Bold policies needed to counter the coronavirus recession

Opinion piece (VoxEU)
Christian Odendahl, John Springford
18 March 2020

The 2008 financial crisis was a global economic catastrophe. Millions of people lost their jobs, their homes, their savings or their businesses as banks collapsed and creditdried up. It sparked the euro crisis, from which countries recovered slowly, with many experiencing a lost decade. Some fear that the COVID-19 pandemic will be just as bad. But while the economic disruption caused by the epidemic looks likely to be large, the long-term effects on the economy will be less severe than the financial crisis, as long as governments act quickly to contain the economic fallout.

Financial crises are, in essence, collapses in trust in the financial system. Creditors fear that they are exposed to losses and seek safer assets, which in turn leads to shortages of liquidity. Riskier businesses have difficulty borrowing, rendering some insolvent. Tighter financial conditions also lead households and firms to cut spending. Thus the 2008 financial crisis became an economic one: demand cratered and international trade fell 15% from the peak to the trough as the collapse in credit rippled through the global economy. Governments and central banks intervened, but failed to support privatesector spending sufficiently, whether through fiscal and monetary stimulus or a rapid restructuring of the banking system.

The economics of the coronavirus epidemic is different, but some of the fallout will follow a similar pattern. Fears of contagion and government action to contain the spread of the disease have led to a global supply shock, especially in manufacturing. Factories and offices are closing or reducing operations in order to protect workers. As the infected isolate themselves – and other people reduce social contact – they will spend less on flights, in bars and restaurants, and on other social activities. And businesses are facing falling supply capacity and falling revenues simultaneously, as workers and consumers stay at home. This will make many companies illiquid, which if left unaddressed by policymakers, will lead them to lay off workers or close altogether. This is a major reason why stock markets have been in free fall globally, and government bonds have jumped in value as investors have fled to safety.

However, there is a big difference between the uncertainty we faced in the Great Recession and in the euro crisis and the situation now. The scale and the severity of the financial crisis was difficult to predict in advance, or while it was unfolding. The coronavirus pandemic is more predictable to epidemiologists, and therefore to governments. At first, the virus spreads rapidly, with new infections doubling every three to four days, and sometimes faster. That rate can be lowered if containment is effective. Harvard epidemiologist Marc Lipsitch estimates that between 20-60% of the world’s population will get the illness, while the World Health Organisation thinks that, of those who are infected, over 96% will recover (at least in countries with advanced healthcare systems).

This means that – in the absence of containment measures – the pandemic would spread rapidly, peaking in Europe in May or June, after which the rate of infection would drop and the economy would start to recover. But government lockdowns are intended to slow the spread of the virus, to prevent hospitals from being overwhelmed. To the extent that these measures work (and therefore persist), they will raise the cashflow problems that businesses face, requiring more government support.

However, epidemiologists say that it will be very difficult to stop the pandemic altogether. A vaccine is unlikely to be developed in time. The infection rate will start to fall when most people who will get the virus will have already done so, and the economy will then start to recover. All this suggests that the economic consequences, while extremely severe in the short term, need not be as costly as the financial crisis.

There is a clear path of recovery and rebound, so long as governments enact early and aggressive economic policies to support the liquidity of firms, to offset lost wages for workers, to protect the financial system (especially in the euro area), and to stimulate the economy more broadly to aid a quick recovery after the epidemic has run its course. Supporting liquidity The biggest threat to the economy is that viable businesses become illiquid and go bust. Temporary disruptions can have permanent effects: a wave of bankruptcies would leave permanent scars on the economy if firms that would have been successful go under. There would be scarring effects on the future wages of unemployed workers and firmspecific knowledge would be lost, dampening the level of output in the future.

Confronting this risk will require an alliance of bank regulators, public investment banks, central banks and finance ministers. Bank regulators should encourage banks to be lenient on firms in severely affected sectors of the economy, such as tourism, by rolling over existing loans. And the Bank of England and the ECB were right to loosen capital requirements to make it easier for banks to lend. But banks will not be able to alleviate businesses’ liquidity problems on their own. Extending the terms of loans will lead banks to take on risk. Public investment banks should also provide subsidised credit to the more affected parts of the economy. This is usually done indirectly via private banks, which take on part of the risk of that loan and perform diligence on the company’s accounts. That process limits the risk to the public bank’s balance sheet. And as a result, firms that were already on the cusp of bankruptcy, such as the British airline FlyBe, would be unlikely to get publicly subsidised liquidity support. Germany’s ‘big bazooka’ – its state investment bank will provide unlimited emergency lending to firms – is the right approach and should be adopted elsewhere, too.

Alongside targeted measures, the ECB and the Bank of England added broad-based credit stimulus to the economy in their announcements last week. They were right to do so: even well-targeted measures via private banks and public investment banks may not satisfy all of the demand for credit. Much looser monetary policy is warranted. While the Bank of England cut rates and the ECB did not, they both enacted forms of liquidity support to banks. The ECB put together a new programme of long-term refinancing operations (LTROs), which provide very cheap liquidity to banks at negative interest rates. It also tweaked the terms for its targeted long-term refinancing operations (TLTRO III), increasing the programme’s scope and lowering the rate; and it added more private bond purchases to its existing programme of quantitative easing. These policies will help to curb the contraction in bank lending. 

