The scenarios for economic recovery

To understand the speed and shape of the recovery, it is useful to look at the two possible exit phases from the Covid-19 pandemic (Dynan, K et al., PIIE, April 2020): “Two phases in advanced economies. Phase 1. Getting infection rate down. Baked in. End by early summer. Phase 2. Keeping infection rate down. Large uncertainty. Uncertainty about virus (immunity?), about drugs, vaccines, tests about scaling up potential of test production. Will determine path of lockdown. Could last 6-18 months.”

That means that in most countries the level of economic activity and confidence could not be reestablished in a year and a half due to the health situation. Before considering economic policies, the return to normal is the first test for governments.

Also, the most complete plans to ease the health crisis face operational difficulties due to the lack of tests and other medical health requirements. According to The New England Journal of Medicine (Harvey V. Fineberg, M.D, April 2020), countries may be able to defeat Covid-19 in 10 weeks by following the next steps:

1. Establish unified command. “This commander carries the full power and authority of the American President to mobilize every civilian and military asset needed to win the war.”
2. Make millions of diagnostic tests available. “The nation needs to gear up to perform millions of diagnostic tests in the next 2 weeks.” (…) “Without diagnostic tests, we cannot trace the scope of the outbreak.”
3. Supply health workers with PPE and equip hospitals to care for a surge in severely ill patients. “Ample supplies of PPE (personal protective equipment) should be standard issue to every U.S. health worker who is in the front lines caring for patients and testing for infection.”
4. Differentiate the population into five groups and treat accordingly. “We first need to know who is infected; second, who is presumed to be infected (i.e., persons with signs and symptoms consistent with infection who initially test negative); third, who has been exposed; fourth, who is not known to have been exposed or infected; and fifth, who has recovered from infection and is adequately immune” (…) “This would be a game-changer in restarting parts of the economy more quickly and safely.”
5. Inspire and mobilize the public. “Everyone has a part to play and virtually everyone is willing.” (…) “If everyone wears a surgical mask outside the home, those who are presymptomatic and infected will be less likely to spread the infection to others.”
6. Learn while doing through real-time, fundamental research. “Decisions to shape the public health response and to restart the economy should be guided by science.”

It is well known that the key point in tackling Covid19 pandemic is testing (Berger, D.W, et al., March 2020; Gros, C. et al., April 2020), because it can dampen the economic impact of the coronavirus and reduce peak symptomatic infections.

Unfortunately, we are not seeing these reactions in many countries. In most cases because of a shortage of key material, as markets have been seriously intervened globally and supply chains have been affected. This delay in social and health policies make us consider some important points:

1. We cannot assume that consensus estimates for global and country growth are too pessimistic. If we have learned anything from the history of global growth estimates is that most analysis tend to have an optimistic bias even in crisis periods. Most analysts did not see a crisis in 2008 and, even more importantly, a majority still did not see it in 2009, when it was evident. It is true that estimates at the beginning of any given year must be revised, but not because they are too pessimistic, usually the opposite. Budget agencies over-optimism is also evidenced by Frankel, 2011[13].
2. Calls for large fiscal packages to offset the pandemic may be ineffective. Not just because the economy was slowing down in 2019 with large fiscal programs in place. Admittedly, estimating multipliers is notoriously difficult, but there are several reasons why fiscal multipliers are probably lower than they were previously (Allen-Reynolds, J., February 2020), because output gaps are almost inexistent.  This is not a demand problem, it is a supply shock followed by a forced shutdown, and governments must apply the correct measures to outpace it.
3. A rapid recovery is now virtually impossible. The shutdown of developed economies will likely last for months. The shutdown of emerging economies is likely to start just as developed economies gradually lift the lockdown, and impact 2021 and 2022 growth estimates. The financial implications in an world were debt was already at record-highs may add a string of credit events to an economic shutdown.
4. The diminishing returns of monetary easing were already evident in 2018 and especially in 2019, with global manufacturing PMIs in contraction and growth estimates that came down significantly throughout the year. Growth downward revisions were widespread in the middle of significant coordinated central bank injection operations and widespread interest rate cuts.

The recovery path in China can be used as an example. The Caixin China General Services PMI experienced only a partial recovery in March at 43.0 basis points (less than 50 basis points reflects contraction), up from a record low of 26.5 in February but far below 51.9 in January. Other leading indicators, such as passenger flows, business start-up fees and hotel reservations, also show a partial rebounded from the lows in February, but again in contraction territory.

Before macroeconomic figures are published, the main effect of Covid19 on the economy we are seeing is on labor markets. Both in the United States and Europe unemployment is rising. During the last three weeks, jobless claims in the US increased by 17 million people.  In seasonally and calendar-adjusted terms, the impact of Covid 19 would be slightly below, but as frightening as 14.6 million people across the country (Rinz, K., April 2020).

