Will Covid leave scars on the world economy?
Will Covid leave scars on the world economy?
In assessing the speed and scope of the recovery, we look at three key questions.
1. The cause: different recessions leave different legacies
There is a distinction to be made between recessions caused by external shocks and those which are endogenous or internally generated - the former tend to see faster recoveries than the latter.
The current downturn is very much an exogenous shock as the Covid-19 pandemic stopped the world economy. In this respect it is similar to a war, where daily economic activity is brought to a halt and all attention is focussed on the more pressing battle for survival from the external threat. Once the “war” is over, the economy should quickly normalise as the threat is lifted.
In our current forecasts, we see activity returning to pre-pandemic levels in Q2 this year in the US and Q4 next year for the UK; periods of 1 and 2 years respectively. The shorter downturn should mean fewer long run effects where workers lose skills and become permanently unemployed, known by economists as “hysteresis”.
2. Imbalances: debt and deficits
However, the pandemic has created significant imbalances. The impact on government borrowing has been enormous. Figures from the IMF show public debt in the G20 advanced economies to be at levels last seen after the second world war.
The new US Treasury Secretary Janet Yellen has talked of the need for fiscal policy to “go big” to prevent a repeat of the post global financial crisis (GFC) recovery period, even if it risks higher inflation. The IMF and World bank have both been vocal on the need to keep fiscal support going.
In our view, such a position makes sense, but we should recognise that it will have to be accompanied by an extended period of low interest rates to be sustainable. At this stage, we would note that fiscal dominance of monetary policy is becoming the new reality.
3. Disruption: how will post-pandemic spending look?
We assume that the pandemic ends and the virus becomes endemic; always with us but not the same threat to everyday life. The strong performance of the industrial sector through the pandemic means that the focus will be on recovery in disrupted sectors such as retail, travel, accommodation, arts and entertainment.
In gauging the potential disruption, the BoE recently published estimates of how much task reallocation would be needed in the labour market as a result of changes in expenditure patterns. Assuming that Q3 2020 represents the new normal for spending as the first lockdown was lifted, there would be an above-normal level of task reallocation. This would test the flexibility of workers to acquire new skills and move sectors.
On the capital side, much IT and communications equipment can be easily re-deployed. It is also possible to repurpose buildings, turning office to residential for example. Although many will be in the wrong place, the challenge comes in more specialist areas such as transport, where it is difficult to repurpose equipment and can lead to scrapping.
There will be scarring effects from the pandemic and most economists expect trend growth to be reduced as firms close and some workers become long-term unemployed.
Although we acknowledge the uncertainties around this, we are more optimistic. More generally, lessons learnt from the GFC mean that we are not experiencing a systemic liquidity or credit crunch and the authorities recognise the need to keep monetary and fiscal policy support in place. Recovery should be faster as a result, limiting the ultimate impact on trend growth.
On the productivity side the reallocation of resources will be painful, but it will enable firms to be more efficient, no doubt increasingly aided by new technology.
Although there are still considerable uncertainties over the path of the pandemic and the global vaccine roll-out, these factors point more towards a brighter path for the world economy than experienced after previous recessions.
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