The world has seen depression, recessions, banking, debt, exchange rate, and inflation crises. Never in the last hundred years did it witness a crisis forcing firms to suspend operations and workers to stay home at the same time across the globe. The pandemic shocked both the supply and demand sides of markets in every economy by adding a virus contraction risk to mobility and assembly. This disrupted production, trade, and investments with multiplier effects as markets and governments responded to contain and suppress the rage of the virus.
Just as the global financial crisis of 2007-09 prompted a rethink of the economics profession's understanding of financial markets and macroeconomic policy, the pandemic may focus attention on several other blind spots such as the role of social factors in economic decision making at the individual and collective levels. However, the time-tested supply-demand framework as a way of unbundling economic problems withstood its ground.
A two-in-one shock
Moving from one place to another or getting together with other people increased exposure to the virus. People reacted to that risk by reducing their labour supply for whatever they were doing to earn livelihoods. This was different from the previous crises in 2007-09, in which the supply shock was in the financial sector, and from crises caused by wars and natural disasters, in which the shock destroyed infrastructure and the labour force.
About half of the world's population has been under some degree of lockdown, according to a New York Times estimate. Reduced mobility acutely affected sectors that rely on social interactions (travel, hospitality, entertainment, tourism, personal services). Quarantines, lockdowns, and social distancing allowed the health care system time to handle the surge in demand for its services and researchers to develop therapies and vaccines. At the same time, they challenged keeping intact the economic and financial fabric of societies even in advanced economies with strong governance capacity and well-equipped health care systems. Workplace closures disrupted supply chains and lowered productivity.
Notwithstanding agile digital responses, the pandemic necessarily implied a decline in the ability and willingness to supply goods and services. Digital technologies, already on an expansion path, enabled firms and households with digital access to quickly respond to preserve income when strict social-distancing protocols are in place. Online shopping accelerated e-commerce by nearly a decade in just a few months. However, an overwhelmingly large as well as small enterprises in manufacturing and services were unable to use their economic capacity. Macroeconomic textbooks call it an adverse aggregate supply shock.
Restrictions on mobility and assembly suppressed demand. This was deepened by radical uncertainty about the progress of disease and economic policies. Households increased precautionary savings. Shopping, like we used to, turned risky. Workers losing jobs due to business closures cut consumption. Firms became wary of investing. Worried that consumers and firms will not be able to repay, lenders held back on extending credit. Overall, the ability and willingness to spend on goods and services declined. Macroeconomic textbooks call it an adverse aggregate demand shock.
The tornado like collapse
These are not vastly different from previous crises other than the fact that the supply and demand shocks coincided. But the comparison ends there. Edward Lorenz, the father of Chaos Theory, postulated that a butterfly flapping its miniscule wings over at Brazil might incite the violence of a tornado in Texas. In a complex global economic system, made of interconnected suppliers, customers, consumers, workers, banks and so on, a black swan event produces a similar butterfly effect. Poor food safety standards or whatever in Wuhan, a small event from a global perspective, triggered the Covid-19 outbreak globally leading to massive economic consequences.
The virus barricaded demand and supply with a chain reaction in the real economy. Decisions to cut back consumption and work helped reduce the severity of the epidemic. The same decisions exacerbated the size and duration of the recession. Overall, demand effects have evidently been larger than the supply shock. Large drop in demand forced firms to close leading to a rise in layoffs and a further drop in consumption.
How does the post virus equilibrium compare with the pre-virus equilibrium? A variety of economic outcomes are possible in theory depending on the pre-existing conditions of the economic agents. For instance, as some theoretical researches have demonstrated, firms hold much of their productive capital in their workers. When forced to shed labour beyond a certain threshold, their productivity suffers. But to keep paying the wage bill while sales and revenue are plummeting, these entrepreneurs need credit. This is harder to get because lenders cannot be sure of repayment beyond the assets or future income borrowers can pledge as guarantee. Low expected productivity causes low collateral value. Low collateral value means limited borrowing and low productivity. The virus shock magnifies and perpetuates due to credit market failure.
A generalized and unprecedented collapse in global activity ensued, surpassed in depth only by the two World Wars and the Great Depression over the past century and a half. Global economic output was 20% below where it otherwise would have been in April 2020, tipping millions into extreme poverty for a prolonged period. Most commodity prices reached their recent lows in mid-2020 indicating conclusively the dominance of depressed demand over the supply contraction effects on prices.
Reduced public fear as the science of the virus unfolded and lockdown fatigue spread; better calibrated government policy; and adaptation by businesses mitigated the economic impact in the so called "second" wave of the virus currently in progress.
Wider economic divide
In addition to output loss, the pandemic accentuated pre-existing inequities by causing a k-shaped recession through adverse impacts on employment for low-skilled workers while those in white-collar jobs protected income by working from home and the income and wealth of digital providers zoomed, literally and figuratively. Nobel laureate Joseph Stiglitz noted that Covid-19 has not been an equal opportunity virus. "It goes after people in poor health and those whose daily lives expose them to greater contact with others" in poor and advanced economies alike.
Essential and poorly paid workers had to continue working at greater risk of contracting the virus. The pandemic broadened the threat from automation to low-skilled, person-to-person services workers. All of this decreased the demand for certain types of labour which inevitably exacerbated inequality. The k-shaped recession found a hospitable home in most economies rife with market power and political patronage systems. The rules of the game matter. Weak constraints on corporate power, low bargaining power of workers, and unequal application of rules governing the exploitation of consumers and workers have all conflated to foster greater rent seeking and inequality amidst the pandemic.
