Fighting the virus has forced governments to prohibit activities that are central to how modern economies work. Travel to and from work, restaurant visits, and cross-border flights have all been prohibited. Schools and universities are shut, many non-essential businesses closed.
This is what makes COVID-19 different to past economic shocks. Fighting the virus has meant governments closing large parts of the economy. Supply and demand have both declined sharply.
And the response by economic policymakers has had to reflect this reality. Alongside an increase in spending on healthcare, measures thus far have aimed to provide relief to firms and households affected by the coronavirus outbreak. They have also tried to prevent any lasting damage to the economy.
Traditionally the response to a sharp contraction in spending is for governments to try and stimulate consumption and investment. After recapitalizing the financial sector, measures in response to the 2008 Global Financial Crisis (GFC) worked to increase investment and household consumption. Roosevelt’s New Deal, in response to the Great Depression, boosted employment and increased infrastructure spending directly.
Measures introduced in response to the virus outbreak have had to do something different entirely. They have had to put the economy on life support, allowing large parts to be shut down, while trying to prevent job losses and business bankruptcies.
Trying to stimulate the economy now would be counterproductive in the fight against the virus. Measures introduced by policymakers will be deemed a success if they prevent economies from suffering lasting damage, allowing a strong recovery once the health crisis has passed.
Preventing job losses
Protecting employment is key. Mass unemployment will hamper economic growth both in the short and long term. If firms have laid off workers, they will find it harder to ramp up production when the economy restarts. Hiring and training new workers takes time, creating inefficiencies. Long term structural unemployment harms an economy’s growth potential as workers become detached from the labour market.
This is why countries, including Germany, the UK and France have been quick to implement wage subsidy schemes, modelled on the Kurzarbeit scheme. By subsidising a significant proportion of an employee’s wage, firms will be able to hold on to staff, and have the staff to increase output when demand returns. Firms will also keep hold of their skilled workers.
This is also what makes the sudden increase in US unemployment such a concern. The end of March saw weekly unemployment claims pass 6.5 million. Before COVID-19, the record weekly filing was 700,000. This will make it harder for the American economy to recover.
US unemployment claims hit record levels (in Tsd)
Source: FRED, Bloomberg, Clarus Capital
Policymakers are also working to protect firms' cash flow. Part of the $2 trillion CARES Act will provide support in the form of loans to affected American businesses. Loans can be used to meet wage costs, rent and utility bills, and will be forgiven if firms retain employees.
The Federal Reserve has also restarted a 2008 programme to support lending to small businesses. It will also now purchase corporate bonds. Making sure viable firms are able to survive the disruption brought by the virus will mean contagion can be contained: supply chains can remain intact, creditors can be paid, and workers can be kept in jobs.
The CARES Act also provides support to households. Unemployment benefits will be expanded (both in generosity and coverage) and checks will be distributed to households.
Protecting household incomes will help to prevent hardship and allow consumption to resume as soon as social distancing measures are lifted. It will also help to prevent defaults on loans and mortgages. This would risk a health crisis spilling over into a financial crisis.
Preventing a financial crisis
Central banks are taking measures to prevent a financial crisis. They have activated measures to reduce pressure in funding markets. The Fed has made existing dollar swap lines more attractive as well as extending them to more central banks in a manner similar to the period after the GFC.
This increases access to US dollars, the global reserve currency, for banks and firms outside of the US. It has helped to ease some pressure on the dollar. This all comes after the Fed committed early on to purchase assets in the ‘amounts needed to support smooth market functioning’.
Costs of the shutdown
Still, the immediate costs of shutting down the economy will be severe. Preliminary estimates by the OECD suggest that for each month an economy is shut down annual GDP growth will decline by up to 2 percentage points (not accounting for the multiplier effects caused by lower demand, and for government intervention).
Partial or complete shutdowns will be felt across the economy (in %)
Source: OECD, Annual National Accounts; and OECD calculations; Clarus Capital
The St Louis Fed estimates that US unemployment could rise beyond 30% in the second quarter of this year (not accounting for the support provided by the CARES Act). This calculation is based on the proportion of the American workforce working in services that are affected by the shutdown.
The longer-term psychological effects of COVID-19 are even harder to predict. Even when the health crisis passes, there are questions about whether old consumption and investment patterns will return.
Will people be as prepared to dine in crowded restaurants? Will there be an increase in precautionary saving as consumers feel more uncertain about the future? Will firms be as willing to operate just-in-time and global supply chains? The answer to these questions, along with how well policymakers protect economies, will shape growth after COVID-19.
Written by Thomas Schiller, Ad-Hoc Economics