20 03 22

Daniele Langiu          daniele.langiu@gmail.com

Fabio Sdogati             sdogati@mip.polimi.it

[This is the English Version of our paper in Italian posted yesterday, March 21st]

Time passes at a horrible speed, in the conditions in which we live. While up to three weeks ago we had very little literature on the relationship between the pandemic and the outlook for economic activity, and no estimates for the size of the possible effects, now articles, forecasts, interviews, reports multiply by the hour, and it has become difficult to follow properly what it is written, or said. And the topic is always, or almost, that of economic forecasts.

In a piece of March 4, one of us wrote that, in the absence of data and reliable forecasts, it would be better to deal with the classification of the types of profile of the reaction of economic activity to the virus shock, and then start reasoning to sift through different hypotheses. At that time, reasons were advanced in support of a pessimistic view of the evolution of the crisis. Today we discuss the research conducted, or the positions expressed, by some economists who offer support for our hypothesis.

1. The first contribution we want to present is that from 9 March by UNCTAD, a United Nations agency, as reported in the article COVID-19 likely to cost economy $ 1 trillion during 2020: “We envisage a slowdown in the global economy to under two per cent for this year, and that will probably cost in the order of $1 trillion, compared with what people were forecasting back in September. “[…] “One “Doomsday scenario” in which the world economy grew at only 0.5 per cent, would involve “a $2 trillion hit […]”.

2. The second position we want to present is that of Thomas Philippon, Professor of Finance at the Stern School of Business of New York University, a position that can be quickly gauged from this tweet:

The forecast breaks away from all the prudential attitudes assumed by most economists until a few days ago: the crisis may or may not last beyond six months, but it will be characterized by the highest rate of decrease in production activity ever recorded, something of the order of 10% -20%. Note that these are rates never actually imagined before, not even in the Great Recession of 2008-2009. And this in one or two quarters, a unit of measurement with respect to which we are used to thinking of 1-2% GDP variations in normal times.

A contraction of such dimensions is not only horrible in itself: it occurs in a context of continuous spread of the pandemic, and of very high uncertainty about a possible improvement in the health situation in most of the world. In other words, this contraction occurs, is taking place, as a result of a health shock that translates into economic shock according to a loop that is repeated country after country: it is such loop that makes the economic contraction global. The substantial coexistence of the health crisis and the economic crisis, originally conceived as a ‘supply crisis’, forces companies and governments to face the dramatic trade-off between safeguarding the well-being of the population on the one hand and safeguarding production and distribution of goods to the same population. We will return to this trade-off later.

3. It has been seen in recent days that Governments and Central Banks seem to have understood the severity of the current tragedy, and have begun to intervene, adequately according to some, in a largely insufficient way according to others, to stimulate the economy, including the health sector as a priority: they would offer the stimulus that the private sector would never be able to provide. To give an idea of what the level of public intervention is considered not unreasonable by our reference colleagues, we recall a tweet by Olivier Blanchard, former Professor of economics at MIT.

Note that the deficit/GDP ratios Blanchard refers to are monstrous, liable to cause potentially severe damage to the vestal virgins of balanced budgets! It will be said: but they are wartime deficits. Indeed, they are; however, it would be necessary for those supporting such view to show that the present one is a radically different situation in terms of the power to destroy economic activity. And even Thomas Philippon, for those who want and have time to read the discussion that follows his leading tweet, reviews a number of exceptional measures both on the monetary and fiscal policy sides, exceptional in terms of political commitment and, obviously, in terms of expense commitment. After specifying that comparing the present crisis to a war is perhaps excessive, Philippon claims that: “Better comparison is natural disaster, but on scale we have not seen before. So the impact on public debt will be very large. Public debt can easily increase by 50% of GDP. Given the current low rates, this need not create sustainability issues in large currency areas.”

The exhortation to governments to spend in proportion to the size of the problem is reinforced by the consideration that, with interest rates close to zero, this will not pose debt sustainability problems in large monetary areas (such as the Economic Union and European Monetary, or Euro Area). We share these policy conclusions by Philippon.

4. On March 18 JP Morgan cut global growth estimates: US GDP down 14% in the second quarter, Eurozone GDP down 22%, China’s GDP down 40% in the first quarter.

5. On the one hand, the order of magnitude of the deficit/GDP ratio that Blanchard, as early as February 24, imagined probably necessary, urging policy makers and the general public to reflect on that scale; on the other, Philippon’s positions on the sudden, abysmal collapse of production activity and the radical nature of the measures he advances, are largely consistent with the research published on March 13 by Pierre-Olivier Gourinchas, Professor of Economics at the University of California-Berkeley. At the heart of Gourinchas’s reasoning is trade-off between the need to maintain a level of health security for the population (politically determined) acceptable on the one hand, and to maintain a level of productive activity associated with an adequate income production and a socially acceptable unemployment rate. The trade-off can be represented with the help of two graphs, the first of which illustrates the benefits of containment pandemic policies:

Gourinchas contrasts this graph with a comparable one on the trend of the recession, which shows that a flatter curve for the pandemic, potentially the result of measures of social distancing and suspension of production, has its counterpart in a deeper curve for the recession, and vice versa:

We have already talked about this trade-off in the past weeks, but Gourinchas shows it in a concise and effective way. Essentially, the problem is therefore that the more effective the decisions taken to flatten the spread curve of the pandemic, the heavier the consequences for productive activity and employment, and that both in terms of intensity and duration.

