The Economic Emergency - why we should all be worried

In the first part of my two-part article on the excellent piece of research by the London Business School the “Economics of a Pandemic – the case of COVID-19,” I dealt with the science of the pandemic and the suppression policies being adopted by various countries to decrease the replication number of the disease and to flatten the curve of infection.

Flattening the infection curve steepens the recession curve. The measures that help solve the health crisis make the economic crisis worse. On the other hand, in the absence of suppression policies a recession would be much more severe. Suppression polices buy time and that time must be used well.

In this second part of my article, I will deal with the global economic emergency that is certainly going to follow the onslaught of this pandemic and with the measures that can be taken, mainly by governments, to also flatten the recession curve and safeguard our livelihoods.

According to the London Business School, the macroeconomic outlook is bleak:

·      A global recession is inevitable. The Euro Area GDP is expected to fall materially.

·      The effects from a lower demand caused by uncertainty, social distancing, isolation and lock-down policies will be much larger than from the disruption of the supply chain.

·      Businesses and households will, for an unknown period of time, experience a total or partial loss of income.

·      The large drop in demand will force certain businesses to close and not re-open for business. This will lead to a rise in lay-offs and a further drop in consumption and investment.

·      With little or no government intervention, the economic costs will be immense.

·      Government spending should be immediate and as large as the predicted drop in GDP, focusing directly on cash disbursements to firms and households.

·      Central banks should provide financial backing to the government, not just through their own reserves but also by printing money if necessary.

·      A Global shock needs a global response. No country has the fiscal capacity to stand alone.

At the time of writing, this article there were 1,056,159 confirmed cases, 57,206 deaths and 207 affected countries and increasing. Right now, the priority is to control the spread of the virus and to reduce as much as possible the tragic loss of human life. Nothing is more important.

It is equally sad to read that in a matter of a few weeks hundreds of thousands of jobs have already been lost across Europe and the U.S. Safeguarding our livelihoods is not something we can leave for later. It certainly does not look like we will have normality any time soon. Rather, we should brace ourselves for a long period of economic recession.

The COVID-19 crisis bears none of the characteristics of previous crises. It is likely to be the biggest economic threat of our generation. It is more akin to a global war than a global crisis. This emergency requires economic measures and solutions that have not been used before. There is still a lot of uncertainty about the progress of this pandemic and nobody knows how long the spread of the virus will last. We therefore do not know for how long the economic consequences are likely to last. What we know is that the economic recession that will follow COVID-19 will dwarf the 2008-9 financial crisis.

For Larry Fink, CEO of Blackrock, these are unprecedented times, which he has not seen in his 44 years of finance. Fink emphasises “this is not a financial crisis. Dependency on central banks to moderate the problem can only achieve limited results…..this is a crisis of confidence.”  

This crisis is different because, unlike previous crises, COVID -19 has killed both supply and demand and therefore the supply of income – the lifeblood of every business and household. All businesses, particularly small businesses rely on cash flows whilst young families and renters would typically have little cash-in-hand. The output loss associated with the Covid-19 crisis is likely to be permanent.

On the supply side, the COVID-19 has disrupted global supply chains. Industries will have difficulty producing as the world labour supply decreased due to mandatory quarantines and social distancing. On the demand side, businesses will be forced to close due to the large drop in demand leading to a rise in lay-offs. Going forward fewer businesses will be inclined to invest and less people inclined to spend. Layoffs mean lower consumption, eventually depressing the aggregate demand. The large drop in demand dries up corporate cash flows, triggering bankruptcies and lay-offs.

Clearly, because of the scale of economic devastation that the COVID-19 crisis will cause, businesses and households cannot face the economic emergency that is going to follow on their own without help from governments. This therefore begs the questions: what can governments do and how much is actually needed?

What can governments do?

The interest free postponement of certain tax payments are indeed important measures as these alleviate imminent cash flow and liquidity concerns that businesses will certainly face.

Governments should address the insolvency risk and not just the liquidity risk. 

