Wednesday 18 March 2020

The Coronavirus Shock: A Look at an Unprecedented Crisis

Robert Boyer, Ekkehard Ernst and Xavier Ragot respond

What makes this crisis different from previous economic crises?

Ekkehard Ernst (International Labour Organization)
The shock is completely exogenous and is not the result of economic imbalances. The impact is symmetrical on demand and supply (albeit with a different temporality). The impact is also highly uncertain (unlike an oil shock).

Robert Boyer (Cournot Centre/Institute of the Americas)
The previous crises resulted from the unfolding of cycles largely endogenous to the economic system: an acceleration of inflation called for a rise in interest rates at the time of the Trente Glorieuses (French Thirty Glorious Years), a deficit in foreign trade justified austerity policies in the 1980s and 1990s, and then financial liberalization sparked a succession of speculative bubbles (of the internet and then of real estate) whose bursting precipitated a downturn in the economy. This new crisis is, on the contrary, the result of an exogenous event originating in a Chinese Province. The emergence of an unknown virus is spreading throughout the world due to the mobility of individuals linked to the internationalization of trade and investment and mass tourism. To avoid an explosion in morbidity and mortality, after some hesitation, most governments have decided to take public health measures, in addition to containment measures, resulting in an economic crisis resulting in brutal financial market adjustments. The sequence is thus unique, even in relation to the two oil shocks of 1973 and 1979: an event from elsewhere strikes national economies that have become increasingly interdependent in trade, investment, production and intellectual property. Economies are vulnerable to the judgments of an international financial system, which is prone to swing from the most unbridled exuberance to extreme pessimism.

Xavier Ragot (Observatoire français des conjonctures économiques [OFCE])
The economic shock is very different from that of 2008: the 2008 financial crisis was a negative wealth shock (end of a housing bubble) and a sudden end to bank and bond financing. It took time to reach a new valuation of the assets. The current crisis is a negative supply and demand shock due to containment measures. This shock is transient in nature (even if the consequences may be long-lasting).

How far reaching is the shock?

Ekkehard Ernst

  • A recession, at least until summer, or even longer depending on the duration of the measures.
  • The possibility of rearranging long-term value chains and introducing redundancies in international trade with implications for production costs. 
  • The risk of a financial crisis erupting thereafter.

Robert Boyer
The heart of national economies has been affected (consumer goods and the automobile, transport, services, trade, tourism sectors, and so on) all over the world. The corresponding cost is very difficult to estimate, however, which is directly linked to two major unknowns: first, and above all, the duration of the pandemic, which research has not yet been able to identify; and second, the reaction of public opinion to containment measures and to massive government support programmes of the affected industries. Two radical uncertainties come into synergy: the characteristics of the virus and the impact of policies that have never been tested.

Xavier Ragot
The shock that will shake the world economy has had no precedent in the past 70 years. The largest fall in quarter growth was around 5% in the spring of 1968. During the 2008 crisis, the fall in quarterly growth was 1.6% at most. In this case, the fall is 10% to 30% over a quarter, before a possible rebound. Uncertainty about the magnitude of this economic shock remains high for obvious health reasons. Confinement measures will affect much more importantly certain sectors of the economy, such as commerce or the arts and entertainment.

What are the orders of magnitude?

Ekkehard Ernst

  • -5 to -10% growth in OECD countries in 2020;
  • a weak recovery in 2021;
  • resumption of inflation over a 10-year horizon.

Robert Boyer
Over time, estimates increasingly point to a fall in activity as measured by GDP. The evolution in China is enlightening. It gives us some perspective since it was the first country to suffer from the epidemic and to implement containment, which is being widely adopted by a growing number of countries. The first two months of 2020 saw industrial production drop by 13.5%, retail sales by 20.4% and fixed investment by 24.5%. We also observe very contrasting developments depending on the sector.

Xavier Ragot
To give an order of magnitude, if the French government had to pay half of the salaries of companies for a month and a half, it would represent a cost of 50 billion euros, or an increase in public debt of about 2.5% of GDP. This amount is consistent with the announcements made by Bruno le Maire, who spoke of possible costs for public finance of tens of billions of euros. Such an increase in public debt, even doubled (by the game of automatic stabilizers), is largely absorbable by the financial markets. Indeed, during this period, world savings will increase substantially, which is seen by the current fall in interest rates (see the rates in the US today). For the record, the increase in public debt after the 2008 crisis was 30% in France, as well as in many other countries. The current European budget/fiscal policy will not be able to meet the challenges we are facing. The European Commission has tried to define a fiscal policy by using residual money from structural funds. These amounts are too small to have a significant impact, given the urgency of the situation. If the Commission had its own debt capacity, it could help finance targeted health measures. This is not the case, however.

How should fiscal policy respond?

Ekkehard Ernst
Similar to the fall in GDP, with coordination at least at the European level in the absence of a stronger (possible) response from central banks.

