So far, the economic impact of the virus is bad, but just how much worse could it get, asks David Prosser.
In 1665, as the bubonic plague tightened its grip on England, Cambridge University took the unprecedented step of closing its doors. One of its young students put the period of isolation to good use: Isaac Newton spent his forced sabbatical at home doing the groundwork for what would become his theory of calculus.
More than 350 years later, the calculus that Newton developed underpins the economic models we are using today to plot the likely consequences of Covid-19, the new coronavirus that has spread so quickly around the world. The anecdote is a reminder that the consequences of these so-called black swan events can be both unknowable and far-reaching.
Still, here’s the headline news in terms you don’t need a Newtonian intellect to understand: the economic fallout of Covid-19 will be bad, very bad, or somewhere in between. “Prior to the coronavirus outbreak, there had been signs that the worst was over for both world trade and the manufacturing sector,” says Ben May, director of global macro research at the think-tank Oxford Economics. “However, this tentative optimism has been dashed by the current disruption.”
For bad, think of the OECD’s central forecast for global economic growth in 2020, which it has already reduced from 2.9% to 2.4% to reflect its estimate of the impact of the coronavirus crisis. In parochial terms, that implies a short-lived recession in the UK this year, followed by a strong bounce-back as normality returns.
As for very bad, the OECD’s downside scenario has growth falling to 1.5% this year; Oxford Economics thinks the figure could even be 1.2%. These projections are more analogous to our experience following the global financial crisis, the last black swan event.
As Money Observer went to press in mid-March, it was too early to know how serious Covid-19 will prove. Initial hopes that it would be contained in China have been dashed, with the World Health Organisation formally confirming a pandemic in early March. Different countries are taking different approaches – the UK, notably, has taken less aggressive measures than many European counterparts – but scientific experts are divided about what lies ahead. Economically, meanwhile, there is no getting away from the fact that draconian measures, from the US’s ban on flights from Europe to the lockdown in Italy, will have significant impacts.
Clearly, a short-lived crisis in which the world is able to defeat the virus by spring or early summer will have less serious economic consequences than an enduring crisis in which workplaces and schools remain closed for an extended period.
Financial markets certainly fear the worst. The collapse of global markets in early March – plunging many into bear territory – reflects real fear that the economic impact of Covid-19 will be severe and long-lasting. Bernard Baumohl, chief global economist at the Economic Outlook Group, understands that concern. “Whether it’s formally declared or not, we are dealing with a pandemic,” he warns. And while, as Baumohl says, “no one can say with much confidence how much harm the virus will do to people or how much damage it will do to the global economy”, a Covid-19 recession will be worryingly unusual: it will have both supply- and demand-side triggers.
On the supply side, the best case is that firms simply become a little less productive as workers take time off sick. Widespread school closures or limits on travel will amplify the problem, with greater numbers of people unable to work. And where employers are forced to close for a period, the crisis will be of even greater magnitude, particularly as the effects are felt through global supply chains that cannot easily be unpicked.
Still, one bit of good news about supply shocks is that they’re gratifyingly temporary – they tend to be u-shaped, unpleasant on the way down, but with a smart recovery. Periods of under-production can be made up later, when conditions return to normal – staff returning to work can do overtime, perhaps, while unused inventory can boost output for a period.
Unfortunately, this is less true of the demand side. When consumers lose confidence, and stop going out for meals, buying cinema tickets or going on holidays, they don’t do all those things twice when confidence returns. This is sometimes overlooked by conventional models, argues Simon Wren-Lewis, a professor of economics at Oxford University who has developed economic models to study the effects of flu pandemics. “All this assumes consumers who have not yet got the disease do not alter their behaviour, [but] for a pandemic that spreads gradually this seems unlikely. A demand shock can hit specific sectors very hard, depending on how consumers behave.”
This is particularly the case in economies such as the UK, which depend heavily on consumer spending. In this context, setbacks on the stock market are especially worrying, given the damage they do to confidence. Even without quarantine measures that effectively force consumers to spend less, people will naturally feel less comfortable with spending money in the months ahead.
The combination of demand- and supply-side triggers is complicated, warns Wren-Lewis. “Falls in social consumption do not scale up all scenarios by the same amount, for the simple reason that supply and demand are complementary,” he explains. “If school closures and people taking more time off work increase the size of the supply shock, the demand shock has less scope to do damage.” Even so, his previous modelling work put the worst-case GDP decline in the UK at a scary 6 percentage points.
Policymakers will seek to mitigate the crisis. Governments and central banks stand ready to administer economic medicine, from direct relief to individuals and businesses to economy-wide measures. These are already being put to work. Emergency interest rate cuts in the US and the UK will provide some comfort. March’s Budget was full of support for individuals and businesses struggling with Covid-19 related problems. Improved credit for businesses, funding for sick pay and other benefits, and measures such as business rate exemptions will all help.
Monetary policy support may have to be long-lasting, with longer-term bond yields already reflecting this. “Markets are suggesting that the Fed’s response will not only be forceful, but also permanent,” argues Moritz Sterzinger, a director of Chatham Financial. “The current five-year swap rate implies average inflation below 1% in the medium term – a pessimistic outlook.”
Herein lies something else to worry about, however. Lower interest rates and policies such as quantitative easing and fiscal measures encourage consumers to spend and provide businesses with much-needed financial support. But they do nothing to confront supply-side problems, where there is a further danger lurking. In extreme circumstances, supply chain delays and business closures could lead to product shortages and, ultimately, the return of inflation.
“The challenge posed by a supply side-driven downturn is that it can result in sharp declines in production and widespread bottlenecks,” says Kenneth Rogoff, professor of economics and public policy at Harvard University. “Generalised shortages – something that some countries have not seen since the 1970s – could ultimately push inflation up, not down.”
Such an outcome would leave policymakers in a terrible quandary. Do they continue to offer monetary policy support on the downside and risk a disastrous increase in inflation because of supply side issues? Or do they take a more traditional approach to rising inflation by tightening policy and leaving the demand side to fend for itself?
The optimistic view is that we may not reach this stage – that public health interventions, warmer weather and medicinal advances will stop Covid-19 in its tracks at an early stage. Still, even if the virus had been confined only to China, the importance of its economy globally means that from a financial perspective at least, you could not have picked a worse place for an isolated outbreak.