Whither the Pandemic Economy?

Originally published at Project-Syndicate | August 19, 2020

The good news is that the unprecedented initial policy response to the economic downturn triggered by COVID-19 has averted a worst-case scenario, making comparisons to the Great Depression unwarranted. The bad news is that a return to strong, sustained growth seems as far off as ever.

JACKSON HOLE – To comprehend the present, much less to foresee what lies ahead, is as challenging today as at any time in my 30-plus years of professional life as an economist, forecaster, and investor. But challenging does not mean hopeless. The contours of the global economic landscape remain discernible despite the intersecting layers of fog brought on by a pandemic, rising populism, and widespread social strife.

The COVID-19 pandemic’s negative impact on global economic activity is unprecedented. During the second quarter of this year, the US economy is estimated to have contracted at an annualized rate of 32.9% – a far steeper decline than any other in the post-war period. Economic lockdowns and a sharp increase in precautionary savings amid so much uncertainty have depressed spending, impeded production, and disrupted distribution across wide swaths of the world economy. The UK has endured its worst quarterly GDP contraction (20.4%) in recorded history.

As a result of such turmoil, from February to early June, global aggregate demand collapsed, output plunged, and unemployment soared. Unemployment rates across the world’s advanced economies have approached levels not seen since the Great Depression of the 1930s.

Though there is much uncertainty, one thing is clear: forecasting the business cycle now hinges on forecasting pandemic control. The virus arrived at a time when both inflation and inflation expectations were very low across almost all advanced and emerging economies. Although both supply and demand have been disrupted by COVID-19, it is probable that the pandemic and its economic fallout will exert deflationary pressure on the world economy for the foreseeable future. That is particularly problematic at the current moment, because if falling inflation is not arrested, today’s mounting debts will be more difficult to repay.

SPINNING THE MONETARY WHEELS

Under these conditions, monetary policy is likely to remain highly accommodative for considerably longer, with both short- and long-term interest rates remaining at extraordinarily low levels for the remainder of 2020 and probably well into 2021. Owing to the climate of uncertainty and the already-high debt burdens, the potency of monetary policy will remain diminished, justifying a continuation of ultra-low (even negative) interest rates and massive central-bank asset purchases. The less traction central banks have, the longer they will have to press down on the accelerator.

An open-ended commitment to accommodative monetary policy means that, despite an unprecedentedly large fiscal expansion in many countries, massive increases in government deficits and debt will not pose near-term risks to borrowing costs or to financial markets more broadly. This is not to suggest that net government debt levels won’t someday pose political, policy, financial, and economic challenges. Gross government debt levels are projected to exceed 140% of GDP in the US and 160% of GDP in Italy by 2021. But most of these difficult debt questions can and probably will be postponed, perhaps for many years (as has been the case in Japan for several decades).

Champions of Modern Monetary Theory (MMT) may welcome without hand-wringing a world in which central banks are monetizing government spending on a massive scale. At first glance, MMT certainly appears to have been vindicated, in the sense that neither deficits nor debt seem to matter nowadays. The major central banks have become willing financiers of the public purse. But the idea that we could enshrine the current situation as the new normal is wrongheaded.

After all, debt monetization is warranted only when economies are operating well below potential, with unemployment soaring. That is when central banks can finance massive deficits without increasing the risk of runaway inflation. Moreover, central banks are already overburdened, having been given more objectives than they can achieve with the tools they have. To demand that they also finance social-welfare policies, irrespective of the cyclical or financial risks they are already mandated to mitigate, is to flirt with disaster.

A HALF-EMPTY GLASS

The pandemic arrived at a time of stalling globalization, slowing labor-force growth, and anemic productivity gains across most major developed and emerging economies – a trend that had been building for two decades. Some commentators have dubbed this condition “secular stagnation,” while others have disputed whether that moniker fits. Whatever one calls it, it has become the backdrop for a new period of rising inequality, heightened political discord, growing civil unrest, and concerns about environmental and financial viability.

The pandemic thus has introduced severe new trials for already-strained political systems around the world. Looking ahead, uncertainty about whether sustainable growth can be achieved will weigh persistently on private- and public-sector decision-making. And that, in turn, will have potential negative implications for physical- and human-capital investment, and hence for trend growth and asset prices.

What does all this mean for the global economy over the remainder of 2020 and beyond? In its June World Economic Outlook, the International Monetary Fund forecast that global output would decline by 4.9% in 2020. But, in the absence of a widely available COVID-19 vaccine, a favorable viral mutation, or the discovery of effective antiviral treatments, that projection risks being optimistic, especially given the likelihood (already visible in the United States and Australia) of renewed, amplified epidemic waves.

Moreover, even if the IMF is correct, its forecast would represent the largest contraction of global economic activity since the Great Depression. In the US and many other countries, an abrupt GDP decline has been accompanied by soaring unemployment, with roughly one in five workers experiencing either joblessness, furlough, or reduced working hours. For Americans, in particular, losing a job often means losing health insurance – with spiraling negative implications for the unemployed and their families.

Worse, the labor-market recovery will probably be highly asymmetric, and the pace of re-hiring will be much slower than was the pace of firing. In the coming months, it may become increasingly difficult to muster additional transfer payments, income support, and credit guarantees as quickly and at the scale seen so far. Europe has taken the lead, with Germany and others prevailing over the “frugal four” (Austria, Denmark, the Netherlands, and Sweden) to embark on EU-wide fiscal support that complements steps at the national level. But in the US, partisan disagreements over payroll taxes and changes to tort and bankruptcy law have undermined and delayed legislation to extend unemployment benefits and transfers.

