2008, redux?

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A collapse in stock markets, co-ordinated policy statements and emergency interest rate cuts: the events of the past week have inevitably led to comparisons to October 2008. But the differences are as significant as the similarities. To understand why it’s helpful to think about the underlying economic forces that are at play.

The crisis of 2008 was, in essence, what economists term a “balance sheet” recession. House price bubbles inflated earlier in the decade and when they subsequently burst, the hole in households’ balance sheet forced a collective shift towards saving (i.e. paying down debt) rather than spending. This in turn exposed vulnerabilities in a highly-leverage banking system. As counter-party confidence collapsed, the financial plumbing froze up. All of this manifested itself in a collapse in aggregate demand.

In contrast, the shock posed by the coronavirus affects both the supply- and the demand-side of the economy. Factory shutdowns, travel bans, supply-chain disruptions and school closures represent a supply shock – the ability of the economy to produce goods and services is diminished. But fewer trips to shops, restaurants and cinemas represent a demand shock – consumer spending falls. Large falls in the stock market also feed into weaker demand by reducing household wealth. These effects can be self-reinforcing, since factory shutdowns can reduce the income of workers, which in turn reduces spending.

In other words, the crisis of 2008 was a financial shock that affected the demand side of the economy. The crisis of 2020 is an economic shock that affects both the demand and the supply side of the economy. The two situations are fundamentally different. This has three implications for what is likely to follow.

The first relates to the shape of subsequent downturn. The 2008 crisis led to a deep recession followed by an extremely slow recovery as households and financial institutions repaired their balance sheets. The coronavirus shock is likely to trigger large falls in output in the affected economies over the next quarter but, provided that the virus fades, activity should rebound as supply constraints are lifted. The outlook is unusually uncertain but our sense at this stage is that this is most likely to be a short, sharp shock.

The second implication relates to the role that policymakers can play in cushioning the downturn and stimulating a recovery. Policy stimulus – both fiscal and monetary – works by stimulating demand. It therefore had a clear role to play in 2008. But its role today is less obvious. Targeted, temporary and large fiscal support in the form of loans and subsidies to the hardest hit firms can help to mitigate the shock form the virus, and monetary support can help to counter some of the financial effects. Central banks could also offer cheap finance to banks lending to the most affected sectors. Regulatory forbearance may also help to mitigate any strains in the banking sector. But the speed of recovery will depend in large part on how the virus spreads and when the containment measures are lifted and life returns to normal.

Finally, the worst-case scenario today looks different from in 2008. Economic history shows that the most severe depressions tend to be caused by asset price collapses. In 2008, these effects were magnified by high levels of leverage in the banking system and vulnerabilities in the global financial system (dependence on wholesale finance, short-term credit lines and so on). Debt levels remain high today but are concentrated in less risky areas (government sector rather than households). Meanwhile, banks are better capitalised. Pockets of risk exist – particularly in the corporate sector – and some of these vulnerabilities in the energy sector may be exposed by the sharp drop in oil prices over the past day. But we don’t think these are large enough (yet) to trigger a global crisis.

All of this means that the most likely worst-case scenario today is a sharp but probably short recession rather than an outright depression. As the virus spreads, there’s a good chance that that “worst case” scenario quickly becomes the most likely scenario. But the legacy of the virus beyond the next 6-12 months is uncertain.

One possibility is that it takes the developed world one step closer to full-scale “Japanification” (see here for more). Another possibility is that interest rate cuts heighten the risk that a hunt for yield in an environment of low returns eventually causes bubbles to inflate, which in turn sows the seeds of the next major crisis. It remains to be seen how events will play out, but it’s increasingly difficult to escape the sense that this is the biggest risk hanging over the global economy beyond the coronavirus.