The mechanics of an economic shock explained
The coronavirus pandemic is a global crisis of epic proportions. From an economic point of view, it is triggering both a negative supply and demand shock. It’s a negative supply shock because global supply chains are severely impacted or even completely interrupted. It’s also an extremely severe demand shock. Several sectors including tourism, logistics and leisure for example see demand for their services almost grinding to a complete halt. And because citizens’ revenues ultimately derive from production, household income is falling quickly. Meanwhile, companies refrain from investing and international trade is collapsing. Unemployment is soaring. The crisis is creating huge havoc in financial markets too.
In other words, economies around the globe are entering a downward economic spiral and confidence among firms and households is taking a big hit. A global recession is now all but inevitable. Even more worrying, there’s a real risk that the downturn becomes a self-fulfilling and ever-deepening depression in case the coronavirus is not brought under control and the lockdown measures remain in place for several months instead of weeks. Many companies could face bankruptcy in this risk scenario, in turn triggering defaults and trouble for the banking sector. The financial system would experience unprecedented stress.
How big will the economic fall-out be?
Unfortunately, the size and persistence of the economic impact are unknowable because the duration of the economic shock depends on how the virus will behave and which public health policy reactions are being put in place (and for how long). Uncertainty looms large. Like a healthy person who catches the seasonal flu and is quickly back to full power, the crisis could be short and sharp. Such a ‘V-shaped’ hit seemed likely when COVID-19 was essentially a Chinese problem and China was dealing with it forcefully. However, while a short-and-sharp crisis is still possible, it’s looking increasingly less like the most likely outcome.
Indeed, the economy is taking a much worse hit than observers initially expected. Chinese data for January and February reveal that industrial output in China was down by 13.5% compared to last year while retail sales fell by 20%. Spending on machinery and infrastructure declined by 25%. While the total number of infections has stabilized, the economy has not. Activity is recovering only very gradually and output is still way below levels seen at the start of the year. Logically, with the spreading of the virus, economists have been busy slashing their forecasts for the rest of the world. Global GDP could easily fall by more than 1% in 2020, which would be twice the decline seen in 2009. Activity in the Eurozone could fall by as much as 10% according to several estimates.
An extraordinary crisis requiring extraordinary measures
That said, economists would better refrain from making outright predictions now as these can all too easily create a false sense of certainty and objectivity. All focus should now be on what policymakers can do to cushion the economic fallout. Crucially, effective policy requires central banks and governments to work closely together.
Central banks are offering cheap and limitless funding for commercial banks that lend to the hardest-hit companies and households most at risk. They are also taking up their role as lenders of last resort by buying financial assets such as government and non-financial corporate bonds. In doing so central banks want to make sure that governments and companies keep access to lending at low borrowing costs. Another goal is to stem panic in financial markets.
Arguably, fiscal policy has an even bigger role to play. A broad range of measures including the expansion of access to health care, schemes of temporary unemployment, loan guarantees, deferral of tax payments and social security contributions, direct compensations for income and revenue losses, rescue funds or even direct payments to households are being implemented or considered. The German rescue fund for example encompasses €400bn in public guarantees, 100bn in equity stakes and 100bn in loans. Total new government borrowing could reach more than 350bn in 2020 (around 10% of GDP). Other countries are also stepping up efforts. Public deficits will soar as a result. However, that should not be the main worry now. The only right approach is to do ‘whatever it takes’ to protect public health and cushion the economic pain so that we can get immediately back to action when this dark episode has passed.
What should I do?
As explained, there’s a real risk that the downturn becomes a self-fulfilling and ever-deepening depression in case the coronavirus is not brought under control and the lockdown measures remain in place for much longer than anticipated. The humanitarian costs of the COVID-19 pandemic continue to mount, with more than 723,000 people infected globally (at the time of writing).
The solution to limiting the humanitarian and economical costs of this crisis are closely aligned and start with a strict follow up of the lockdown measures. This should be yours and everyone’s priority.