MORE U- THAN V-SHAPED

A deceleration and weakening of the public-policy response will inevitably impair household income and create more uncertainty, sapping any potential rebound in demand. Without renewed confidence in sales and revenues, firms will likely curtail re-hiring, capital expenditures, and other spending. Hence, there is every reason to believe that the recovery will be more U- than V-shaped. And that is before one even considers the risk of recurrent setbacks – owing to spikes in COVID-19 infections, hospitalizations, and deaths – in the quarters to come.

Nonetheless, comparisons to the Great Depression remain premature and unwarranted. That calamity lasted more than a decade and was exacerbated by catastrophic policy failures, including the collapse of national banking systems and international financial norms, and the imposition of stiff, beggar-thy-neighbor tariffs and other trade restrictions.

Today, by contrast, central banks and finance ministries have taken early and decisive action to minimize the risks of bankruptcy, bank failures, and cross-border illiquidity. US President Donald Trump’s trade war has doubtless caused disruptions, but not the protectionist contagion of the 1930s.

Just as John Maynard Keynes would have advised, governments have eased fiscal policy rapidly and substantially, even in typically recalcitrant countries like Germany. While no one can predict how long the pandemic and social-distancing policies will handicap the world economy, measures already taken to mitigate collateral financial and economic damage should prevent today’s severe economic downturn from becoming an unnecessarily protracted one.

But this does not mean that upbeat year-ahead forecasts will prove correct. The IMF expects positive global growth of 5.4% in 2021, and various senior US Federal Reserve officials are hopeful that unemployment will fall below 10% by the end of the year. Yet, even if economic, social, and political pressures reduce the likelihood of any US states or countries resorting to another extreme lockdown, renewed viral outbreaks will almost certainly trigger partial shutdowns and introduce more demand-sapping uncertainty.

THE RECOVERY WILL NOT BE SYNCHRONIZED

Globally, the recovery is sure to be uneven. Those countries that have been better able to contain the virus (China, South Korea, Japan, Germany) will enjoy earlier and more sustainable recoveries than those that have failed (namely, the US and Brazil). This geographic dimension represents a departure from the past, when US cyclical leadership underpinned almost all recoveries from global downturns.

The dollar’s sharp decline since its high in March may already reflect investor expectations that the US will struggle to keep pace with many of its developed-economy peers over the remainder of 2020, and perhaps into 2021 as well. To be sure, a weak greenback at least will tend to support commodity prices, providing a minor respite to many emerging economies. But rising commodity prices are unlikely to boost overall inflation by very much, given their small share in overall value-added, not to mention the inability of firms or workers to pass along cost increases through higher prices or wage demands.

In fact, the prospect of a slow, uncertain, and uneven global economic recovery is a key reason why inflation is likely to remain subdued in most advanced and emerging economies, despite extraordinary monetary and fiscal easing. While the disruption to global production and supply chains could create bottlenecks – and thus shortages and higher prices – the more likely scenario is that prices and wages will be kept in check by a combination of weak demand, elevated uncertainty, and low inflation expectations.

Accordingly, central banks are apt to keep policy rates at or near historically low levels for considerably longer. Despite the massive increases in public borrowing, benchmark government bond yields therefore will probably remain very low (negative in inflation-adjusted terms) over the 2020-21 forecast horizon.

That’s bad news for savers and those living on fixed incomes and pension plans, but in macroeconomic terms, it is simply unavoidable, given the vast excess supply of productive capacity and labor worldwide. In any case, the longer the status quo of low interest rates prevails, the more likely it is that creditors will need additional assistance –through both fiscal transfers (to the elderly) and regulatory forbearance (for pension schemes or insurance companies otherwise required to hold debt securities).

A HAZY HORIZON

The development of a safe and effective vaccine would of course be a potential game changer. But a vaccine, by itself, is not the same thing as widespread vaccination and the achievement of broad immunity. Even if a vaccine is approved by the relevant authorities in the coming months, producing and distributing it at scale will take much longer, and there could be remaining questions about its longer-term effectiveness, not to mention the likely social resistance to its widespread acceptance. These complicating factors suggest that pandemic concerns could linger well into 2021, even if asset prices were quickly to discount a more benign post-pandemic environment.

Finally, as important as the pandemic is for the global business cycle, economists, policymakers, and investors must not overlook the other factors driving growth, inflation, public finance, and asset prices. The pressure to address climate change and inequality (of incomes and opportunities) is likely to intensify, and, before long, soaring levels of public debt will be added to the list of priority issues.

Faster economic growth would be immensely helpful in cushioning the costs of shifting to more sustainable environmental, social, and political arrangements. Reliable, consistent economic growth has been the engine of the American Dream ever since the immediate post-Civil War era. But with the three pillars of post-World War II growth – demographic structure, productivity, and globalization – all weakening, and with our collective ability to borrow from the future reaching its limits, one should not assume that accelerated trend growth will miraculously re-emerge.

Neither populism nor unfettered capitalism offer compelling strategies to address these near- and long-term challenges. Nor can technology do so on its own, given its tendency lately to produce “winner-take-all” outcomes that fail to improve broader wellbeing. Beyond the hazy pandemic horizon lies an even more complex future, one that holds both the promise of exciting new discoveries, innovations, and solutions to collective problems as well as significant challenges that will entail difficult trade-offs.

In any case, the best solution usually takes the form of collective action, locally and globally. Many of today’s challenges are shared by all, and thus demand collaboration and adherence to fairness and other collective values. Amid so much adversity, individuals, organizations, communities, and countries have an opportunity to find common ground once again.