Reemerging from the COVID-19 Recession

The last time I wrote a comprehensive piece about the economic impact of COVID-19 was almost two months ago back in mid March. At the time, there were just 140,000 cases of the disease across the world and we were only beginning to see some of the immediate economic effects of the pandemic. I ended the piece by contemplating whether a global recession would be on the way, but avoided directly addressing this question because the future was very uncertain at the time. By today, COVID-19 has infected over 3.5 million people, killed 250,000 of them and forced almost every nation to go into strict lockdown conditions that have contributed to a major decline in economic activity. Although much about the future continues to remain uncertain, there’s no doubt that the question I contemplated back in mid March has been answered in the affirmative. Therefore, this piece will focus on understanding the nature of the recession we find ourselves in, and exploring the policies and strategies that will help us recover.

Lives or Livelihoods?

A recession is a significant decline in economic activity that leads to decreased economic output, inflation and employment. Although COVID-19 has led to declined economic output, and unprecedented increases in unemployment, the recession that this “Great Shutdown” has caused is fundamentally different from traditional recessions like the one we experienced back in 2008. This is because normal recessions tend to follow a certain pattern; first, they are preceded by a boom characterized by a period of sustained high growth. Second, this boom gives financial institutions the confidence to take far more risks. These risks then lead to some people worrying about the future and suddenly the markets realize that they are over a cliff, gravity kicks in and the party ends in a crash that freezes liquidity as everyone does nothing but hold onto whatever cash they have. This leads to declined investment, consumption and cash flow problems for businesses that cause bankruptcies and put people out of work. The result is an economic mess that the government and central banks have to solve through liquidity injections, quantitative easing and increased government spending. Eventually, confidence is restored, the economy starts up again, confidence builds until we reach another boom, and the whole cycle repeats itself. This cycle is called “The Business Cycle,” and is one of the first things you would learn in a Macroeconomics course.

The recession we are facing today is fundamentally different because it’s removed from this cyclical process. Economic activity is falling today because of COVID-19’s potential impact and our policies designed to protect public health from it, rather than years of naked hubris and excessive risk taking. As a result, the current recession is more akin to the weekend or a national holiday like Christmas because our own decision to shutdown and prioritize public health over the economy has caused it. Naturally, this decision between prioritizing lives or livelihoods has raised a lot of debate across the world, but a simple economic diagram called a Production Possibilities Frontier(PPF) that shows the different combinations of economic output and public health we can achieve reveals that lives should always be prioritized over livelihoods.

A PPF during “normal” times, when we have a choice between how much public health and economic output we want, can be seen above. Although the PPF does not tell us what we should produce or what we want to produce, it clearly reveals what we can produce. The curved line indicates the upper limit of the combinations of health and economy we can achieve; any point within the shaded region is also a possibility, but this is not desired since it indicates that we are underachieving in both areas relative to our potential. The PPF is concave rather than a straight line in order to account for the law of increasing opportunity cost, which leads to the phenomenon where the opportunity cost in terms of the other, increases as public health or economic output is increased. For example, if we were to increase public health from a low level by moving from point A to B then the opportunity cost in terms of economic output would be lower than if we were to increase public health from a higher level by moving from point B to C. Nevertheless, despite this tradeoff, in “normal” times we can decide on the level of economic output and public health we want by moving along (or within) this PPF. Unfortunately, during a pandemic this PPF changes and puts us in a position, where we can’t achieve acceptable levels of both economic output and public health.

The figure seen above reveals the PPF during a pandemic, which has gone through two main transformations when compared to the original PPF. Firstly, because the upper level of public health and economic output we can achieve declines during a pandemic, the entire PPF has shifted inwards. Secondly, the PPF hollows out in the middle because the pandemic puts us in a situation where even an increase in public health from a low level by moving from point E to H costs a lot in terms of economic output because we would need a lot of social distancing to halt the spread of COVID-19 to do so. The same logic applies the other way around as well since we would need to sacrifice a significant amount of public health even to increase economic output from a low level by moving from point H to E. Therefore, during a pandemic we find ourselves in a situation, where our usual marginal thinking about trade-offs falls apart and we have to choose and prioritize between either public health or economic output. In other words, we have to prioritizes lives and stay at point H or prioritize livelihoods and stay at point E since we wouldn’t want to be at a point in the hollowed-out-portion because that would leave us with lower health or economic output than if we prioritize one or the other.

