies were lower in 2020 than in 2019, illustrating the extent of subsidies to firms.¹³

Regarding the extent of the decline in economic activity, the first estimates predicted a fall of approximately 7% in the EU (Eurostat, 2020a; European Commission, 2020b), which turned out to be quite accurate according to the preliminary statistics for 2020. The decline in global GDP was in the same range, around 5%. The most recent forecast by the International Labor Organization (ILO, 2021) points to global unemployment increasing by 1.1% paired with a decrease in labor force participation of 2.2%, while the WTO (2020) estimates that trade will diminish by 9–10% in 2020. Predictions of the economic outcome of the COVID-19 crisis have been volatile, mirroring the uncertainty surrounding the diffusion and the effects of the different mutations that have appeared.¹⁴ Presently, as the vaccine is rolled out, the optimistic view dominates.

The immediate policy response in the initial phase of the crisis was to implement monetary measures to ensure that markets were liquid, accompanied by the provision of state-guaranteed loans. These policies were extended by a number of less conventional measures at the industry and firm levels, which can be divided into the following categories: (i) general, i.e., covering all sectors and companies (e.g., tax deferrals); (ii) sector-specific measures (e.g., tourism); and (iii) those primarily targeted at SMEs, start-ups, and innovation (e.g., earmarked funding). In particular, SMEs have been the focus of several policy initiatives. The justification is that in most countries, these account for the majority of employment and value added and represent the largest number of enterprises. Moreover, they also have a weaker financial position and modest cash reserves, are less digitized, and generally have lower technical know-how than larger firms, while in a normal market situation assessed to have viable future prospects.

Measures to support companies—apart from limiting the spread of the pandemic—can be classified as policies to increase liquidity in the market, deferral of taxes and employer contributions, loan guarantees, financing (access to credit, cash benefits, a moratorium on repayments, and interest), furlough wages and employment subsidies, and, finally, structural measures directed toward competence strengthening, sustainability strategies, and innovation. The latter measures have, however, been relatively rare.

The World Bank claims that approximately 850 different policy instruments have been used (World Bank, 2020), the most common of which are summarized in Table 1, although they come in a plethora of varieties. The levels of these support schemes are historic at the same time as large differences prevail between countries, with possible long-run economic consequences (e.g., policies to increase R&D and foster innovations). It is also questionable whether these measures have had the intended effect and reached those most in need of support, issues that will be further elaborated in the policy section below.

Most of these policy measures remained in place during the second stage (third quarter 2020), even though some became more limited (e.g., the percentage share that furlough wages would cover), while others had more of a one-time character (e.g., cash injections to households and firms). Note that within the EU, these crisis efforts have been made possible by changing the state aid rules in March 2020, followed by further easing in April. These were recently prolonged until December 31, 2021.¹⁵

The EU has implemented extensive support measures, including the Corona Response Initiative in March 2020 (around 37 billion euros), followed by 28 billion euros from the EU’s structural funds. The most ambitious initiative is the EU’s Recovery and Resilience Fund of 750 billion euros, distributed between 390 billion euros in grants and 360 billion in loans. This corresponds to almost 5% of the EU’s GDP and is planned to be financed through a mix of emitting bonds, EU taxes (carbon dioxide, financial, and digital transactions), and green tariffs. The ECB (2020) has also taken action, starting with the Pandemic Emergency Purchase Program (PEPP) in March 2020, and announcing that further efforts may be needed to increase liquidity and keep interest rates down. Similarly, the European Investment Bank (EIB) increased its commitments as the crisis became deeper.

Additionally, at the country level, a number of policy initiatives have been implemented, varying in extent and coverage.¹⁶ For instance, in the USA, the Paycheck Protection Program (PPP) was introduced early to alleviate financial constraints for firms with fewer than 500 employees. Similarly, in March 2020, the CARES Act was passed, consisting of 2000 billion US dollars allocated between loans to large and small firms and direct cash transfers to households. To that, the Biden stimulus package (The American Rescue Plan) can be added, amounting to 1.9 trillion US dollars, which corresponds to roughly 9% of the U.S. GDP. The U.S. has also allocated $100 billion to the Endless Frontier Act to promote R&D, innovation and entrepreneurship, targeting 10 areas defined as strategically important. Moreover, a number of European countries have made similar undertakings; France and Germany have earmarked resources for these purposes as well as smaller countries like Finland, Ireland and Norway.

