The immediate effects of the coronavirus on the global economy are becoming increasingly clear and point to a sharp fall in output across the world. Recession looms. The effects over the longer term are less obvious. The most likely outcome is that economies return to the pre-virus path of GDP within a couple of years, albeit with some lost output in the meantime. But that hinges on several things going right over the coming months and quarters.
- The immediate effects of the coronavirus on the global economy are becoming increasingly clear and point to a sharp fall in output across the world. Recession looms. The effects over the longer term are less obvious. The most likely outcome is that economies return to the pre-virus path of GDP within a couple of years, albeit with some lost output in the meantime. But that hinges on several things going right over the coming months and quarters.
- There’s little doubt that output is set to fall sharply across the globe over the first half of this year. But the outlook beyond the next couple of quarters is much less certain – or, in the words of Jay Powell, “unknowable”. It’s possible to think of three plausible outcomes. The best case is that economies suffer no permanent loss of output and return to their pre-virus path of GDP. The worst case is that economies suffer a permanent loss of output and then settle on a permanently lower path of GDP. In between, it’s possible that economies suffer a permanent loss of output but eventually return to their pre-virus path of GDP. These scenarios are shown in the chart below.
- What might cause each of these scenarios to develop? The first (best case) scenario would entail a large loss of output during the shutdowns which is then fully made up once containment measures are lifted. (The light blue line on the chart.) In other words, all of the spending on things like travel, holidays, meals out and the like that is foregone in the shutdown period takes place in subsequent quarters – in addition to the spending that would have happened in those quarters anyway. In our view, this seems extremely unlikely. We won’t commute twice a day over the summer to compensate for not commuting at all in the spring. Some spending will therefore be permanently lost.
- The middle scenario entails a large loss of spending and output during the shutdowns that is not fully recovered in subsequent quarters. (The dark grey line on the chart.) But the level of GDP a few years from now is ultimately unchanged. In other words, life returns to normal. We don’t compensate for a loss of holidays in this year by taking more next, but we do take the same number of holidays in 2021 as we would have done before the virus struck. This seems plausible.
Chart 1: World GDP (T = 100)
Source: Capital Economics
- The worst-case scenario entails both a permanent loss of output and a permanently lower path of output. (The dark blue line on the chart.) There are two ways in which this could happen. The first is that the virus creates lasting damage to the supply-side of the economy. Capital could become obsolete (for example, if otherwise solvent businesses go bust), increased risk aversion could pull down investment or skills could atrophy if people lose their jobs and remain out of work for a substantial period of time. One risk is that governments are successful in bringing the virus under control only for it to return next year, thus causing another hit to output. (This happened with the Spanish flu outbreak in 1918-19.)
- The second way that the virus outbreak could lead to a permanently lower path of output is by causing lasting weakness in demand. This could come through another period of austerity as governments deal with the fiscal costs of the crisis. But it could also happen if the scale of the economic shock that unfolds over the coming months leads to a heightened tendency towards saving by consumers and a reluctance to invest by businesses.
- So where does this leave us? If governments step in to prevent otherwise solvent businesses from going bust and stand behind the banks; if bond markets are tolerant of higher public debt burdens; if we are fortunate to avoid repeat outbreaks of the virus; and if the “animal spirits” of firms and households ultimately returns, then the most likely scenario is that economies suffer a permanent loss of output but eventually return to the pre-virus path of GDP. (The light grey line in the chart).
- But if any of these conditions fail to hold, then the most likely outcome is that economies suffer a permanent loss of output and settle on a lower path of GDP. (The dark blue line).
- It’s impossible to know whether the virus (or something like it) will return. But from a macro perspective, the risks of ending up on the dark blue line rather than the dark grey line are greatest in those countries where governments are slow to respond, or bond markets are less tolerant of higher debt burdens. And the latter is most likely to be a concern in heavily-indebted euro-zone economies (Italy) and emerging economies (Brazil, South Africa).
Neil Shearing, Group Chief Economist, firstname.lastname@example.org