The economic effects of the Covid-19 pandemic are devastating worldwide. The IMF is projecting that the world economy will contract by 3% in 2020, before rebounding by 5.8% in 2021. The V-shaped recovery is predicated on the pandemic receding in the second half of 2020. A U-shaped scenario, with a prolonged recession, is also possible if the pandemic lingers, or if the recession triggers banking and/or sovereign debt crises.
Will GDP growth get back to its pre-crisis trend in the aftermath the pandemic? Is an L-shaped scenario likely, with a permanent decline in the growth rate? Uncertainty surrounding the path of the pandemic impairs long-term visibility. However, analysis through the lens of “growth accounting” provides a useful starting point for thinking about the consequences of the pandemic for long-term growth. Deeper marks could be left on growth through three mechanisms: (i) a slowdown in “total factor productivity” (i.e., efficiency) gains; (ii) slower capital accumulation; and, (iii) a slowdown in employment growth and the formation of human capital.
Global value chains (GVCs) are likely to be a victim of the pandemic. The strong growth of GVCs promoted efficiency by allowing firms to exploit the comparative advantages of countries at different stages of production within industries. The World Bank estimates that GVCs increased their share in global trade from 40% in 1990 to almost 55% in 2007.
The pandemic has caused the breakdown of GVCs, while revealing their limits: when a link in the chain breaks, as in China earlier in the year, upstream and downstream suppliers and clients are affected and the value chain breaks up. The consequences can be particularly severe for public health because many pharmaceutical companies are highly dependent on ingredients produced worldwide.
Regulations are likely to contain the international fragmentation of production in key industries, especially for public health reasons, while firms will reassess the optimum degree of GVC participation. The pandemic may predictably lead to a decline in GVCs, reinforcing a trend already visible in the aftermath of the global financial crisis. Efficiency gains may thus be tamed, leading to a slowdown in potential growth.
Deep crises often lead to lasting reductions in corporate investment. After the global financial crisis, in 2008-18, the investment ratio in advanced economies fell to 21.5% of GDP, from 23.3% in 1990-2007. Two factors are likely to depress corporate investment after the pandemic.
First, the health crisis could increase precautionary household saving, thus weakening consumer demand in the long run. This may happen if households realize that their savings are not sufficient to deal with the uncertainty that such emergencies create. The massive destruction of jobs may also increase savings.
Budget deficits will also swell leading to soaring public debt. According to projections, if GDP falls by 10% in 2020 public debt will increase to 145% of GDP in the United States and 108% in the Euro zone. Barring higher inflation or financial repression, ensuring debt sustainability will eventually require long-term fiscal austerity, which will dent disposable income, predictably depressing consumption. Slower consumption growth, due to precautionary savings and lower disposable income, is likely to reduce the investment ratio, thus denting potential growth.
Second, non-financial companies are over-leveraged, as they borrowed excessively at low interest rates after the global financial crisis. The OECD estimates that non-financial corporate bond debt reached 15.6% of world GDP in 2019, up from 10.2% in 2008. One-third of this debt has a residual maturity of less than three years. The current disruption in corporate cash flows poses a risk of a liquidity crunch, or even of a solvency crisis. A decrease in investment may prove a reasonable deleveraging strategy, especially in view of uncertain prospects of consumer demand.
The IMF predicts that unemployment will rise to 10.4% in 2020, both in the Euro zone and the United States, up from 7.6% and 3.7% respectively in 2019. There is evidence that higher unemployment may increase the “natural unemployment rate” through hysteresis effects. The gradually reduced employability of long-term unemployed is the most common cause of hysteresis in unemployment.
A higher natural rate of unemployment will not necessarily reduce the rate of employment growth. Permanently higher unemployment could, however, further compress consumption, and therefore investment, thereby indirectly reducing potential growth through the capital accumulation channel discussed before.
Rising unemployment can also affect potential growth through lower human capital formation and productivity of the new entrants to the labor market. As Barry Eichengreen argues, in the aftermath of deep recessions, new entrants remain unemployed longer and are paid less compared to previous patterns. Lower wages reflect lower productivity, as long unemployment spells reduce on-the-job training.
An “L-shaped scenario” of the crisis cannot thus be ruled out. However, there is hope that the risk will be mitigated as governments have mobilized significant resources to combat the pandemic. Policy support packages can also mitigate risks if they are well designed. It will be important to improve the financial resilience of firms; spread budget stimulus over time; avoid premature fiscal tightening; use innovative financing instruments, such as joint-liability debt in the euro area; and avoid as much as possible the permanent separation of workers from their jobs.