The coronavirus is a classic negative “exogenous shock,” an unforeseen event that hits the economy from outside and pushes it into recession. On closer inspection, many such shocks turn out to be “endogenous,” that is, arising from the internal workings of the system. The Global Financial Crisis felt like an exogenous shock, but it was really a complicated endogenous one. Economists talk of “policy shocks” and “technology shocks,” but these too arise from within the economic system. Next to a solar flare or an asteroid hitting the earth, COVID-19 feels like the closest thing to a genuine exogenous shock.
The distinction matters because the more “exogenous” the shock the easier it should be for the economy to return to its prior course or condition once the shock dissipates. This is the relative good news about the COVID-19 recession: if the virus runs its course or is quashed by an effective vaccine being developed, the economy should be able to return to some semblance of normalcy, without too many lingering negative effects (like the headwinds of secular debt deleveraging in the wake of an asset-bubble-fueled financial crisis).
But there are some more sobering counterpoints to that optimism. The unique feature of this recession is that it is happening as an integral by-product of the public policy response to the health crisis. This turns the usual logic of recessions and macroeconomic policy responses on their head. In a usual recession, aggregate demand falls for some reason and the government (including importantly the central bank) tries to restore the lost demand as quickly as possible by easing monetary and fiscal policies. In the COVID-19 recession, governments have suppressed economic activity so as to stem the spread of the pandemic. It is not so much the pandemic, as the responses of governments to it, that has caused economic activity to contract as much as it has. Recession has been part of the pandemic cure.
The fall in economic activity in such a short span of time is unprecedented. The IMF downgraded its global (real GDP) growth forecast by 8.2 percentage points (pp) between January and June (from 3.3% to -4.9%). Even in the Great Depression, GDP did not fall, and unemployment rise, so fast. The unemployment/underemployment (U6) rate in the US rose by 15.8 pp in just two months, from 7.0% in February to 22.8% in April (by June it was down to 16.5%); in the Great Recession it rose from 10.8% (in August 2008) to an initial peak of 17.1% (in October 2009), but this 6.3pp increase took 14 months. In the 20 weeks since mid-March the cumulative total of initial unemployment claims in the US is equivalent to one-third of February’s workforce. Even after three months of “record” increases in non-farm payrolls, all of the jobs growth since September 2014 stands wiped out.
This last observation highlights a key point about interpreting economic data in such volatile times. After a sharp fall in activity, it is important to look at both levels and rates of change in taking the pulse of the economy: if a variable drops by 50% and then rises by 50%, it is still 25% below where it started.
Governments have responded to the sharp fall in economic activity, much of which they imposed, with aggressive monetary and fiscal policy easing. Usually the aim of such measures is to stimulate economic activity and restore the shortfall in demand as quickly as possible, but this time is uniquely different. Governments do not want consumers to go on an across-the-board spending spree (at least not just yet), because this would defeat much of the purpose of the “social distancing” and “lockdowns” imposed to fight the virus. Rather, macroeconomic policies are aimed more at keeping the economy in a state of “suspended animation,” so that it is ready to recover strongly when the pandemic coast is clear. Thus fiscal policy responses have been centered on income transfers and loans and loan guarantees (rather than government spending on GDP), and monetary policy responses have focused on central banks providing “liquidity” to the real economy and easing fiscal constraints by buying bucket loads of government bonds (this “quantitative easing” or QE just restores the central bank reserves and part or all of the bank deposit money that the government creates by running a budget deficit but “sterilizes” by issuing bonds).
Most of the widespread concern that is expressed about governments running up so much debt and central banks “printing” too much money is misplaced and reflects academic and policy thinking that is held hostage to twentieth century paradigms. The “functional finance” perspective of Abba Lerner, a brilliant but younger contemporary of John Maynard Keynes, is more useful. The judgement on when and how to pull fiscal and monetary policy levers should be based on what is needed to keep the economy at full employment with price stability (and with financial stability), rather than being driven by arbitrary fiscal targets and monetary probity.
A rising stock of government debt does not impose a “burden” on our grandchildren. For one thing, government debt never has to be repaid in the way that households or companies are on the hook for their debts. As the recent experience with QE should make clear, one arm of the government – the central bank – at will can convert government bonds into central bank money (reserves), which no more has to be repaid than a twenty dollar bill does. Government bonds are better viewed as a means by which people can transfer purchasing power through time. The simplest way to see this is to note what the national accounting identity for the world as a whole says: the private sector can save more than it invests only if the government runs a budget deficit.
As was learned in the twentieth century and codified in the contemporary macroeconomic policy framework, governments printing too much money can lead to high inflation, if too much purchasing power ends up chasing too few goods. The well-known remedy then is for governments to modulate that purchasing power by tightening monetary and fiscal policy. Governments can find it useful to raise taxes in order to keep inflation in check (and to redistribute income and ameliorate negative and positive externalities), but they don’t need to do so to repay their debts or to avoid imposing a burden on future generations.
The real burden of a recession falls on the people today who lose their jobs and suffer associated hardship and on future generations who will likely inherit a slightly smaller stock of productive capital than they otherwise would; the longer and deeper the recession the bigger that burden. What goes by the moniker of “austerity” gets this all wrong.
