The Covid-19 Coronavirus has now had a severe impact on global stock prices and we are seeing almost as much focus on the potential economic policy response as on the ongoing health policy reaction. Some are calling for a coordinated response by global central banks, like during the global financial crisis. Others argue that Italy should be allowed to expand its fiscal deficit to offset the adverse economic impact.
What should economic policymakers do, and what will they do? Here are a few thoughts.
First of all, the Fed has already done something—it cut interest rates three times last year to provide insurance against a possible shock to global economic growth. Covid-19 is not the shock the Fed expected, but it would be helpful for confidence to point out that monetary policy is ahead of the curve.
How much more policy support is needed depends on how bad the shock gets. This in turn depends on (i) how severe the epidemics turns out to be; and (ii) the degree of disruption to economic activity, which hinges not just on contagion rates, but also on consumer and business confidence and on government measures such as travel bans, quarantines, school closures.
On the health outlook, what we know is relevant to the economic impact. In short:
- Compared to similar recent previous epidemics Covid-19 has affected a lot more people (in 2003, SARS affected over 8,000 people; MERS had about 2,500 confirmed cases; Covid-19 has hit over 85,000 people so far).
- However, Covid-19 seems slightly less contagious than SARS based on the classic measure (known as “R0”) of how quickly a virus spreads, an estimate of how many people on average suffer contagion from a single infected person (for Covid-19 the R0 is currently estimated at 2.2; the R0 for SARS was about 3 before it was contained; for MERS estimates varied in a 1-5.7 range depending on location). R0 needs to be brought down to less than 1 for contagion to peter out.
- Covid-19 seems much less deadly: the estimated death rate so far (number of deceased patients divided by number of confirmed cases) is 3.4%; the death rate for SARS was 9.6% and for MERS 34.4%.
- By way of comparison, the regular flu has infected already about 1 billion people globally, but with an estimated death rate of only 0.1%.
Contagion and death rate estimates are especially uncertain in the early phase of a breakout. In which direction are the Covid-19 numbers likely to be wrong?
Since the symptoms are very similar to the common flu, tests have mostly been limited to severely ill patients or those known to have had exposure to affected people. Moreover, some diagnostic tests can result in false negatives—failures to detect infected people. Both these factors would result in an underestimation of the number of cases. This in turn would imply that contagion rates are higher than current estimates, but also that the mortality rate is lower.
Most of these preliminary numbers seem reassuring. However, the large size of the initial outbreak in China and the greater volumes of global tourism and trade imply that we have many more confirmed cases than for SARS and that new cases have appeared in a rising number of countries. (another caveat here is that the SARS numbers might have been under-reported, as China was criticized for hiding the extent of contagion).
This has had the greatest impact on people’s confidence. It has been made worse by uncertainty (we are not yet entirely sure of how the virus spreads, and we don’t yet have a vaccine), by the fact that medical experts disagree in public on the dangers (much like economists) and by statements from some prominent health officials that cross the line from prudence into alarmism: the head of the World Health Organization saying the “virus is more powerful […] than any terrorist attack”, and the deputy director of the US Center for Disease Control and Prevention (CDC) claiming that it’s only a question of when, not if the Covid-19 will become a pandemic.
The economic impact is already being felt and will become more intense in the coming months. It will be most intense in China, where PMIs have plunged in February and Q1 GDP might contract for the first time since the cultural revolution. China today accounts for about 20% of the global economy, compared to less than 9% in 2003 (SARS) and plays a pivotal role in global supply chains.
Countries closely linked to China, especially in Asia, will feel significant repercussions; in some cases these will be compounded by domestic measures to limit contagion, as in Korea and Japan. Global tourism will suffer a serious blow. Italy, where contagion has struck the economic engine regions of Lombardy and Veneto, might tip back into recession (then again, Italy is almost always in recession). A number of corporates have warned they expect an impact on demand and earnings—this will likely be reflected in a more cautious stance to investment and hiring even in countries that have seen little contagion so far, like the US.
The current perception of the economic damage is probably exaggerated by the fact that we are using stock markets as the preferred gauge. Given that asset price valuations have been inflated by years of easy money, investors are quicker to pull out at the first sign of trouble. The magnitude of the drop in stock prices reflects not just the expected severity of the shock, but also the concern that previous prices might have been excessive. The same applies for the reaction in high-yield credit markets, given the marked loosening of lending standards.
The debate now centers on how long the negative impact to growth will last, and whether the recovery will be fast (V-shaped) or slow (U-shaped). Let’s take as a most likely scenario that the contagion will peter out by spring, in line with the normal flu seasonality. This seems reasonable given that in China, where the contagion started, the epidemic peaked in early February and new daily reported cases have since fallen by 80%. True, the virus has spread around the world, but other countries are more prepared and need to contain a much smaller initial outbreak compared to China.
It will take at least a few more months for tourism to recover. Lost revenues and wages will reduce 2020 GDP—people will not vacation and eat out twice as much to make up for the months of fear. We should expect a slowdown in both investment and hiring as businesses take a more prudent stance. The recent collapse in equity prices will also negatively affect both corporates and consumers. The bigger question though is whether the current slump will force a large number of companies out of business and cause permanent disruption to supply chains. If it does, the damage will last longer; if it does not, the rebound in the second half of the year should be more V-shaped.
This is where a policy response comes into play. I expect the Fed will cut interest rates. A rate cut is much more warranted now than it was last year, and should help stabilize equity markets and confidence. A coordinated monetary response is unlikely, and in my view unnecessary—this is not a shock comparable to the Global Financial Crisis. In Europe, ECB President Lagarde said monetary easing is not yet justified; it would also be less effective than in the US, given that the ECB is already engaged in meaningful monetary easing. A fiscal policy stimulus would help, particularly in the most affected countries—ideally targeted to the businesses and consumers most impacted. I think we will see some fiscal stimulus, on a country by country basis; how much will depend on the severity of the slowdown in each country. I don’t expect it to be especially effective—governments are good at spending money, but rarely at spending it well.
Overall, this should set the stage for a stronger recovery in the second half of the year. I would also note here that global supply chains have already proved very resilient to shocks, and have become increasingly flexible and adaptable over the past three years of persistent trade tensions and uncertainty.
My pet peeve: the current predicament shows it would be wise to run policy tighter when the economy is doing well and to focus more on supply-side structural measures. Policymakers would be in a much better position to react today if they had not been running monetary policy in emergency mode for the last several years and if they had gotten public finances in better shape. And if loose monetary policy had not boosted asset prices and corporate borrowing beyond all prudence, we would not now be facing confidence-shattering market corrections.
I also find it dispiriting how lack of leadership is compounding uncertainty and undermining confidence further. I mentioned above the alarmist statements by health officials, which seem out of proportion with what we know so far about Covid-19. In the US, many commentators see an economic slump as the last hope to prevent President Trump from being re-elected, and this compounds the usual doom-and-gloom bias that the media have displayed for the past ten years—again unhelpful to the economic policy and health policy response.
Weakened political and social institutions make Covid-19 more dangerous than it need be.