The long view: Apocalypse now? The outlook for the global economy after the Covid-19 pandemic.

The word was dropped by the French Minister of the Economy, Bruno Lemaire: “there is no comparison other than the Great Depression of 1929.

It is understandable that the State in France, as everywhere else in the world, is calling for a general mobilisation in this “war against this invisible and still little known enemy”, which is Covid-19, a coronavirus of the same family as SARS or MERS-COV, but with its own “epidemiological signature”, which researchers and care workers are struggling to decipher, in a real race against time. A race for life, because this virus kills. Officially promoted – albeit belatedly – by the WHO as a global pandemic, this new coronavirus has already caused tens of thousands of deaths. It could kill hundreds of thousands before disappearing into the wild, or taking an endemic form and recurring each winter season in a more or less virulent form.

Is the comparison with the 1929 crisis warranted?

It doesn’t take a Nobel Prize in economics to see the catastrophic economic impact of the radical containment measures taken by the governments of dozens of countries around the world to contain the spread of the coronavirus and to “flatten the curve”, as we now call it (see our article on this strategy). These measures now affect nearly 3.5 billion people, or half of the world’s population.

Very early on, financial markets anticipated the resulting collapse in economic activity. The price of oil plummeted – spurred by the failure of the meeting in Vienna between OPEC and Russia to reach an agreement that would limit oil production following the expiry of the previous agreement on 1 April 2020. The sell-off then spread to the equity markets – with a crash that reversed several years of stock price gains in a matter of days – and then to other risky assets, such as publicly traded corporate debt and emerging sovereign debt. Even a G7 country like Italy had to temporarily face investor mistrust over its debt, as a result of Christine Lagarde’s clumsy rhetoric. The major central banks (Federal Reserve, ECB, Bank of England, Bank of Japan) stepped in to reassure the markets, governments and companies that a deluge of liquidity was about to pour down and that central bankers would do “whatever it takes” – to use the famous phrase of former ECB President Mario Draghi – in order to prevent a liquidity crisis from morphing into a devastating insolvency crisis.

The States then took up the efforts of the Central Banks, in a rather scattered order. The G20 said it was ready to mobilise 5 trillion dollars, of which nearly 3.5 trillion actually corresponded to the plans already announced by the United States (2 trillion dollars) and the European countries (1.5 trillion euros). These consensual declarations failed to mask the breakdown of multilateralism and the lack of a more systematic strategy of cooperation at the international level. Ironically, Saudi Arabia, which is leading the G20 for the first time in its history, did not shine in its sense of responsibility, launching a devastating price war in the aftermath of the OPEC+ Vienna meeting, heralding considerable financial difficulties for the oil majors, serial bankruptcies for US shale oil producers and an unprecedented amplification of economic, political and social crises in commodity exporting countries which do not possess the financial largesse of Saudi Arabia or Russia.

The first estimates of the economic impact of this health crisis had the effect of a cold shower:

  • In the United States, nearly 3.3 million people were out of work in the week ending March 20. An absolute record – never before seen! – of this statistic.
  • In France, INSEE calculated using experimental methods that the response to the crisis would lead to a 35% drop in economic activity, representing a loss of 3 percentage points of annual GDP per month of containment.
  • The “flash” Purchasing Managers Index (PMI) for March, published by IHS Markit, also dived into the abyss around the world

But the most worrying thing is not this synchronised halt in global supply and demand, however brutal and unprecedented it may be. If this “global economic stroke” were to be as brief as it is violent – a quarter or two at most – it would be like transposing to the real economy the algorithmic crashes that we occasionally see in the financial markets.

Beyond the handling of the health crisis and the exceptional support measures designed to ensure that hundreds of millions or even billions of people around the world do not lose their livelihoods overnight, the most worrying concern are the medium- and long-term consequences of the crisis for the global economy. In other words, the critical question is whether the patient can recover quickly once the cause of the disease is contained, perhaps even experiencing a surge in activity that would offset the initial weakness, or whether this unexpected shock is only the prelude to a lasting paralysis and to a long and uncertain recovery.

The answer to this question is extremely difficult today. There are compelling arguments for a rapid recovery of the world economy once the health crisis is under control. We can mention among these arguments the exogenous nature of this crisis – in contrast to the financial crisis of 2008 – and the postponement of demand that will not fail to be expressed once the crisis is over. Isn’t China already out of the woods? In any case, it managed to escape the apocalypse that some people were predicting. Other factors, however, indicate that the macroeconomic feedback loops and the micro-economic distortions that aggravate crises have already started. The knock-on effect could spread from the economic sector to the banking sector and vice versa, in a self-sustaining swing that could usher in not only a global recession – we are already in that stage – but a genuine depression, i.e. a lasting and hardly reversible decline in activity and employment.

