The Pandemic Will Structurally Change the Global Economy More Than We Think

Those who say there are no letters left in the alphabet to describe the evolution of the world economy after the pandemic are absolutely right. It is abundantly clear now that we cannot expect to see a rapid V-shaped recovery — nor should we expect a complete stagnation or a L-shaped recovery.

The Square Root-Shaped Economy

The newest version of recovery, the K-shape, reflects the increasing disparity between the winning and losing sectors, including the middle class.

So rather than suggest a letter, I would like to call for a different shape recovery in a post-COVID world: the square root. A square root begins with a strong upswing, much like the one we are experiencing now, even as the pandemic still lingers.

However, this rapid recovery is immediately followed by a structural slowdown. In other words, the problem is not so much a sudden collapse in activity, but the negative impact that follows.

The big question is: Why would the pandemic bring lower growth? There are several reasons.

4 Reasons Why COVID Brings Lower Growth

Firstly, companies will be less profitable and will react by cutting fixed asset investment.

Secondly, the distribution of income will worsen worldwide. In fact, the pandemic has caused a serious deterioration in business profitability throughout the world. Similar to the global crisis in 2008, companies will want to recover their profitability and profits, for which they will have to reduce employment and wages. This will worsen the already battered distribution of income worldwide.

In other words, greater downward pressure on unit labor costs, and therefore on household purchasing power, seems inevitable. To make matters worse, the asset price bubbles stemming from ultra-lax monetary policies are bound to increase the divide between the working class and those able to invest in financial assets.

Thirdly, state intervention in the economy is leading to a much larger share of zombie companies. The fact that interest rates are to remain low will make it possible for governments to continue to finance such unproductive companies and their related misallocation of savings.

The fourth potential negative consequence is that global financial instability could be one of the key unintended consequences of the pandemic, due to increasingly volatile flows in emerging economies and doubts about the role of the dollar as a reserve currency.

Unstable Capital Flows

The combination of ultra-abundant global liquidity and fluctuations in risk aversion can lead to highly unstable capital flows, which remain crucial for many emerging countries. And the more an emerging country depends on external financing, the more costly this situation can be in terms of volatility of capital flows and economic performance.

Another form of financial instability may come from the growing doubt surrounding the role of the dollar in the world economy, stemming from the lack of U.S. leadership, the sharp increase in U.S. external debt and the ultra-expansionary monetary policy of the Federal Reserve.

China is well aware of the importance to U.S. long-term hegemony of the USD as the reserve currency, and will have no qualms about using the weapons it has at its disposal, to weaken the role of the dollar in the long run.

The Hiatus in Education

The fifth and final reason is driven by the loss of human capital due to the discontinuation of education programs globally. There is bound to be a reduction in fertility rates for many years, given the negative impact of the pandemic on household income for years to come.

If we analyze each of these points in greater detail, lower growth in the medium term seems unavoidable and with it, the continuation of the ultra-low interest rate environment we are in. The loss of human capital, as well as loss of financial capital due to the sharp drop in investment, in addition to the destruction of business fabric due to bankruptcies, are all bound to have lasting effects, which demand policies cannot do much about.

Social Reform Needed

Any cushioning effect must come from innovation and changes in societal norms, including faster digitalization and, possibly, the further greening of economic activity. Still, the efforts which would need to be made for technological and societal innovation to completely offset this trend towards lower potential growth look Herculean to me.

In summary, the economic impact that we can expect from this pandemic in the medium term is not promising for companies, families or governments. It’s hard to think of a more devastating shock to the world economy and not just because of the immediate effects.

It is time to rethink many of the basic principles of our economic model to mitigate these impacts.

(This opinion piece was originally published in Brink news: https://www.brinknews.com/the-coronavirus-pandemic-will-change-the-global-economy-more-structurally-than-we-think/)