The Economy in the Time of Covid-19

Following up on yesterday’s note (Business in the Time of Covid-19) here is an overview of where the economy currently is with Covid-19 and where it can be expected to go over the coming months.

If interested please sign up for my April 3rd London Business School webinar on the topic. Tomorrow’s note will focus on the role of economic policy through the crisis.

Where are we?

Although we haven’t yet got the data to confirm it, it appears that most countries are currently entering a major recession. This is happening as a direct outcome of government policy aimed at pushing back the Covid-19 infection curve (see Figure 1).

The result of shelter at home/lockdown policies is that the economy is being subject to a major adverse supply and demand shock. The adverse supply shock is due to people being unable to work which produces an abrupt decline in output. The adverse demand shock is because people are unable to go out or travel and so their spending opportunities are limited. This is compounded further by those who can’t work may also be not earning and so have to cut back their expenditure. The danger is that these effects will cumulate over time and lead to even larger falls in output as firms go bankrupt, unemployment rises and consumers spend less.

The immediate impact on the economy is large and dramatic. Assume that 20% of the economy completely shuts down for two months and then recovers e.g a 20% loss for 1/6th (2/12) of the year. That is just over a 3% reduction in GDP growth for the year. If the shut down lasts for four months then it is double that e.g nearly 7%. Obviously, this all depends on how much of the economy is affected and how much output in those sectors declines but as this calculation shows it is pretty easy to quickly get to large negative numbers.

What to expect?

The simplest answer is we don’t know what comes next. Economics has a poor forecasting record in the best of times and these are not the best of times. Given we don’t know how the disease will spread, we don’t know how long government’s will impose a shutdown for and given we don’t really know how pandemics impact the economy the forecast uncertainty is huge.

Economists shouldn’t be blamed too much for that failure. No one seems to be demanding forecasts from the epidemiologists, who find themselves at the heart of this crisis, and hopefully economists will follow them in not succumbing to offering them. Ultimately the reputation of epidemiologists as well as economists in this crisis should be judged by the interventions they recommend and not the forecasts they make.

One way of gauging the likely impact on the #economy is to go back and look at previous pandemics. The obvious instance is the Spanish Flu of 1918-20 (or more correctly the ‘Great Influenza Pandemic’). Gauging the impact of this pandemic is complicated by the fact it predates the collection of GDP data and its effects are intermingled with the end of WWI.

It was also a very severe pandemic contributing towards 39 million deaths (2% of the world’s population) and possibly even 50 to 100 million. Given current projections of Covid-19 the Great Influenza Pandemic should be considered as an upper bound/worst case in terms of mortality outcomes and possibly also in economic terms.

Barro, Ursua and Weng (2020) review data across 43 countries and estimate that the Great Influenza Pandemic produced GDP declines of around 6% of GDP and around 8% in consumption. The World Bank in a 2006 simulation exercise suggest a serious global pandemic would contribute to a 5% decline in world GDP. These estimates reinforce the simple arithmetical calculations made above – we seem set for a substantially large drop in GDP.

That the recession will be deep seems inevitable. What is harder to know is its duration. Whilst economists have plenty of experience of ‘regular’ recessions caused by financial crisis or tightening monetary policy we have little of global #pandemics. As a consequence, any forecast will be based on assumptions on what could happen rather than exploiting past empirical regularities as to what has happened.

The problem is exacerbated by the fact that even in ‘normal’ times economists have problems predicting turning points e.g. shifts from boom to recession and back again. As a result discussion tends to revolve around a business cycle alphabet of whether the recession will be V, U, W or L shaped – as shown in Figure 2.

The most optimistic forecasts assume a V shaped recession. The logic here is that whilst a sharp slowdown is inevitable, once restrictions are removed the economy should roar back. In effect #Covid19 will be just like an extended weekend or Christmas vacation with the economy quickly restored. In this case the second half of 2020 will see dramatic growth rates just as the first half saw disastrous ones. As drawn in Figure 2 the bounce back is not complete – the level of GDP does not return to where it was. Some firms will have gone bankrupt, some workers will remain unemployed and others will have experienced a fall in wealth. The bigger these effects the greater the gap between pre crisis GDP and what it returns to.