Faced with this decision between lives and livelihoods, we should always prioritize public health over economic output because of the simple fact that we know how to bring the economy back to life, but have no way of bringing people back to life. Sacrificing public health by prioritizing the economy will lead to an irreversible long term decline in public health and productivity, which will inevitably cause a dark, L-shaped recession on the supply side and in turn lead to not only decreased output and employment, but also increased inflation. This means that if we prioritize economic output, over time, our PPF will sink as seen in the PPF above so that point E declines and the level of economic output we can achieve decreases. Therefore, prioritizing public health over economic output is far more desirable since it would ensure that the economy is ready to bounce back in a V or U shaped recovery because we would be curtailing the pandemic’s long term economic consequences. Furthermore, because of the irreversible effects of the pandemic, prioritizing lives over livelihoods quickly is important because waiting to make a decision will permanently shift the level of public health we can achieve as seen in the PPFs below.

The importance of choosing lives over livelihoods in a timely manner is not only backed by the economics, but also by history. For example, the US suffered a 18% drop in manufacturing during the 1918 flu, which is quite a significant recession, but the states that prioritized health sooner and implemented strict social distancing measures ended up bouncing back with higher long run economic growth after the pandemic, when compared to the states that prioritized their economies over public health. If you are curious to learn more, I explained this in greater detail in my last post about the history of pandemics.

Government Intervention in the Age of COVID-19

Although choosing lives over livelihoods can curtail the pandemic’s long term consequences, government intervention is very important to minimize the impact of the pandemic’s and the shutdown’s effects in the short run. Looking back at a pandemic PPF, without effective government intervention, we will underachieve relative to our potential on both the economic and health fronts and remain within the PPF at point B. Therefore, effective government intervention that will help us reach point H during the pandemic, and quickly bounceback with a V or U shaped recovery thereafter will have to come across two dimensions. Firstly, there is a call for centralization in our resource allocation to deal with the current health crisis and minimize its effects on public health. Secondly, governments have to intervene with blunt, yet smart policies that will protect livelihoods and curtail the economic consequences of the “Great Shutdown.”

A Call for Centralization to Protect Lives

Despite the fact that COVID-19 has caused a health crisis, just like with any other crisis the key to effectively dealing with the situation lies in efficient resource allocation. Aside from a handful of nations, the entire world allocates a majority of their finite resources based on the free market and the invisible forces of demand and supply that interact within it because of the free market’s marked superiority in terms of efficiency. Despite their efficiency however, free markets are notoriously slow when it comes to change. Therefore, when it comes to dealing with a pandemic like COVID-19 that can cause irreversible damage to public health within days, the urgency and need for coordination imply that governments need to adopt policies that allocate resources akin to times of war. In other words, resource allocation has to move from free market forces in favor of centralized command and control approaches because the efficiency gain that comes with the free market is greatly offset by its laggardness.

This notion can be better understood with an example. Let’s imagine a situation, where one factory needs to produce face masks and another needs to produce ventilators, but we don’t know which factory can produce each product at the lowest cost. In a decentralized market economy, each factory owner will have to look at the situation and work out what to do. They might choose to both jump in and start producing the product that they think can be produced most efficiently. However, once they retool for that purpose and begin production we run the risk that they both end up choosing the same thing, which will leave us with either too many face masks and too few ventilators or vice versa. To avoid this problem, the factory owners might choose to wait and see what the other factory owner chooses to do and then do the opposite. But in this world, we have both factories in a deadlock situation as they wait for the other to make a decision, which will lead to costly delays. Alternatively, we can move to a centralized command and control approach where the government decides on who produces the face masks and who produces the ventilators. This prevents both the duplication and delay problems, but exposes us to the risk that the government makes the wrong choice and the factories end up producing both goods at a higher cost than otherwise. Although this is not ideal, at times of crisis we cannot let the perfect be the enemy of the good and have to resort to centralized resource allocation and bear the potential productive inefficiency because the delays that come with the free market approach will be far more costly.