The experience of the 1930s has taught us that the mechanics of a depression involve a steep fall in demand, on such a scale that it causes a massive collapse in supply, which in turn triggers more layoffs of workers and more business failures, thereby actioning a downward spiral. The economist John Maynard Keynes understood that before anyone else at the time. His proposals were endorsed in the United States by F.D. Roosevelt, and were later universally adopted after World War II. Today, the real question is whether there are sufficiently powerful pull-back devices around to prevent a new deflationary spiral.

Under normal circumstances, there exists spontaneous recall forces in the economy. A temporary decline in demand leads to lower prices and wages that encourage consumers to buy more and producers to produce more, allowing the economic engine to start up again. Nevertheless, some of the demand is definitively lost following a major negative shock (see the paper published by Valerie Cerra and Sweta Chaman Saxena in the American Economic Review). In the present case, this may include for instance the demand for services such as retail trade, catering, hospitality and transportation. The slump in demand drives many of these businesses to reduce their workforce, leading to a further reduction in overall aggregate demand. Moreover, this shortfall in demand is only marginally offset by the surge in e-commerce, home delivery services (Amazon, Deliveroo), homeworking solutions, Netflix-style entertainment platforms, medical services, and the manufacturing of masks and other medical devices….

In order to break a self-sustained cycle of supply and demand destruction, it is essential that households’ disposable income is not excessively affected. This explains the importance of unemployment insurance mechanisms and social transfers that compensate for a temporary loss of income, especially if this loss is the result of government-imposed measures. The more violent and systemic a shock is, the more justified these compensatory mechanisms are, from both an economic and moral point of view (see this column by Kate Bahn in Barron’s). Moreover, this justifies arrangements that allow companies to keep their employees, including short-time working schemes, whose cost is borne by the State, and more generally all the measures that alleviate fixed costs no longer covered by operating income (e.g. social security contributions, loan repayment charges, miscellaneous levies and taxes).

A key difference between the 1930s and the current period is the nature of the global monetary regime. In the 1930s, a fixed exchange rate system based on the Gold Exchange Standard was in place. This system ensured the stability of participating economies and facilitated trade among them in normal times. But in times of crisis, it was a very rigid constraint and it prevented the self-adjustment of these economies to violent shocks such as the 1929 crash. Under the current post-Bretton Woods regime, the flexibility of exchange rates and the ensuing independence of monetary policies makes it easier to absorb this kind of shocks. As a matter of fact, the negative impact of declining oil prices is less strongly felt in Russia, where the depreciation of the rouble acts as a shock absorber, than in Saudi Arabia, where the currency is pegged to the US dollar. On the other hand, financial markets are now much more integrated than a century ago. Information flows immediately from one end of the planet to the other. For this reason, it is important to set up “circuit breakers” to prevent the crisis from spreading via the financial channel. A few years ago, the IMF for example acknowledged the benefits of capital controls that some emerging countries (e.g. Brazil, Malaysia) have implemented in times of crisis.

Another fundamental difference with the 1930s is the structure of the world’s major economies, which are all today – to varying degrees – post-industrial economies. There is a strong prevalence of services (especially knowledge-related services), a scaled-down manufacturing sector and a marginal primary sector (i.e. agriculture and mining) as regards its contribution to total value added. At first glance, China, which achieved its industrialisation later, is an exception to this general statement, all the more so as the Middle Kingdom has gradually become the “factory of the world” and the main engine of world growth over the last twenty years. Manufacturing industry still accounts for 30% of Chinese GDP. Nevertheless, even in China, the service sector is now the primary driver of growth. The recent developments could accelerate the structural transformation of the Chinese economy, which began in the aftermath of the 2008 global financial crisis.

The urge to implement a swift response

In order to understand the full impact of this structural transformation, it is necessary to take a small step back and remember that investment has been the most volatile component of GDP over the last two hundred years, to the point that business cycles theory considers changes in this component to play a central role in triggering and perpetuating economic cycles. This is evidenced by the so-called “Samuelson Oscillator”, named after the Nobel Prize winner in economics Paul Samuelson. Yet, post-industrial economies are much less capital-intensive – investment represents less than 20% of GDP – which leads to lower fluctuations in economic activity. Over the short term, these economies are consumption-driven. In the medium to long term, their growth depends much more on total factor productivity gains – the famous “residual” highlighted in the 1950s by economists Moses Abramovitz and Robert Solow – than on capital and labour accumulation. This was corroborated by subsequent observations. Indeed, from the end of World War II to the late 1960s, a marked moderation of economic fluctuations was observed in Western countries, leading some economists to announce the death of business cycles and related crises. It was in a way the victory of Adam Smith and his “invisible hand” over Karl Marx and his “class struggle”, foreshadowing the victory of the United States over the USSR.

