Consensus catching on that this time is different - Capital Economics
The Chief Economist’s Note

Consensus catching on that this time is different

It will be years, if not decades, until we fully understand the long-term economic effects of the pandemic. However, mainstream views about the economic legacy of COVID-19 are starting to shift. Whereas most commentators initially argued that the pandemic would permanently depress output, many are now rethinking their early assessments. Indeed, in its latest World Economic Outlook, published earlier this month, the IMF forecast that most advanced economies would now return to their pre-pandemic paths. 

One reason for the shift in views is that the incoming data have been stronger than was generally anticipated a few months ago. This partly reflects the fact that economies have become more resilient to lockdowns. Another factor is the huge scale of fiscal stimulus that has been announced in the US. This will boost aggregate demand there in the near term but should also reduce the degree of “scarring” and thus the hit to the economy’s long term supply potential. 

However, alongside these factors there has also been a more fundamental reappraisal of the nature of the current crisis. 

Economic crises are often followed by a period of much weaker GDP growth that causes output to become lodged on a lower path than the pre-crisis trend. This was true of the 2008 global financial crisis and most commentators (though not us!) have argued it will be true of the pandemic too. But like generals fighting the last battle, economists often fall into the trap of forecasting the last crisis. This can lead to muddled thinking. 

It’s important to understand the reasons why economies can get stuck on a permanently lower path of GDP following a crisis. Three stand out. The first is that the pre-crisis rate of growth itself was unsustainable, meaning the post-crisis rate of expansion is necessarily lower. 

The second factor is that crises can destroy supply potential. Capital is rendered obsolete and high and persistent levels of unemployment cause skills to atrophy. This reduces the capacity of the economy to produce goods and services and lowers the post-crisis growth path. 

The final reason is that households and businesses are often forced to repair their balance sheets in the wake of a crisis, thus restraining their spending and resulting in a prolonged period of extremely weak demand. This post-crisis state may in fact not be permanent and demand may ultimately return. But the period of adjustment can still depress growth for several years.

However, as we’ve argued before, none of these factors apply to the current crisis. The pre-crisis growth rate was unusually weak rather than unsustainably strong; government support schemes have limited supply-side damage to economies; and, while the finances of some households and businesses have clearly been hit hard, in aggregate, at least, private sector balance sheets are stronger now than they were before the pandemic struck.

Accordingly, while in previous crises, including in 2008, the global economy failed to return to its pre-crisis path of output, this time we do expect it to return to its pre-crisis trend. (See Chart 1.) If we’re right, then the consequences will be significant. 

Chart 1: Global GDP (2019=100)

Most obviously, if there is no permanent damage to GDP, then the main constraint on future growth is the extent to which virus-related restrictions on activity and movement remain in place. Assuming that vaccine rollouts allow restrictions to be lifted, output should snap back (the big risk therefore is that the virus mutates in a way that reduces the efficacy of vaccines and requires restrictions to remain in place). What’s more, if we’re right in expecting output to ultimately return to its pre-virus path, then there should be no need for a period of fiscal retrenchment to close budget deficits – this should happen automatically as economies return to health. 

None of this means that the pandemic won’t have consequences that will reverberate for years to come. Some countries and regions will recover faster than others (the US and China will lead the way while Europe and Latin America will take longer to recoup lost output). 

More fundamentally, the virus has wrought changes to the way we work, shop and live, some of which are likely to be permanent. There will also be consequences for public finances. While budget deficits should close as output recovers, public debt burdens will be higher. This may encourage some governments to pursue austerity measures to bring down public debt. But others may become more tolerant of higher inflation, or resort to measures such as financial repression, to keep a lid on debt service costs. Finally, as I argued in my last note, the pandemic has accelerated US-China decoupling.

But in many ways, this is a more subtle legacy than that of previous crises. Those have tended to leave a visible mark in the form of a prolonged period of much weaker economic output. Anyone expecting a similar outcome today may find that this time really is different.