6. And this is what Bloomberg wrote, on March 18, about the expansionary policies deemed necessary at this stage:

“Governments are finally getting the message that they’ll have to run exponentially bigger budget deficits to keep economies afloat as the coronavirus brings the world to a sudden halt.

Capitals from Berlin to Washington are shaking off fiscal restraint and vowing to fight the virus’s economic fallout with a blitz of spending. The tally of pledges is approaching $2 trillion worldwide and rising daily, and much of it will have to be financed with public debt.

President Donald Trump endorsed checks to every U.S. household in a stimulus plan that settled at $1.2 trillion. Australia will also provide handouts, and Japan may too. Having already dropped her commitment to a balanced budget, German Chancellor Angela Merkel even said she was willing to discuss pooling the euro-area’s borrowing capacity.”

7. Given the seriousness of the situation, the Economic and Monetary Union decided on March 20 to suspend the Stability & Growth Pact, thus giving room to the governments of member countries to overcome the budget deficit limit of 3 % of GDP and, therefore, to adopt expansionary fiscal policies wider and more far reaching than those authorized to date.

8. And it’s time to act as a community, as seven German economists subscribe, which require the issuance of a trillion euro in bonds issued by the Economic and Monetary Union: “Community bonds are now needed to spread the cost of the crisis across many shoulders. This can help the worst affected countries and prevent them from falling into a solvency crisis without their own fault. To this end, eurozone countries should issue EU bonds of 1,000 billion euros (around 8% of the eurozone’s gross domestic product) limited to this crisis. ” (translated by us, DL & FS)

9. What about monetary policy? Great emphasis has been placed on so-called ‘exceptional’ measures already taken by central banks around the world. In what sense such measures are ‘exceptional’ it is not yet clear to us: are they exceptional because they are traditional but out of traditional dimensions, or are they exceptional because they are new, never adopted before? Many of those we have mentioned place emphasis on the measures specifically adopted on this occasion, measures aimed at maintaining high liquidity in the system and providing businesses with the credit lines they will presumably need. From our point of view, the size and characteristics of the crisis require a strong coordination between central banks first of all: in a slogan, if the epidemic is global and production chains are global, the adequate political response must necessarily be ‘global’ or, at least in the first instance, coordinated globally. One way to accomplish this is by adopting strong coordination between central banks that guarantee unlimited credit lines to each other to avoid cash run problems. But the crucial point is probably this: that central banks be central banks, that is, lenders of last resort. And this towards all economic subjects, first of all governments. Paul De Grauwe, Professor in European Political Economy at the London School of Economics and Political Science, summarizes this concept particularly clearly:

“Because they [national governments, ndr] have no choice but to support failing companies, illiquid banks, and struggling households, national governments could be entering dangerous territory. The more their debt increases, the greater the risk that their bondholders will panic, as we saw during the 2010-2012 sovereign debt crisis. And the countries experiencing the largest debt increase as a result of the “coronacrisis” – Italy, Spain, and France – are among the four largest eurozone economies.

To head off the risk of a bond-market panic, the ECB should be preparing to buy up distressed governments’ bonds.”

10. Our position can be summarized as follows:

1. For the first time in living memory we are facing a trade-off between the health dimension of a shock and its economic dimension;
2. To address the question ‘how long will it last, and how serious will it be?’ we think of a dynamic, multi-country and multi-shock model, which is triggered by a health-related shock that generates in turn a contraction in production. Such contraction affects sequentially the entire global production network, from country to country. The health-production trade-off generates further reductions in production activity and, consequently, in demand. We want to make clear that it is the lack of demand that affects production in a violent and persistent way, after the health and production shocks due to the ‘layoffs’ of workers and social distancing measures;
3. These are the reasons why we pay serious attention to growth forecasts reported in this paper, rather than to so-called ‘optimistic’ estimates dreaming of ‘normal’ contractions;
4. If our way of reasoning, if our model is reasonably representative of reality, then this crisis will be long lasting, expensive, and generalized worldwide;
5. It follows that we emphasize the need for public intervention of intensity and duration never seen in the past seventy years. When an entire country is (rightly) quarantined, then production collapses, incomes of most social group collapse, demand for goods and services collapses. To counter a total collapse, the necessary deficit/GDP ratios will make a mere 3% blanch: that 3% on which European governments, encouraged by so-called ‘liberal economists’, built the narrative of austerity and consequent stagnation – mutilating healthcare at the same time;
6. We must therefore not be afraid of public deficits, and we must think carefully about the ‘permanent stimulus’ hypothesis put forward by Paul Krugman;
7. On the other hand, as well presented by the Financial Times, it is time to realize that saying today that ‘central banks are lenders of last resort’ has far more important implications than it has been the case so far: they can and must open credit lines to governments, families and businesses, in order not to let liquidity problems arise and financing the demand for public goods, consumer goods, private investments.