Offsetting lost wages Finance ministers should also provide liquidity support through fiscal policy. Firms have to pay wages, even if they have been forced to reduce production for want of labour or supplies. Governments should consider short-work schemes (known as Kurzarbeit in Germany, where it has been in place since 1910). Companies can apply for grants if they have to reduce the working week for their staff. The German government has just announced a simplified and more generous short-work scheme as a result of the COVID-19-related disruptions. But not all workers are covered through such a policy. Precarious employees on temporary or zero hour contracts and the self-employed will be the worst hit. Governments must provide quick and unbureaucratic support to these groups. One option is to pay every citizen a coronavirus basic income of €500 per month through private banks, which will be slowly clawed back through income tax later for all those earning above-average incomes. This way, only those who need it will collect it.

To contain the pandemic, more governments will have to temporarily close educational institutions, such as schools and childcare facilities. This threatens family finances – especially single parents – if they have to take unpaid leave from work. The health risks for older people from COVID-19 mean that grandparents cannot step in (German grandparents usually provide 4 billion hours of childcare services per year). Parents need clear incentives and support to take care of the children themselves. Parents of young kids should be allowed to take paid sick leave for daycare and school closures. Further fiscal support can be provided by deferring the collection of VAT and payroll taxes from businesses for three months. Italy has already deferred the payment of payroll taxes. The benefit of that policy is that it provides liquidity very broadly, but it is not without risks: firms on the cusp of bankruptcy will also be able to defer taxes, leaving the state holding the bag when they go under. But many governments in Europe pay negative interest rates on short-term borrowing. So finance ministries would make a profit from accepting delayed tax payments. The net effect to the government balance sheet – a slight loss because of bankruptcies – may well be worth the additional liquidity support in the longer term.

Protecting the financial system
Emergency liquidity support by governments may lead to strains in the euro area’s financial system. Government bond spreads have risen, especially after ECB President Christine Lagarde’s unfortunate statement on 12 March, when she said that the central bank was “not here to close spreads”. The opposite message to markets is required from euro area policymakers, who must make clear that the ECB will provide unlimited liquidity to governments who are under temporary financial stress. They should announce that the European Stability Mechanism (ESM), the euro area’s bail-out fund, will be open to all member states, without imposing tough conditions as is usual for a bailout programme. Lagarde should stress that the ECB is ready to use its Outright Monetary Transactions (OMT) programme of unlimited government bond purchases if a government needs it. And the European Commission should allow member-states to break the euro area’s fiscal rules this year for COVID-19-related measures.

Speeding the economic recovery
Once this year’s epidemic is over, there will be some catch-up growth as businesses restock inventories and consumers make up for forgone spending. This is different from the aftermath of the financial crisis, when debts proved to be unsustainable and had to be worked down, leading to a prolonged period of lower consumption than would otherwise have been the case.

But there will be a difference between the shape of the post-epidemic recovery in manufacturing, which will probably experience a sharp rebound, and the services sector, which may struggle for a longer period of time. If consumers planned to buy a new pair of spectacles but could not buy them when supply was disrupted, they are likely to do so once the epidemic is over. Consumers will not, however, make up for the meals out that they would have eaten while they were isolating themselves. Football matches will be played in empty stadiums and concert tours will skip cities or will be cancelled altogether. ‘Social consumption’ – such as meals out, concerts or travel – will be hit hardest, with depressed demand possibly continuing into the summer and autumn as people fear infection even after the epidemic has run its course.

Manufacturers may be able to cope with mere liquidity support, as discussed above, because they can reasonably hope for a rapid recovery. But fiscal support will be needed to speed the recovery in services after the worst of the epidemic is over. Governments do not want to encourage people to travel and go to restaurants and other big gatherings, and they should not seek to stimulate social consumption now. But governments could announce that, after the epidemic has officially ended, there will be a six- to nine-month VAT cut for services sectors that have been hardest hit. That would also encourage banks to extend credit to these businesses, knowing that they will have higher revenues once the epidemic ends.

Even before COVID-19 reached Europe, its economy was struggling. Now that the outbreak has become an epidemic, a recession in the first half of 2020 is all but certain. This makes early and aggressive action to stimulate the economy – and to manage expectations about future stimulus – imperative. Since the virus is so contagious, the rate of infection is likely to peak within three to four months before falling back, which means that governments have more certainty than usual about the future path of an economy. If they fail to act, they risk a wave of bankruptcies and rising unemployment. They must be bold.

Christian Odendahl is Chief Economist of the Centre for European Reform.
John Springford is Deputy Director of the Centre for European Reform. 

This chapter is part of Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes you an read the full publication here.