The two oil shocks of the 1970s fuelled an inflationary spiral and disrupted the macroeconomic balances that had previously prevailed in Western economies, but they also accelerated the transition of these economies to the post-industrial stage. These shocks fostered the birth of new information technologies by encouraging the search for more efficient organisation methods. From the 1980s onwards, the volatility of macroeconomic variables (GDP, inflation, interest rates, exchange rates), dropped again. The last two decades of the 20th century were chiefly marked by the outright collapse or by the orderly dismantling of planned economy systems in both Russia and China and by the repeated economic and financial crises in the newly industrialising countries – the so-called “emerging markets” – to which Wall Street and City bankers were eager to lend money. The financial crisis of 2008, however, served as a reminder that large-scale systemic disruption was still possible, including in post-industrial economies. In appearance, the current crisis is totally exogenous in nature, unlike the 2008 crisis, which was caused by the collapse of a “Ponzi pyramid” at the core of the US banking system.

The current crisis is more akin to a natural disaster that is affecting the entire planet. The recovery could still be V-shaped but the downside risk grows bigger every passing day. Indeed, in such exceptional circumstances as the ones we are experiencing today, betting on spontaneous recall forces would not only be very risky but suicidal. Indeed, it is of paramount importance to protect the world economy from a new deflationary threat – such as the one posed by the Great Depression. The materialisation of such a threat cannot be ruled out for the euro area, for example, or for Japan, which has virtually been in deflation for twenty years and whose deflationary tendencies have only been thwarted by massive state intervention. Indeed, over the last two decades, the Japanese government has been forced to spend and incur ever-increasing debt to compensate for the sluggishness of private consumption and investment. The stalemate in industrial production in the euro zone and Japan is an enduring reality that has set in immediately after the financial crisis of 2008. Another sign of this stark reality in the run-up to the current crisis has been the disconnection between the lacklustre performance of the real economy and the roaring ascent of financial markets, artificially boosted by ultra-cheap money and shares buybacks.

In China, the already very high level of indebtedness of companies, banks and municipalities threatens to cause a severe financial crisis if a massive fiscal stimulus, of the same magnitude as the one deployed in the aftermath of the 2008 financial crisis, is implemented. Moreover, China has yet to resorb the production surpluses that emerged after 2008 and there are no signs that the Chinese authorities are willing to water down any further the resorption of these surpluses. This explains China’s reluctance to heed calls from Europeans and Americans for a globally coordinated response to the current crisis. This is all the more true since China is already beginning to emerge from its self-imposed economic shutdown and considering that the structure of the Chinese economy has changed a great deal over the last ten years, as mentioned above.

In the absence of massive intervention by governments and central banks in other G20 countries, the effects of positive feedback loops – more commonly referred to as “vicious circles” – could outweigh the countervailing forces. The message seems to have been well received as evidenced by the massive support plans developed on both sides of the Atlantic. Fortunately, the instruments at hand are now much more sophisticated and diversified than they ever were before. Policymakers have the benefit of hindsight from a century of conventional and unconventional economic policies. As Edmund Phelps and Roman Frydman explain in a column published on the Project Syndicate site, there should be no taboo. It is important that States use all the existing instruments and invent new ones if needed in order to assume their systemic insurance – and reinsurance – function.

Will this be enough? It will depend on the duration of the crisis. As we have already mentioned, the world economy is today in a very different situation from what it looked like in the 1930. On one hand the growth drivers are more diversified and balanced than they were before, in an era that was exclusively dominated by the Western powers. On the other hand the interactions and interdependencies – both on the real and financial levels – between the different mainstays of the world economy are also stronger today. In other words, the resilience of the world economy to exogenous shocks might seem stronger today but the synchronicity of the shock is arguably also higher, as are the risks associated with “sudden stops” of capital flows, especially for emerging economies (see work by Guillermo Calvo on this subject).

The end of globalisation as we know it ?

The question of an overhaul of globalisation as we know it arose with force immediately after the outbreak of the Covid-19 epidemic in Wuhan, in China earlier this year. The containment measures enforced by the Chinese government had then caused a near paralysis of the Chinese economy and a disruption of major regional and global supply chains supplied by the “factory of the world”. Some multinational corporations, among which Apple and others, warned that they will not be able to fulfil orders for some of their products on time, due to the impact of the crisis on their Chinese operations.

