Why the Economics of Coronavirus is Very Different from the Great Depression

Macroeconomic policy may help today, but it will be no panacea. The wealth of nations is determined by technology, human capital, institutions, and social cohesion. A column by Fabrizio Zilibotti.

Fabrizio Zilibotti
«In the short run the physical presence of workers is often an important constraint.»

What can economic policy do to alleviate the pain of the coronavirus crisis? Most economists agree on the emergency measures. Central banks should inject liquidity into the system in order to avoid massive bankruptcies and layoffs. Concerns over fiscal discipline must be temporarily set aside to give governments the leeway that is necessary to face the emergency.

However, beyond the surface, there is uncertainty and diversity of opinions about the medium and longterm strategy. For example, the center for Initiative on Global Markets (IGM) at the University of Chicago Booth School of Business recently run a poll among influential macroeconomists on the two sides of the ocean. One of the question we were asked is: «The economic effects of COVID-19 coming from reduced spending will be larger than those coming from disruptions to  supply chains and illnessrelated workforce reductions.» Among the European panelists (weighted by self-reported confidence), 43% agreed with the statement, 41% declared themselves uncertain, and 12% expressed disagreement. The American group provided similar answers (with a higher share of uncertain). This is not an academic question. It has major implications about which policies may work and which ones are bound to fail.

To put the theme in perspective, let me recall that the two most recent episodes of severe global recessions were of different nature. In the 1970s, a surge in oil prices caused by the OPEC cartel triggered an important recession. Policy makers responded by expanding demand and spending, in the wave of the Keynesian policies of the 1960’s. Yet, those policies do not work when the recession originates from a supply disturbance such as the increasing oil price. In fact, the governments’ responses did not help recovery and, instead, fed inflation, which had to be tackled through painful adjustment policies in the 1980’s. The Great Recession of 2007-09 was very different. The crisis was largely demand driven. The fall in asset prices eroded collaterals and caused a deleveraging spiral. In this case, the joint intervention of central banks and the fiscal stimulus policies proved in the end successful.

Important spillovers to demand

The mindset of macroeconomists and policy makers tends to be influenced by the most recent episode. Yet, in my view, the lessons of the Great Recession are not a powerful guidance to the management of the coronavirus crisis. First and foremost, the original event is a supply shock. This shock has many facets. Apart from the people who fall ill and cannot work, many firms cannot operate their production activity efficiently because of the lockdown. In many instances, workers must resort to nonstandard working conditions that reduce their productivity. Technology and organization may slowly adjust but in the short run the physical presence of workers is often an important constraint. An even more important component of the shock is the disruption of the supply chain. When the epidemic strikes in one continent, it affects the ability to produce anywhere else in the world. Disruptions of international trade makes things worse. Few days ago, Roche’s CEO Severin Schwan recalled in an interview that guaranteeing the production of active ingredients within national borders would be illusory. «You cannot bring the global supply chain to a country» said he.

While the source of the crisis is a supply shock, it is certainly true that there are important spillovers to demand. Small firms lose a cash flow that is essential for their liquidity needs. This may trigger inefficient liquidations and job losses. Some people may become unable to pay their rent, their tax bill, etc. In short, there are negative shocks on both the supply and demand side, which requires a menu of policies. Monetary and fiscal policy can help, here.

Nevertheless, it would be unwise to put excessive faith or expectations in the effectiveness of policies that stimulate aggregate demand. First, because the supply shock is deeper and more persistent than we had initially anticipated. Even if the summer granted us a truce (which is unclear), experts expect a renewed virulence of the contagion in the fall. Only when a vaccine will be available and produced in large numbers will we be allowed to breath and return to normal life. The expectation is that this may take about 18 months, and there is still great uncertainty around this estimate. Second, in many parts of the world – arguably the most exposed – the economic and human crisis has not yet started. We might see humanitarian crises, migration pressure, etc. The scenario of a couple of years of global social and economic turmoil is unfortunately realistic.

Investing in training programs

If we have to live through the hardship of a prolonged public health emergency, an important problem is the demand-supply mismatch. Economies cannot easily adjust the provision of services (e.g., health care services) that are in more urgent demand during the crisis. In contrast, there is excess capacity in sectors such as tourism or restauration. Increasing aggregate demand will not alleviate this mismatch. People will not book more vacations if they receive cash transfers from the government. They may rather save or increase the demand for those services whose supply is inelastic. However, government intervention can ease this mismatch like in the management of a war economy. In war times, governments take actions to shift resources (labor and capital) where these are most urgently needed. In our times, they could make large investments in training programs for the jobs that are more socially useful in the current situation. Importantly, idle resources exist. A large number of young people entering the labor market face the risk of unemployment. Others risk losing their current job. Young people are also less susceptible to the medical risk. Intensive training programs could divert in relatively short periods (say, few weeks) significant human resources to services whose shortage is dramatic, like paramedical services, personal care, IT, etc. Given the ongoing demographic trends, building an excess capacity in these sectors will not be a waste.

After the storm, the crisis will leave us some unpleasant legacies. One or two years of disruption of the education system will not be easy to remedy — one extra year of education yields about 10% increase in the human capital and productivity of an individual. In addition, family life is likely to suffer long-lasting effects. Divorce rates have risen significantly in Wuhan as couples were forced to spend long time together during the home quarantine. Family instability will have additional negative effects on future generations. The crisis may have undesirable social consequences. For families with children, the shutdown of schools will impose a disproportionately burden on women inducing them to quit the labor
force. This will slow down the secular trend towards gender equality. A sad dividend will be the reduction in the old age dependency ratio. How large the relief on the pension system will be is unclear, and we must do now all we can for it to be as small as possible.

In summary, while macroeconomic policy can help today, it will be no panacea. The wealth of nations is ultimately determined by technology, human capital, institutions, and social cohesion. The economic effects of coronavirus crisis will ultimately hinge on those factors.