To summarize, there are a vast number of policies on different levels that have been implemented in a more or less ad hoc manner without a consistent strategy or analysis taking into account how these measures interact or whether they complement or counteract each other, i.e., if they generate suboptimal solutions.

Crises are recurrent in market-based economic systems and, as noted above, tend to originate in the financial and real estate sectors. Other factors may also generate crises, such as technological paradigm shifts that turn much of the existing know-how obsolete, leading to firm exits, unemployment, and economic hardship. To moderate the fluctuations in economic activity, in particular when the effects are more profound, governments resort to a variety of stabilization policy measures. These have shifted over time, and I will describe the traditionally used measures in the next section and argue why and how they should be complemented with additional instruments.

One particular concern of crises is the possible emergence of long-run hysteresis effects, i.e., persistent negative effects on employment and growth. It may then take considerable time before the pre-crisis growth trajectory and employment participation rates are attained, leading to considerable welfare losses. Furthermore, most crises initiate a restructuring process, opening up new ways of running firms and organizing production, and penetrating markets.¹⁷ Some industries are threatened, while others will grow and thrive.

In functioning market economies, this will induce a reshuffling of factors of production, and new business opportunities will arise. Such restructuring is likely to be particularly pronounced if paralleled by other profound changes, such as rapid technological development or a globalization process. Hence, economies that can prepare firms and employees for such structural adjustments also stand the best possibilities of reaping the benefits of the ensuing opportunities. Supply-side measures at the micro-level could contribute to facilitating such restructuring, thereby increasing the overall efficiency in moderating cyclical swings, as well as expanding future growth possibilities.

The building blocks of growth are well known: proper institutional conditions regarding the rule of law, well-defined ownership rights, independent and credible courts, the absence of corruption, etc. (Rosenberg & Birdzell, 1986; Acemouglu & Robinson, 2012). Contemporary growth models stress investments in human capital and R&D that are supposed to generate ideas and innovations that then drive, or endogenizes, growth (Aghion & Howitt, 1998; Arrow, 1962; Romer, 1990). More recently, endogenous growth models have been questioned since they neglect the importance of policies that promote the dissemination of new knowledge or new combinations of existing knowledge, to create economic value and societal use.

Two such knowledge diffusing mechanisms that have been highlighted in recent research are entrepreneurship (Acs et al., 2009; Braunerhjelm et al., 2010; Audretsch et al., 2012) and labor mobility (Braunerhjelm et al., 2020; Kaiser et al., 2015). Entrepreneurship, or entrepreneurial human capital, could be seen as a factor of production corresponding to physical or other human capital, which is necessary to unleash business renewal, innovation, and transformation (Audretsch, 2007; Braunerhjelm & Lappi, 2020). Recognizing the role of knowledge diffusion in economic development, which is a considerably more complex policy issue than knowledge investments and encompasses several policy areas (new ventures, taxes, access to capital and competence, competition, etc.), has implications for the design of stabilization policies.

When the economy is exposed to an exogenous shock that affects both demand and supply—as in the case of the current COVID-19 crisis—policy measures to counteract these effects should address both sides. In addition to stimulating demand, policies need to take into account short-run supply-side obstacles that could impede economic recovery while incentivizing activities that could increase an economy’s production potential.¹⁸ Furthermore, if combined with long-term structural reforms, e.g., with regard to the labor market, infrastructure, housing, and the supply of skills, it is likely to insert confidence within the business sector, which would improve the probability of investments, new ventures, and economic recovery (Stiglitz, 2020). Thus, a partially new and more comprehensive policy design is necessary to cope with crises such as COVID-19.

