GLOBAL ECONOMICS UPDATE
Economies after COVID
- The COVID pandemic will leave a profound economic legacy. But unlike previous crises, this will not necessarily manifest itself in much weaker rates of long-term economic growth. Instead, the economic legacy of the pandemic will be felt in changes to economic structures, an increasingly fractured global economy, and the need for a period of ultra-low interest rates to manage debt burdens. In this environment, equities are likely to outperform bonds.
- Most of the debate among economists has focussed on the effect of the virus over the next couple of years: the impact of new restrictions to contain its spread, the prospect of a vaccine and the likely shape of the eventual recovery. Some of the more interesting questions, however, relate to the longer-term. At some point, the virus will be quashed – either through herd immunity or, perhaps more likely, a vaccine. But the economic consequences will persist for years, even decades. We have explored these in detail in a series entitled “Economies after COVID”. You can find all the pieces on our website; this note summarises the key points.
- One way of thinking about the long-term consequences of the crisis is to consider how long it might take economies to return to their pre-virus paths of GDP. On this, most economists are agreed – the pandemic will deliver a lasting blow to output and the global economy will be substantially smaller by the end of this decade than would otherwise have been the case. But we suspect that some of this pessimism about the long-term is overdone.
- Admittedly, in many crises, including the 2008 global financial crisis, economies do not return to their pre-crisis trend. Output becomes lodged below its previous path on a permanent basis. But it is important to understand why this can happen. Three reasons stand out.
- The first is that the pre-crisis trend was unsustainable. In many cases, pre-crisis growth is boosted by factors that cannot last and very often end up sowing the seeds of the crisis itself. As a result, the post-crisis trend 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.
- Finally, crises often result in a prolonged period of extremely weak demand, for example because households and businesses are forced to restrain spending to repair their balance sheets. While this post- crisis state may not be permanent and demand may ultimately return, the period of adjustment can last for long enough to give the impression of having reduced trend growth. Indeed, it may actually do so if it causes permanent scarring of the labour market.
- All of these factors lowered the path of output following the 2008 global financial crisis: the pre-crisis trend was inflated by housing and credit bubbles, and was never likely to be matched after the crisis; the crisis itself reduced the size of the financial sector, which, since it is a high productivity sector, reduced the supply potential of economies; and balance sheet repair in the wake of the crisis constrained demand and suppressed growth.
- But viewed through the same lens, the COVID-19 crisis looks rather different. For a start, potential growth in many economies had already fallen sharply before the crisis, thus lowering the bar in terms of a path back to “normality”. Furthermore, although the COVID-19 crisis will shrink some sectors, these are generally lower productivity ones such as hospitality and leisure. Investment that has been “lost” during the crisis is a small share of the overall capital stock in most economies. And while some capital stock has been rendered obsolete (airlines, some office space and so on), the crisis is likely to spur investment in new areas, including digital technology. Neil Shearing, Group Chief Economist, firstname.lastname@example.org Global Economics Update
- This leaves the prospect of an extended period of demand weakness as the chief reason to be concerned about the long-term effects of the virus on GDP. For now, the impact on demand is being mitigated by wide-scale fiscal support. Accordingly, the biggest risk is that this is withdrawn prematurely by governments seeking to repair some of the damage to public finances. This would be a self-defeating mistake.
- None of this is to say that the virus will not leave an economic legacy – just that, policy missteps notwithstanding, this legacy may not reveal itself in measures such as GDP. So where should we look?
- The behaviour of consumers and businesses will change in a post-COVID world. The lesson from past pandemics is that, while they do not tend to trigger behavioural changes “out of the blue”, they do tend to accelerate changes that were already underway. In a post-COVID world, we should expect more working from home, more online shopping, and less business travel.
- This will have implications for the sectoral make-up of economies. While some sectors, particularly around digital technology, are likely to grow, others, as noted earlier, are likely to shrink. The consequences of these shifts will be profound, particularly for property markets. Governments will need to decide how much of the transition to leave to market forces and how much to actively influence.
- This brings us to another area of change – the size and role of the state. The virus has expanded the powers of government but also reshaped what voters expect in return. Public health, it seems, is the ultimate public good. The state may shrink back as the virus passes, but the odds are that it won’t.
- If so, this will raise challenging questions about how to fund governments. Taxes are likely to have to rise, albeit only once we return to full employment. But the prevailing view among economists that, on top of this, an additional dose of austerity will be required to bring down public debt levels may be wrong. For some countries, a combination of economic growth, low interest rates and the passage of time may be enough to erode debt burdens gradually. In addition, governments and central banks may not just become more tolerant of higher inflation – they may actively target it.
- Finally, the fallout from the virus is likely to intensify the pushback against globalisation and multilateralism that had been building before the outbreak began. The absence of a co-ordinated policy response to the virus is already striking. But the pandemic is widening the rift between China and the rest of the world. It will come to be seen as the moment when decoupling became irreversible and globalisation began to retreat.
- The market implications of all of this will be shaped to a large extent by the response of central banks. Our view is that monetary policy will be kept extremely loose, in part to help manage the increase in public debt that has resulted from the crisis. If we are right, then real interest rates will remain in negative territory for some time – perhaps for the rest of this decade. In that environment, the returns from equities are likely to beat those from government bonds. But we suspect the outperformance of large-cap US equities will come to an end.
This great article was sourced at CapitalEconomies.com