Question

 

Having largely ignored Covid-19 as it spread across China, global financial markets reacted strongly last week when the virus spread to Europe and the Middle East, stoking fears of a global pandemic. Since then, Covid-19 risks have been priced so aggressively across various asset classes that some fear a recession in the global economy may be a foregone conclusion.

In our conversations, business leaders are asking whether the market drawdown truly signals a recession, how bad a Covid-19 recession would be, what the scenarios are for growth and recovery, and whether there will be any lasting structural impact from the unfolding crisis.

In truth, projections and indices won’t answer these questions. Hardly reliable in the calmest of times, a GDP forecast is dubious when the virus trajectory is unknowable, as are the effectiveness of containment efforts, and consumers’ and firms’ reactions. There is no single number that credibly captures or foresees Covid-19’s economic impact.

Instead, we must take a careful look at market signals across asset classes, recession and recovery patterns, as well as the history of epidemics and shocks, to glean insights into the path ahead.

Last week’s brutal drawdown in global financial markets might seem to indicate that the world economy is on a path to recession. Valuations of safe assets have spiked sharply, with the term premium on long-dated U.S. government bonds falling to near record lows at negative 116 basis points — that’s how much investors are willing to pay for the safe harbor of U.S. government debt. As a result, mechanical models of recession risk have ticked higher.

Yet, a closer look reveals that a recession should not be seen as a foregone conclusion.

There is no doubt that financial markets now ascribe significant disruptive potential to Covid-19, and those risks are real. But the variations in asset valuations underline the significant uncertainty surrounding this epidemic, and history cautions us against drawing a straight line between financial market sell-offs and the real economy.

What Would a Covid-19-Induced Recession Look Like?

Though market sentiment can be misleading, recessionary risk is real. The vulnerability of major economies, including the U.S. economy, has risen as growth has slowed and the expansions of various countries are now less able to absorb shocks. In fact, an exogenous shock hitting the U.S. economy at a time of vulnerability has been the most plausible recessionary scenario for some time.

Recessions typically fall into one of three categories:

• Real recession. Classically, this is a CapEx boom cycle that turns to bust and derails the expansion. But severe exogenous demand and supply shocks — such as wars, disasters, or other disruptions — can also push the real economy into a contraction. It’s here that Covid-19 has the greatest chance to infect its host.
• Policy recession. When central banks leave policy rates too high relative to the economy’s “neutral” rate, they tighten financial conditions and credit intermediation, and, with a lag, choke off the expansion. This risk remains modest — outside of the U.S. rates are already rock bottom or even negative, while the Federal Reserve has delivered a surprise cut of 50 basis points. Outside of the monetary policy response, the G7 finance ministers have also pledged fiscal support.
• Financial crisis. Financial imbalances tend to build up slowly and over long periods of time, before rapidly unwinding, disrupting financial intermediation and then the real economy. There are some marked differences globally, yet in the critical U.S. economy, financial crisis risks are difficult to point to. Some commentators point to the bubble in corporate credit, as seen in significant issuance and tight spreads. Yet, we struggle with the subprime analogy of the last recession, as corporate credit neither funds a real economy boom (as subprime did with housing), nor is the debt held on banks’ balance sheets. Both factors limit the systemic risk of a potential shakeout in credit, though this risk can’t be dismissed entirely. It’s difficult to see Covid-19 contributing to financial imbalances, but stress could arise from cash flow strains, particular in small and medium enterprises (SMEs).

Looking at this taxonomy, and again at history, there is some good news in the “real economy” classification. Though idiosyncratic, real recessions tend to be more benign than either policy recessions or those induced by financial crisis, as they represent potentially severe but essentially transient demand (or supply) shocks. Policy recessions, by contrast, can be, depending on the size of the error, severe. In fact, the Great Depression was induced by perhaps the largest policy error ever. And financial crises are the most pernicious kind, since they introduce structural problems into the economy that can take a long time to be corrected.

Questions for discussion

1. Using AS-AD model and your logic, explain

1. The effect of coronavirus on AD
2. The effect of coronavirus on AS
3. The overall effect on GDP and price level

2. How can you explain the term “policy error” (hint: no, it is not discussed in your textbook, you should explain it based on the article).
3. Explain the meaning of “real recession”. Can coronavirus spread cause a real recession? Justify your answer by explaining the mechanism of real recession (hint: no, it is not discussed in your textbook, you should explain it based on the article).
4. Some firms have been closed due to the COVID-19 spread. Can you suggest any government policy, which would a) ensure safety for people and b) not cause a real recession?

Answer 1