V-Shaped Recovery or Hysteresis?

To exit the Coronavirus-crisis, it should be a policy priority to keep people attached to the labor force. But these concerns are almost inexistent in the current political discourse. A column by Fabrizio Zilibotti.

Fabrizio Zilibotti
«Governments find it easier and more popular to issue checks for people to stay at home.»

The first wave of Coronavirus is finally coming to an end in many European countries. What does the  future hold? Some experts expect the economic crisis to be long lasting. Others believe in a V-shaped recovery, namely, as soon as the public health crisis is over, economic activity will quickly resume at its pre-crisis level. This seems to be the preferred bet of the stock market. The SMI Index is down 16% between the peak and the day in which I am writing this article – a respectable but contained fall.

Why is there so much uncertainty? First and foremost, the evolution of the public health crisis is hard to forecast. Is the current slowdown of the epidemic sufficiently robust to guarantee a truce? Most likely, yes. However, some countries are taking chances. Germany and Switzerland started relaxing their restrictive measures after the number of active cases had declined significantly. In contrast, Italy and Spain are scaling down restrictions while they are still close to the respective peaks of infection.

Moreover, the epidemic is still virulent in countries like the United Kingdom and Sweden that took initially a cavalier attitude to containment. Even if there was no outbreak in the summer, there is widespread fear of a second wave around November-December before the vaccine is ready. At that point, the medical systems might be better prepared than when the first wave hit but societies might prove more rebellious and worse disposed to follow the directions from scientists. Politicians may then be prone to follow the whims of the population. In short, the timeline of the infection is a source of continuing uncertainty.

Severe capital outflow under way in Italy and Spain

Then, there are the more strictly economic factors. The case for a quick recovery is that the public health crisis will not have altered the fundamentals of the economy. There is no technological slowdown and the economic activity is only temporarily depressed because of social distancing. As long as public intervention keeps supporting the worst-hit families and allows firms to live through the storm, normality will be quickly restored. The measures require some public debt, but economic growth will quickly turn it into a minor problem.

However, the picture may not be so rosy. The chickens always come to roost. In many industries – such as transportation or tourism – recovery will be very slow. Families may respond to uncertainty and bleak expectations by reducing consumption while firms cut down on investment plans. The crisis may induce many good firms to exit, thereby fostering unemployment. This argument leads some macroeconomists to advocate strongly proactive fiscal and monetary policy even in the form of dropping «helicopter money,» an expression that is traditionally associated with a poor or irresponsible management of the monetary policy, and that today has acquired many supporters. The resurgence of inflation should be the last of concerns, according to the proponents.

Can a dovish monetary policy alone save us? It may be more complicated than just sustain aggregate demand. Consider the European Union. It is becoming clear that the Covid shock has been an asymmetric shock, largely because of the different success of countries in handling the crisis. Countries like Italy, Spain and, to some extent, France are experiencing far larger drops in GDP and employment than are Germany and other Northern European countries. For Italy, the situation is especially critical. The country entered the crisis with a debt-GDP ratio of 135%. We expect that this will jump to 155%-160% during the year, partly due to the falling GDP and partly due to the growing spending needs. Fitch has already downgraded Italy’s credit rating to one notch above junk. A severe capital outflow is under way in both Italy and Spain. Paradoxically, the danger makes politicians more defiant and confident that the EU will cave in to their demands. The argument is, once again, too big to fail. A further downgrade of the Italian debt might trigger a financial crisis that would be a threat to the same existence of the EU.

Culture of dependency

If a large bailout occurs, what consequences will this have on the recipient countries? If it could trigger a rebound, it might be well worth paying for. Unfortunately, it is hard to see a strategy that goes beyond «grab as much money as possible.» There is no discussion of selective interventions. For instance, the Italian government has already announced that it will take full control of Alitalia in June to avoid its going bust. The problem is that, unlike other international air carriers, Alitalia is not suffering just from the coronavirus crisis. It has been a loss-making company for the last twenty years. According to the estimate of Mediobanca back in 2015 the overall burden to taxpayers was 7.4 billion euros. Since then, the drain has continued. Last December, the government granted a 400 million Euros loan under the solemn promise made by the minister Patuanelli that this would be the last bailout. At that time, Alitalia was running losses in excess of one million Euros a day.

Conceivably, transfers to families will make up for a large share of government spending. Emergency help to those in need is a necessity in the short run. Yet, what will happen when economic activity resumes? Both Italy and Spain have a dark track record when it comes to the culture of dependency. Large sectors of its population, especially in the poorest Southern regions, tend to adjust to low economic standards supported by public transfers and occasional employment in the informal sector. The unemployment rate of Spain has spiked to over 20% in three recent occasions (mid 1980s, mid 1990s, and after 2009).

Prolonging the crisis

Deteriorating social norms might turn into an engine of hysteresis of unemployment as they already did in the past. For this reason, it should be a policy priority to keep people attached to the labor force, for instance, by granting tax reductions and exemptions to employed workers earning low wages. These concerns are almost inexistent in the current political discourse, and their mention would attract reprobation and critique. Governments find it easier and more popular to issue checks for people to stay at home. In the end, the EU transfers (or subsidized loans) may be used to finance ill-designed welfare policies that becomes a factor of persistence of the crisis.

While not directly involved in the EU budget, Switzerland cannot relax. Switzerland has navigated reasonably well through the crisis. Yet, it will prove difficult to keep the Swiss economy insulated from the future turbulences in the Euro area. A resurgence of inflation or of financial instability in the Euro area will likely trigger a capital inflow and an appreciation of the Swiss Franc. This might hit the economy right at the time when it rather needs a stimulus. In summary, the optimistic theory of a V-shaped recovery cannot be taken for granted. 2021 might
prove a more difficult year than many forecasters suggest.