Soft loans and loan guarantees are far less effective. Loans have to be repaid. Economist Martin Wolf argues that businesses will take up loans only to ensure their survival through the crisis but soft loans and guarantees do not safeguard against layoffs. Emmanuel Saez and Gabriel Zucman argue, “loans do not compensate businesses and workers for their losses but just allow them to smooth costs over a longer time horizon.” Soft loans will end up being used to settle unreasonable demands for settlement of rent by landlords and for claims from suppliers and other commitments but will not be used to pay the salaries and wages of employees and will therefore not prevent lay-offs.

The first economic priority is to ensure that workers remain employed. It is good to help businesses obtain softer loans to ensure liquidity but it is also important that government will take it upon itself to directly pay all laid-off workers (including self-employed people who have lost their earnings) as if these have been absorbed into the public service. It is employed people earning their usual salary who will eventually (when things return to normal) continue to sustain the many businesses to the extent they now do and therefore help them return to profitable ways. It is equally important for businesses to keep their workers so that they can resume their business quickly, without having to recruit new workers, when demand resumes.

Wage subsidy measures for employees in those sectors that have been worse hit and for employees who had their job terminated are therefore far more effective in the fight against lay-offs. However, wage subsidies may not be sustainable if the crisis persists for much longer than expected.

Governments must also ensure that small to medium-sized enterprises can weather the storm without going bankrupt. Contrary to what many may think, the majority of small to medium sized businesses do not have adequate cash reserves to see them through these unprecedented times. It has been suggested locally that government may have to consider compensating businesses for lost revenues. Although such a measure may prima facie appear to be both unaffordable and unsustainable, it is a theory that is promulgated by economists Emmanuel Saez and Gabriel Zucman who argue that “in the context of this pandemic, we need a new form of social insurance, one that directly targets and works through businesses. The most direct way to provide this insurance is to have the government act as a buyer of last resort. If the government fully replaces the demand that evaporates, each business can keep paying its workers and maintain its capital stock, as if it was operating under business as usual. To see how the notion of a buyer of last resort works, take the case of the airline industry. If demand drops by 80%, the government would compensate this missing demand, in effect buying 80% of plane tickets and maintaining sales constant. This would allow airlines to keep paying their workers and maintain their planes and equipment without risking bankruptcy.”

Governments can only respond to the economic emergency by increasing their borrowing. Although debt is currently attractive, especially given the ultra-low interest rates, not every country has sufficient credibility to afford it without too much sovereign risk therefore the backing of ECB, in Europe, and Central Banks elsewhere is key. It is true that such an approach will inevitably inflate public debt but this could be reduced over time to the position it now is.

In their research, the London Business School conclude that “with little or no government intervention, the economic costs will be immense.”

In the meantime, government and the private sector should start working together to we can start thinking of how to revive the economy

How much is actually needed?

The direct loss of economic output is expected to be short, hopefully a few months. Although this direct loss of economic output is going to be inevitable, governments can alleviate economic hardship during the health crisis and prevent the direct output loss from causing lasting damage to the economy.

Economist Pierre Olivier Gourinchas argues that the financial aid should be of the same order of magnitude as the predicted drop in GDP. Gourinchas estimates that an economy-wide fall in the demand for goods and services of 40% over 3 months leads to a 10% drop in annual GDP. Government should therefore fully compensate private losses by transferring 10% of GDP to the private sector, financed via an increase in public debt. The UK announced a package worth around 15% of GDP, which is equivalent to the expected loss of economic output. Unprecedented!

Bold actions by governments are called for. Fiscal support must be at a scale equal to the expected fall drop in GDP. Notwithstanding its extent, financial aid by governments will always be finite. It is important that government financial aid goes to those businesses and economic activities that need it most, especially those business that have been forced to closed down by government order. The yardstick for who should benefit from financial aid should be the creation of economic value.

David G. Curmi

Source: "The Economics of a Pandemic - the case of Covid-19” Paolo Surico and Andrea Galeotti Professors of Economics at London Business School."