Robert Boyer
March 17, 2020, was marked by a surprising convergence of the plans of France, the United States and the United Kingdom. It is important to mobilize all the capacities of governments to avoid economic and financial collapse. The measures adopted in the United States are unprecedented: a public expenditure of 850 billion dollars, emergency payment of a sum of $1000 to all citizens, refinancing measures for banks and even businesses, including by restoring commercial paper, “whatever the cost”, according to the leaders of the three nations. What will be the capacity of monetary voluntarism (the “quantitative easing” of 2008 renewed in 2020) and then of public expenditure to compensate for structural obstacles in the production and the formation of value creation? What will happen if the loss is permanent due to the low level of productive recovery? If it is not an increase in the dependence on debt — an indication of a persistent gap between the anticipation of growth resumption and a sustainable slowdown — it is neither an investment in the future.

Xavier Ragot
France’s fiscal response must be strong and potentially unlimited. During confinement, it is necessary (in part) to put the market mechanisms on hold: it is necessary to partially compensate for the payment of wages. The first measures in place in many countries are a step in the right direction, that of partial and temporary socialization of wages. Partial unemployment is a powerful tool, which must fully compensate employees.

What’s the best response for France?

Ekkehard Ernst
The same as what I mentioned in the last question above, but with greater coordination with European partners, especially with Germany and Italy.

Robert Boyer
The fact that France does not have control over the ECB’s strategy prevents the monetization of additional public spending as is possible in the United States. In addition, in Germany, public opinion seems to be blocking the pooling of additional debt in response to the threat of the coronavirus. Another concern relates to the weakness of the productive system, which risks suffering from the cessation of activity linked to the confinement phase. The need for aggressive investment in the future should not be underestimated. The good news, however, is that the massive funding of part-time work, inspired by German policy in 2008, can avoid an explosion in unemployment, which makes possible a choice other than defensive flexibility based on job insecurity and wage concessions.

Xavier Ragot
Treasury support schemes for small and mid-sized enterprises (SMEs) should avoid bankruptcies during the containment period. These measures will not be sufficient, however, for the following reasons.

  • Many workers on permanent contracts with temporary employers will not benefit from such a system. A temporary increase in unemployment benefits and intermittent workers’ rights is necessary. A solidarity fund for the self-employed is being set up, as is the relaxation of sick leave for employees.
  • SMEs and even large groups will have to face problems of solvency, not liquidity. Bankruptcies must be prevented during this period.
  • The participation of the State in the capital of large and troubled companies, such as Air France-KLM is necessary.

What’s the best response for the EU?

Ekkehard Ernst
To relax the Maastricht rules (it is planned in any case), strengthen the system of banking protection and widen the analysis of financial stability (the bond market in particular).

Robert Boyer
The obstacles to a coordinated strategy at the European level are great: fiscal, social and public health policies are essentially national, by virtue of the principle of subsidiarity. There remains the weapon of monetary policy. After hesitating, the ECB has announced a broad plan to support the liquidity of banks in order to avoid a collapse in the credit chain and, consequently, a dislocation of the Eurozone. The reallocation of structural funds from the European budget is unfortunately not great enough to support economic activity, while a pooling of additional public debt remains out of reach, as it requires the support of the German government and the revision of European treaties.

Xavier Ragot
Europe must monetize public debts. Governments have taken into account the coming fiscal policy shock, and European treaties allow for rapid action. The Maastricht criteria will be suspended this year due to the exceptional circumstances. The concern now comes from monetary policy. Indeed, the ECB’s communication blunders have revealed that it may not have yet grasped the magnitude of the shock to come. These additional debts must be purchased by the ECB: the fight against the virus must be financed by monetary creation. This monetization is necessary and useful. First, it would avoid an increase in the cost of debt for the most fragile European countries, such as Italy. We must help countries to avoid financial panic in order to give them the means to fight the spread of the virus. There is no reason why Italy should pay more for the fight against the virus than Germany. The role of the ECB is to prevent interest rate spreads on debts induced by the fight against covid-19. The rise in Italian interest rates after the announcement from the European Central Bank will cost the Italian economy 2 billion euros, at a time when those billions would be much better used elsewhere. The ECB’s reluctance contrasts with the determination of the US Federal Reserve, which has just announced a plan to buy back the US public debt of $500 billion, or 2.5% of US GDP. Next, we must immediately look to the post-crisis. The repurchase by central banks of the additional public debt amounts to supporting income by monetary creation. The latter would first increase the savings rate of households, which cannot consume because they are confined. At the end of the epidemic, households will go back to healthy consumption levels. Firms that are still recovering will then experience a recovery through strong consumption, stimulating the economy and generating healthy inflationary pressures, which are lacking today. To date, it is difficult to say whether an additional stimulus plan will be necessary. This will not be the case if the income compensation is done well. It would be wiser to plan today for an investment support plan for the energy transition, compatible with the revival of economic activity over the next few months. The rise of the health emergency should not eclipse the permanence of the environmental issue. There should be a buyback program by the ECB rather than using the European Stability Mechanism (ESM). The possibilities for monetizing public debts are twofold. The first is a programme to buy additional public debts for a limited time, without an explicit allocation plan. The second is the activation of the outright monetary transactions (OMTs) after the opening of unconditional funding by the ESM for the Euro area. Insofar as 1) it is a temporary problem of liquidity and not of solvency, and 2) it is urgent to fight against the growing spread between member countries, the first option seems most desirable.

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