It is likely that we may see a scenario where unemployment rates in developed countries reach record levels, impacting consumption and travel and leisure decisions for many months. In fact, the National Association for Business Economics predicted a United States unemployment rate of nearly 10 percent at the end of 2020 (Schneider, H. April, 2020), with some analysts predicting an unemployment rate of 20% (Faria e Castro, M, Bank of St Louis, 2020). It is remarkable that it would be the highest unemployment rate showed by the US economy since the financial crisis.

Labor markets in Europe are also reacting to an unexpected economic shock. Only in Spain near 900,000 workers were lost their job in the last 15 days of March, according to the official Social Security figures. Countries such as Italy, France and Germany are also seeing severe adjustments in their labor markets.

The key point regarding employment, as we already saw during 2008 crisis, is flexibility. The Germany labor market is one of the most flexible in the world. Companies can reduce their working hours easily, and they don’t have to bring on layoffs to face the situation. That is why one of the first measures of the German Government was to pay the difference between full-time and part-time wages due to Covid19 restrictions.

Another important issue regarding employment is the ease of doing business. The United States (US) is the sixth country over 190 evaluated by the World Bank in its Doing Business ranking. This, jointly with an economy that is less dependent on the banking system than the European one, supposes more recovery capacity when growth returns. In fact, unemployment could come back to 6% in 2021 (Schneider, H., April 2020), a partial recovery supported by the absence of a banking crisis during this year.

The most effective policy responses against a sharp deterioration of the labor market are tax cuts and public transfers as well as unemployment insurance where it is not already working (Faria e Castro, M., Federal Reserve Bank of St. Louis, 2020). Tax deferrals also work, with a budget balance that is likely to deteriorate in 2020 but will improve later thanks to the recovery in economic activity (Anderson, J., et al., Aril 2020)

During the last financial crisis, the US suffered a discouragement effect in the labor market that cut down the labor force participation rate to 62.7% in 2015, which could lead to some unemployment in the non-active population. This effect can be dangerous in terms of social inclusion and wellness, because these citizens are not part of jobless statistics, but have lower disposal income and opportunities.

The last key point regarding the medium-term perspective with Covid19 is inflation. Powerful disinflationary forces remain in place, mainly technology, demographics, and overcapacity. Added to these, some studies suggest that a period of deflationary risk is inevitable, even in a low interest rate environment (see Leduc, S., Liu, Z., and Scott, A., Miles, D.): “Our analysis nonetheless suggests that, through the uncertainty channel, the pandemic is likely to weigh on the economy persistently, depressing economic activity and inflation well beyond the near term.”

The economic implications of a pandemic are not solved with large spending increases. Governments will likely implement large demand-side policies that are the wrong answer to a shutdown of the economy. Most small businesses suffer from the collapse in sales and subsequent working capital build and very little of these effects is mitigated by deficit spending. Demand-side policies may increase debt and overcapacity in the already indebted sectors but do not help the sectors that suffer an abrupt collapse in activity.

A forced temporary shutdown should also include a shutdown of the tax collection system. Governments already finance themselves at negative rates. They must eliminate (not defer) tax payments for companies in the period of crisis to avoid a massive unemployment increase and a domino of bankruptcies and facilitate working capital liquidity lines without recourse to allow businesses and self-employed workers to navigate a shutdown. Governments that make the mistake of maintaining the current tax structure or just prolong the payment period for six months may see important negative consequences. Also, Governments that benefit from extraordinary measures to increase intervention on the economy, including the burden of employee containment to companies, could generate long-term negative effects (Gollier, C., Straub S., 2020).

Unlike other economic downturns, the fall of output in this crisis is not driven by demand: it is an unavoidable consequence of measures to limit the spread of the disease. That is why demand-driven measures alone will not work and Governments should apply supply-side policies. Support should help people stay at home while keeping their jobs. (Dell’Ariccia, G. et al., 2020).

Policies should be global and local, considering the important differences in each country. Unemployment in France does not show the same characteristics as in the United States. Compensation of self-employed workers forced to interrupt their activity must be driven by a cheque or a tax rebate, proportional to the duration of this interruption and based on declared income from 2019. Solutions such as the “helicopter money”, adopted by the US Government “is only useful if it is a response to a demand shock, which is not (yet) the case” (Gollier, C., Straub S., 2020).

The main objective of public policy, hence, may be reoriented to increase public health care capacity and government expenditures should help remedy some of the economic losses produced by containment and mitigation measures, reducing the direct pain inflicted on individuals and businesses and aligning incentives for social distancing.  (Loayza, N.M., et al. 2020)