Structurally weak economic growth and its maldistribution are related. The rich have a higher tendency to save than spend. Oversaving rises with increase in their share of income. Low interest rates and quantitative easing boosted the prices of housing and equities leading to greater inequalities and demand depression. The policy stimulus, designed to stem the rise in inequalities, created more inequality by increasing indebtedness. Both public and private indebtedness transfer income to rich investors who own the debt.
To lock or unlock
The speed of the virus spread caught the authorities woefully unprepared. The economic and social costs are immense without any intervention. Appropriate policy response prevents toxic multiplier effects from kicking in. Contagious diseases are rife with negative externalities. Dealing with all these baffled the policymakers and economists alike.
Absent vaccines and treatments, containment policy saves lives while causing sharp drop in aggregate output. However, the population never reaches herd immunity. Infections recur when containment is relaxed. Gradually ramping up containment measures as infections rise and slowly relaxing them as the population approaches the critical immunity level has eluded most countries. The behavioral changes required by the less harsh "new public health norms" are not easy to comply with consistently over time.
The lockdown policies were justified by the imperative of "flattening the curve." They began with the conviction that Covid-19 was roughly twice as transmissible as the flu, and possibly ten times as deadly. Does that require sustained and intrusive lockdown? Or can masks and social distancing do the trick? But how to ensure compliance?
Consistent answers to such questions are still in the making. While the lockdown appeared necessary to combat the lethal virus, it created livelihood challenges that make lockdowns increasingly difficult to maintain. Hopefully, vaccination will eventually free humanity from this awful dilemma.
Economic orthodoxy on retreat
The post virus equilibrium has been a bad one overall for all economies with varying intensity. In the wreckage left behind a new era on economic policy thinking emerged.
Central banks continued slashing interest rates and printing money to buy bonds (QEs). The interest rate needed to generate enough demand appears to have dipped below zero in advanced economies, a point their central banks could not easily reach. But there is no free lunch. If banks tried to charge negative interest rates, their customers might keep their cash under the mattress.
As an alternative policy instrument, the efficacy of QEs is showing diminishing returns. Reckless buying of corporate debt keeps companies alive that should be allowed to fail. Better for the government to boost spending or cut taxes, with budget deficits soaking up the glut of savings created by the private sector. The main job of central banks is to keep even longer-term public borrowing cheap as budget deficits soar. The fine line between monetary policy and government-debt management has become blurred.
Governments can service much higher public debts when interest rates are zero or negative. An economy can grow its way out of debt without ever needing to run a budget surplus if interest rates remain lower than nominal economic growth. When interest rates are zero, there is no distinction between issuing debt, which would otherwise incur interest costs, and printing money. Central banks can finance governments so long as inflation is low. However, monetary policy loses traction. Expansionary fiscal policy helps precisely because the resulting rise in interest rates allows monetary policy to regain traction.
Most of the policies require the government to spend resources upfront when revenues are down. Governments run deficits and so do private sector firms. Unless households are big savers, anti-virus policies necessarily imply running an external current account deficit. The capacity to borrow, for both the government and the nation, is thus critical. Many countries are rationed out from international private capital markets. They do not have access to the necessary resources to finance the interventions required to provide relief and invest in accelerating recovery.
Several unconventional policies appeared in many countries. These include wage subsidies, equity injections, liquidity provision and loan guarantees aimed to protect employment and productivity. They channel resources to firms beyond what incentive-compatible borrowing limits permit. Such policies are affordable with ample fiscal space or emergency financing from abroad.
In a world of near-zero or negative real interest rates, that is not a problem for advanced countries. It is a problem for many emerging and developing countries, with limited fiscal space. Debt is still attractive, but guaranteed by whom? Some governments have sufficient credibility to afford it without too much sovereign risk. Official lending, whether on a bilateral basis or through multilateral lenders such as the IMF or the World Bank, can in theory make up the financing gap. However, the multilateral lenders have nowhere near the volume of resources required, and their main shareholders are reluctant to provide more capital.
These unconventional policies are feasible insofar as the government is willing and able to deploy the power of the state to make sure all relevant financial obligations are met. Entrepreneurs may be tempted to misbehave, leaving taxes unpaid in the case of a wage subsidy to firms, absconding with profits instead of distributing them as dividends in the case of equity injections, or defaulting on debts in the case of loan guarantees or subsidized credit. Amidst a culture of impunity, such behavior flourishes, thus exacerbating inequality and draining policy space.
Broadening economic analyses
The events of 2020 drew attention to the importance of factors that economists often neglect, such as state capacity and social trust. Social norms and values are in large part determined in local society but can nonetheless be shaped by national policy. Economists will surely rethink their usual approach to the welfare state based on the assumption of rational self-interest and benevolent government. In practice, the world works differently.
Societies have largely chosen to tackle problems such as poverty and inequality through collective rather than individual and bureaucratic solutions. These social choices are partly a response to the difficulties people face providing such things for themselves and getting the state to act in the collective interest. They also reflect values such as ideas about fairness. People are willing to make sacrifices for the greater good in an environment of social trust and reciprocity. As behavioral economists have shown, people do not exclusively behave as hard-nosed rationalists. Public choice theorists have documented a myriad of government failures highlighting the ubiquitous absence of benevolence.
When social norms guarding against "bad" behaviors such as tax avoidance, willful loan default, money laundering and pilfering public money erode, collective action presents less of a trade-off between efficiency and equity than many economists suspect. Analyses deploying assumptions of narrow self-interest are useful in explaining such behavior, but they are not necessarily the best predictors of what will happen. The benevolent government assumption has proven generally useless even under dire straits such as the pandemic.
The failure to take social preferences seriously could mean that economists' prescriptions for making societies more egalitarian and dynamic fall asunder. These insights, renewed by the pandemic, should influence analyses of public policies in the years to come.
Zahid Hussain is an Economist