Conventional stabilization policy tools refer to measures to increase aggregate demand through monetary or fiscal policies (columns 1 and 2, Table 2). The definition of an optimal monetary policy varies from the rather abstract objective of maximizing welfare for a representative consumer given frictions in the economic environment, to the more pragmatic view of minimizing the variance in GDP. Irrespective of definitions, monetary policy has emerged as the primary tool to conduct stabilization policies in recent decades. To achieve this end, central banks have altered the interest rate through open market operations, setting discount rates, quantitative easing, etc., thereby influencing investment and consumption decisions, i.e., demand.¹⁹ The COVID-19 crisis has also witnessed some unconventional measures, such as the use of helicopter money (direct cash transfers). In addition, monetary policies are responsible for access to liquidity and financial market stabilization. Since the monetary policy has been caught in a liquidity trap situation (zero or close to zero interest rates) for some time, it can be expected to take a more accommodating role, primarily focusing on the latter two tasks.

Optimal fiscal policies have been defined similarly, i.e., maximizing the welfare of the representative consumer, traditionally implemented through increased governmental expenditures (e.g., investments in infrastructure, housing). Such policies were common from the 1970s to the 1990s. Some of these measures also improve the supply side of the economy, e.g., by facilitating communications and market accessibility. During the last decades, however, fiscal policies to stabilize the economy have been less frequently applied and more focused on budget balance and sovereign debt ratios.

The definition of an optimal aggregate demand policy implicitly assumes that there are no or few imperfections that hamper or impede the functioning of markets and that transmission to the real economy occurs without frictions. This is rarely the case, however, and these disturbances are frequently associated with institutions at the microeconomic level. The policy measures in columns 3 and 4 (Table 2) address potentially present transmission and supply-side restrictions. These can be considered partly short-term and partly long-term structural measures, where the latter can be expected to instill more confidence among investors and business owners. I will go through these in more detail in the following sections.

As is well known, structural change imposes transition costs as the economy adjusts to new conditions, particularly with regard to increased unemployment and firm closure if exposed to changes in demand and stiffer competition.²⁰ Better coordination between demand- and supply-side policies may alleviate such social costs that normally accompany a crisis by enhancing an economy’s flexibility.

The importance of coordinating traditional monetary and fiscal policy measures to stabilize the economy has long been underscored in the literature.Woodford and Xie (2020) find that the efficiency of fiscal policies is contingent upon an accommodating monetary regime. Otherwise, fiscal policies may trigger hikes in interest rates and vice versa, leading to suboptimal stabilization policies according to Bianchi and Melosi (2017).³¹ They furthermore conclude that it is necessary to consider both long-term and short-term policy targets in a crisis situation, e.g., with regard to inflation levels or debt levels. Benmelech and Tzur-llan (2020) note that the possibility of combining monetary and fiscal policies is not feasible for all countries but depends on sovereign debt and credit rankings, i.e., there is a limit to the extent that fiscal policies can be implemented. In particular, poorer countries with a sizeable debt burden may be stripped of the opportunity to use more efficient fiscal policies and have to resort to monetary policies.

Even though there seems to be a consensus that a concerted strategy of stabilization policies to stimulate the demand side of the economy is needed, a more systematic inclusion of the supply side has not been considered to the same extent. In particular, the issue of how to integrate microeconomic supply measures to stabilize an economy is basically neglected in the policy discussion. Giving the supply side of the economy a more prominent role in stabilization policies requires the presence of an entrepreneurial business sector, i.e., economic agents—individuals, start-ups, and incumbents—that will react and convert policies into economic activity.