The V shape is optimistic because it either assumes a relatively short shut down (so that by 2020Q2 restrictions are removed) or that the knock-on effects from bankruptcy, unemployment and wealth declines don’t lead to a permanently impacted economy (‘economic scar tissue’). There is the possibility that even once controls are lifted the downward lurch of the economy continues as bankruptcies and unemployment intersect until the economy flatlines before eventually recovering at some future date – a U shaped recovery. In this situation the economy takes time to repair itself and for people to find new jobs and new business to start up even though the public health threat of the virus has disappeared. A prolonged continued shutdown would also lead to a U-shaped recession.

Two further alphabetical options are a W shaped recession (where controls are removed, the economy recovers but the virus reappears leading to a further shutdown and then another recovery) and an L shaped recession in which the economy nosedives and never recovers but stays at a new reduced level. This occurs either because eradicating the virus requires such a length shutdown that the economy can’t recover or the economic impact of even a short shutdown sets in play forces that are too big for the government to resolve.

All these alphabetical cases are like a map of the London Underground – they show general shape and connections but contain no accurate scale. In general advocates of a V shaped recession argue that 2020H2 will see dramatic growth and recovery, those who support a U-shaped recession say the slowdown will continue for the rest of 2020 and recovery will occur at the end of 2021 or even 2022. The W shape is contingent on when governments relax controls but is most likely for countries who remove these in Q2 and then reimpose them again in Q3 and of course the L shaped predicts no recovery and the only question is how long the decline takes to finish.

Source: “Safeguarding government’s financial health during coronavirus” Richard Hughes, 2020, Resolution Foundation, https://www.resolutionfoundation.org/app/uploads/2020/03/Safeguarding-governments’-financial-health-during-coronavirus.pdf

Figure 3 shows what happened to GDP in seven cases of countries exposed to major pandemics (Canada, UK, US in 1918-20, Hong Kong in 2003 during SARs and Guinea, Liberia and Sierra Leone during the Ebola outbreak of 2014). On average, it took three years to return to pre-crisis levels- suggesting a U-shaped recovery (although note that depending on the horizontal scale a recession can look U or V). However, the range over all 7 episodes is between 0 and 9 years. Once again uncertainty abounds.

What to make of all of this? The first is that economic forecasts will do nothing to remove the uncertainty firms face. There will be numerous forecasts appearing in the public domain but these will constitute guesswork even more than normal. The simple truth is that economic forecasting is most reliable in regular times but people become most interested in economic forecasts in irregular times. Economic forecasts have something of the character of a refrigerator light that only comes on when the door is closed.

Unless the worst case scenarios around the virus manifest themselves (lengthy lockdowns, the virus mutates and has several waves) or government policy fails or is inadequate the most likely options are a V or a U. That then leads to two key issues to watch out for – in both cases does the economy revert back to its pre-crisis level and if a U how long does recovery take?

In monitoring progress around both these questions it will be important to focus less on GDP growth but rather on the level of GDP itself. Whilst the shutdown is happening #GDPgrowth will be strongly negative. Once controls are removed growth will pick up. However, after -20% growth a quarter of 5% growth is not much to get excited about.

 ·     Economies going through shutdowns are likely to be currently experiencing sharp recessions as a direct result of government policies

·     The rarity of global pandemics makes it hard to forecast their depth and duration. Based on 1918-20 and simulations falls in GDP growth of 5-8% are plausible

·     If recovery is V-shaped then 2020H2 will see dramatic growth but this may be misleading. The focus should be on the level not the growth of output. They key issue is when will pre crisis output be restored.

·     The chance of a U-shaped recovery depends on the length of the shutdown and the extent of economic scar tissue caused by the shutdown

This is a fast-changing situation and the economic issues are rich and complex. To keep abreast please make the most of these extensive materials put together by my colleagues - Professor Andrea Galeotti and Professor Paolo Surico.

Andrew J Scott is a Professor of Economics at #LondonBusinessSchool, Research Fellow Centre for Economic Policy Research and author of the "100 Year Life" and the forthcoming "The New Long Life". 

Twitter @ProfAndrewScott · LinkedIn @ProfAndrewJScott · Website

Subscribe to my Newsletter