Critical voices quickly rose to say that the coronavirus crisis was the last nail on the coffin of the uneven, financially boosted globalisation that the world has witnessed since the 1990s. It must be said that the prevailing world economic order had already been severely shaken in recent years by Donald Trump’s battering against China’s allegedly unfair trade practices, and by the threats allegedly posed to American national security, again according to President Trump, by the forays of state-sponsored Chinese tech Behemoths, the likes of Huawei and ZTE, on the American soil. It has been well documented that these firms are closely aligned with the Chinese national strategic objectives and that their management is closely monitored by the Chinese Communist Party, through the Party cells established within them. The intensification of the trade war, against a backdrop of growing technological and geopolitical rivalry between China and the United States was already signalling the end of the “happy globalisation” narrative, once championed by former US President Bill Clinton.

The European Union entered reluctantly into this debate, when it became clear to European hierarchs and technocrats that China now wanted to establish its power in the very heart of Europe, through the Trojan horse of its “New Silk Roads” project. After having acquired stakes in the Port Piraeus in Greece, in large part as a result of the sovereign crisis of 2011-2013 and of the protracted European response to this crisis, China sought to strengthen its ties with the Balkan countries and with the “Viségrad group”, made up of four former Central European “popular democracies”, which joined the European Union and NATO after the fall of the Berlin Wall. Subsequently, the evolution of the political situation in Italy gave Beijing the opportunity to claim a major strategic victory. Faced with Brussels’s incapacity to help it redress its dire economic situation, Italy, one of the six founding members of the European Union and the third largest economy in the euro zone, has officially subscribed to the Chinese strategic initiative.

Contrary to the American response, where a bipartisan consensus was very quickly forged to “contain” the rise of China, far beyond the swerving sways of a Donald Trump, the European response was at first restrained, bureaucratic and based on the lowest common denominator between its 28 member states (27 since the UK’s formal departure from the EU in January 2020). It was not until March 2019 that China was finally considered a “systemic rival” by the European Commission. Going further, the European Union is now brandishing the threat of a “border carbon tax” targeting products imported from countries that do not apply its restrictive carbon emission standards. This tax could be used against the United States, which withdrew from the Paris Agreement in 2018, but it primarily targets China, even though Chinese carbon emissions have been stabilising for a few years, following the country’s post-industrial shift.

On a more fundamental level, the crisis could initiate a major overhaul of EU-wide economic policies and doctrines, which as of now are still dominated by the primacy of the “free and undistorted” competition over the need to support “European champions” in the face of increasingly fierce global competition. This was illustrated by the veto that was opposed by the European Commissioner Margrethe Vestager to the Siemens-Alstom merger. In the age of artificial intelligence, Europe is still lagging far behind vis-à-vis the United States and China in this field. In the opinion of many experts, the investment plans announced so far by the European Commission and by some Member States in this area remain largely insufficient. The latest roadmap on the subject, unveiled last February by the new President of the EU Commission, Ursula Von der Leyen, is no exception to the rule. On paper, the ambitions are laudable. Quote: “We want the application of these new technologies to be trusted by our citizens […] We encourage a responsible approach to human-centered artificial intelligence,”. But in practice, the European approach remains bureaucratic and sorely lacks economic stamina and financial muscles. It is unclear where the promised 20 billion euros per year of spending dedicated to AI will come from. In any case, this is still a far cry from the hundreds of billions of dollars spent on that matter by China and by the United States.

Beyond these considerations, some political figures would like to take advantage of this crisis to return to a model of isolated and self-sufficient economies “à la Robinson Crusoe “. It was precisely this attitude that magnified the Great Depression and favoured its spread worldwide in the 1930s. None can seriously oppose the move toward “short circuits” and other sustainable practices which aim at bringing producers closer to consumers, while guaranteeing higher standards of quality, and product traceability. In a similar vein, none can reasonably oppose a major overhaul and upgrading of health systems around the world and, more generally speaking, a strengthening of the Nation-States, with increased capabilities to handle systemic risks and to perform their most needed duties, in the face of gruntled yet more demanding political constituencies.

However, the real issue is how to accommodate this much needed rebalancing of the globalisation pendulum toward nation-states – which has already been signalled a few years ago in a book authored by Dani Rodrik – while avoiding the rash urge to unravel the immense productivity gains achieved over the last thirty years, thanks to an ever increasing international division of labor. We are witnessing a sharpening of the debate between these two major conflicting trends: one which is political in its very essence and which conveys the call for greater social justice, more stringent environmental regulations and better protection against rising endogenous threats and exogenous risks, and one which is purely business-minded and utilitarian in nature and which has been built for centuries around the maximisation of profits and dividends – whatever level of social responsibility its lobbyists may claim. While the former trend cannot be ignored anymore, in a world of rising inequalities, the later remains necessary, with some adaptations, for the smooth running of our societies and for the coverage of our basic needs. It is the ever-evolving balance between these two conflicting yet complementary trends that will shape the new political and economic landscape in the years to come, in a post -Covid19 world.