Moreover, as suggested in the knowledge spillover theory of entrepreneurship, different types of firms can be expected to contribute differently to economic dynamism (Acs et al., 2009; Braunerhjelm et al., 2010). Additionally, in the present context, I stress the importance of addressing both new and young firms as well as older incumbents. The former are often more risk-prone and experimental; they tend to drive innovation and competition, but they are also more vulnerable and exit prone. Incumbents are better at scaling up operations, making gradual improvements and innovations and reaching out internationally (Baumol, 2002; Christensen, 1997). By including supply-side measures at the micro-level, firms’ enhanced possibility to survive, innovate, and scale-up also improves the scope for recovery. Such supply measures may also create demand, for instance, by innovative firms providing cheaper goods and services in an economic downturn.³²

Several of the proposed measures have been implemented previously, whereas others are new. To affect the business cycle, interventions should have a temporal, short-term perspective. However, their efficiency depends on an appropriate long-term institutional framework to promote market dynamics. Hence, I will consider both short-term interventions and necessary long-term reforms where the overarching objectives of policy should aim at increasing industrial dynamism and to provide possibilities for firms and industries to strengthen their long-run competitiveness.

Before delving into the suggested micro-level policies, the importance of having well-defined objectives with policy interventions and measurable criteria, followed by stringent evaluations of whether the stated objectives have been attained, should be stressed. There may be strong theoretical arguments to undertake different policy measures, yet the empirical underpinnings are presently scarce or nonexistent.³³ Therefore, well-designed efficiency evaluations of interventions are crucial to learn and adapt policies and to allocate scarce funds to those measures that prove to be most effective.³⁴ Inefficient support schemes and subsidies should be phased out.

Four micro-level policy areas (knowledge upgrading, taxes, financing, and the labor market) are argued to be particularly important vehicles to combat crises and moderate swings in the business cycle but also to strengthen the growth potential and build resilience against future crises. Finally, I will discuss the importance of institutions that generate competitive markets and proportionate insolvency regulations that does not stigmatize failures, both of which are long-term necessary conditions for adaptive and dynamic markets.

Based on a literature review of stabilization policies during primarily the two latest crises—the Great Recession of 2008–2009 and the ongoing COVID-19 that started in 2020—and the plethora of policy measures implemented during 2020, I have argued that the traditional toolbox used to stabilize fluctuations in an economic activity needs to be supplemented. The reasons can be summarized as follows.

First, monetary policy has lost much of its clout due to already exceptionally low-interest rates, even though the important tasks of securing financial market stability and access to liquidity remain. Simultaneously, acceptance of fiscal policies has increased, triggered by low-interest rates. However, the level of interest rates may change quite quickly in the wake of the massive fiscal stimulus packages to be undertaken in particularly the USA and to some extent within the EU. This may constrain countries that are already struggling with high levels of debt and sizeable budget deficits.

Second, the supply side of the economy has basically long been neglected in stabilization policies. The standard measures of large-scale infrastructure investments and similar projects were previously undertaken quite frequently and are presently facing renewed interest focusing on environmental projects, infrastructure maintenance, etc. However, the aim should be to increase demand while simultaneously taking into account supply-side factors, combined with a coherent realignment of policies at the micro- and macro-levels.

Third, even though some of the policies undertaken during the present crisis have been used previously, there are a host of unconventional measures that are more or less experimentally implemented with uncertain effects. Subsidies directed toward firms and employees have flourished. A guiding principle should be that access to subsidies is conditioned on firms’ and employees’ participation in knowledge-upgrading activities. Overall, the testbed of policy measures needs to be rigorously evaluated to filter out the most efficient tools to ameliorate the capacity to handle future crises.

Hence, the main conclusion is that an extended stabilization policy framework should incorporate policy measures that target the supply side of the economy. Temporary policies that aim at smoothing out cyclical effects at the firm level, including investments in real and human capital, access to finance, etc., should be combined with long-term reforms to instill confidence among economic agents regarding future market opportunities. Such measures would serve the dual purpose of strengthening the growth potential over time (augmenting knowledge) and lowering the social costs that appear as economies enter a period of structural adjustment, e.g., higher unemployment (training of employees, facilitating the entry of firms, etc.). This would enhance the business sector’s future competitiveness and strengthen the knowledge base of an economy.

A further effect may be to partially endogenize an economy’s ability to stabilize economic activity as it is exposed to shocks, i.e., make it more resilient. That is however an issue that would require more space than presently available and is a topic for future research.