The COVID-19-triggered recession has highlighted some serious fragilities and vulnerabilities in the global economic system. Not to make light of the death and suffering, by some measures and perspectives, the shock to the global economy system represented by the coronavirus itself is a relatively small one. As of the time of writing, the World Health Organization estimate of total deaths from COVID-19 stood at 800,906, which is not much higher than a very bad influenza season (estimated at 650,000 deaths), and represents about 1.4% of estimated annual global deaths. Yet, via the “policy reaction function,” the impact on global growth has been dramatic.
This should give policymakers, investors and citizens pause. We are far from being out of the woods with this pandemic, but how prepared are governments, economies, and societies for future epidemiological, geopolitical, cyber, socioeconomic, climatic or other shocks?
At one level, the inherent fragility of the hyper-globalized world economy should not be surprising. Markets are very good at “optimizing” but they are not good at “robustness:” the very efficiencies that markets are so good at squeezing out deprives economic systems of the redundancies and slack that might be needed when unexpected contingencies occur.
But there are also concerns about how well equipped governments are, both individually and acting in concert, to deal with COVID-19-type shocks in terms of their information-gathering, decision-making and crisis-response capabilities. In this crisis, many governments have turned to their in-house medical experts, who have suddenly been thrust into high profile policy advice and public communication roles for which they may be ill-prepared and ill-suited. In the COVID-19 post-mortem, political leaders and governments will need to pay serious attention to the question of how better to equip themselves with effective crisis-management tools and frameworks to deal with a range of future contingencies.
The COVID-19 pandemic looks set to have an impact of the economy, society and polity that goes well beyond its near-term impact on the path of GDP, as significant as that is. It is likely to amplify and accelerate a number of existing or nascent trends, as well as produce some new ones that defy discerning from our current vantage point.
Perhaps most obviously the pandemic is likely to have a lasting impact on the nature of work, particularly in the “knowledge economy,” as companies and employees embrace telecommuting and as companies reevaluate not only their real estate footprints but how “virtual” and cloud-based they want to become. More generally, urban life stands to lose some its attraction or at least for many increasingly become a smaller part of a portfolio of locational and life-style choices.
The “globalization” pendulum is likely to swing back a bit further particularly when it comes to the near-shoring and re-shoring of manufacturing supply chains, as the pandemic has highlighted that sovereignty and borders matter more than some thought, and that it is worth sacrificing some pursuit of efficiency in the service of being more self-sufficient.
Because the coronavirus originated in China but so far has wreaked its most damage in the US and Europe, the fault lines that had been developing in US-China relations stand to be accentuated even further, and the geopolitical and geo-economic realignment of the world into US-centric and China-centric spheres of influence is likely to accelerate.
A big concern is that both the negative impact of the pandemic and the positive impact of the recovery from it will exacerbate income and wealth inequalities within countries (so far the advanced economies have been impacted more than emerging economies but this could change).
One of the disconcerting (although from a purely economic viewpoint not necessarily unwelcome) features of this recession, particularly in the US, is the apparent disconnect between the performance of financial markets and that of the real economy, meaning that those with significant financial wealth have done well. US real GDP fell by 10.6% (on a non-annualized basis) in the first half of 2020 and yet the S&P500, at the time of writing, is just 1% shy of its mid-February (and all-time) high. And the brunt of unemployment and wage income destruction has fallen on less skilled segments of the workforce, while “knowledge workers” have been able to “work from home,” that home oftentimes being a second one away from the angst of the locked-down city. The seeds of (further) social unrest and erosion of social capital may be being sown.
Even before the pandemic-triggered recession, the macroeconomic policy world was having a bit of a mid-life crisis. The “natural rate of interest,” that is, the real interest rate associated with the economy being at full employment with price stability (or in central banking-speak, R-star) , appeared to be permanently low, if not even negative, a state of affairs Harvard economist Larry Summers has termed “secular stagnation.” A consensus was forming that, in future, fiscal policy could and should play a bigger role in macroeconomic policy management than in the past several decades. The macroeconomic policy framework, resting on a strict separation of monetary policy from fiscal policy and the assignment of the prime responsibility for managing the macro economy to an independent, technocratic central bank, was looking increasingly in need of overhaul.
The pandemic recession has likely pushed the natural rate of interest even lower and reduced the chances that it will revert to anything resembling a twentieth century norm any time soon. This is not only because of the big hit that already weak aggregate demand has taken but also because of the spur to the virtual economy delivered by the pandemic response, both of which factors are likely to lead to (desired) savings exceeding (desired) investment, the stuff of lower R-star.
The all-hands-on-deck policy response to the pandemic recession has already precipitated aggressive coordinated, if not joint, policy action by the monetary and fiscal authorities. This trend will likely continue and increasingly become codified in changes to the macroeconomic policy framework. By the time the long-awaited respective strategy reviews of the Federal Reserve and the European Central Bank are released, they may be looking anachronistic.
How much of a global gamechanger COVID-19 ends up being is hard to say, but the scope for it to be up there with the likes of the Great Depression cannot be dismissed.
Paul Sheard is a Research Fellow at the Mossavar-Rahmani Center of Business and Government at Harvard Kennedy School. He formerly held chief economist positions at leading institutions in New York and Tokyo.
First published in Woori Financial Plus, 9 August 2020