Therefore, market processes have been abandoned in favor of the accelerated decision making and resource allocation that come with centralization across three areas in order to protect lives when an infectious disease like COVID-19 is rapidly spreading. These include the mobilization of resources to dramatically expand healthcare system capacity, the institution of price controls for certain important goods and services, and the use of blanket restrictions on movement of people. Firstly, although there’s a lot of discussion about flattening the curve so that we can prolong the pandemic and manage with our existing healthcare resources, it’s more useful to build temporary surge capacity and in turn “surf the curve” as seen above. However, rapidly mobilizing the resources necessary to expand capacity at scale requires a war-like centralized resource allocation mindset spearheaded by the government and military. This is precisely how China built entirely new hospitals in Wuhan in just over a week back in March. Aside from China, most nations have failed to rapidly build surge healthcare capacity because they have failed to centralize and in turn lost thousands of lives.

Next, a command and control approach becomes important when it comes to allocating goods that will help mitigate the spread of the virus like face masks, and hand sanitizer. In a free market, panic buying leads to a rapid surge in demand for these goods that in turn lead to price increases. As a result of this price increase, goods like hand sanitizer remain accessible only to the wealthy. However, during a pandemic, products that reduce the spread of the virus have to be accessible especially for the poorer members of society, who are far more likely to contract COVID-19 because they live in more densely populated neighborhoods and don’t have access to good healthcare. Therefore, governments have to implement centralized policies like price controls and even government provision in these markets in order to give everyone a fighting chance against COVID-19, protect lives and maximize social well being.

Finally, a centralized approach is far more effective when restricting movement and increasing the prevalence of social distancing within the community. In his book “Economics in the Age of COVID-19,” Joshua Gans explains the benefits of centralized blanket restrictions on movement as follows:

“When there are restrictions on movement, it is very easy for the authorities to see whether people are moving or not. In their absence it is harder to tell and can require more resources. For these reasons, to deal with the costs associated with COVID-19 transmission, governments have opted for blanket policies akin to martial law in wartime or other times of emergency. These may be supported by penalties for violations but nothing like the type of taxes that economists would otherwise recommend so that exceptions can be made at the discretion of individual decision makers willing to bear a taxation cost. Instead, a heavy-handed approach is used without much room for nuance.”

Furthermore, a heavy-handed centralized approach will also allow governments to implement draconian contact tracing methods powered by data driven, invasive technologies. Although most countries will only be able to centralize their resource allocation and decision making to a certain extent, it’s clear that doing so can save time and lives.

Blunt yet Smart Policies to Protect Livelihoods

Although lives have been prioritized over livelihoods to curtail the long term consequences of the pandemic, livelihoods must be protected during this “Great Shutdown” to allow for a V or U shaped recovery when the pandemic settles down. If livelihoods are not protected through effective government intervention, unemployment will increase, businesses will shutdown, and the process of restarting the economy post-pandemic will be far more complicated. Since the social distancing measures have led to a massive recession, it’s vital that we don’t underestimate its potential consequences and implement blunt policies without being frugal. Yet, at the same time because the situation we find ourselves is very different from a traditional recession, we have to be smart about the policies we choose to implement. We need smart and innovative policies that will help us hit the pause button on our economies so that we can hit play and restart everything when the pandemic settles down.

Firstly, when we consider the monetary space, it’s vital that central banks be blunt with all the tools in their arsenal and implement quantitative easing and expansionary monetary policies. Quantitative easing and expansionary monetary policies aim to increase the money supply and in turn promote economic activity by reducing interest rates and incentivizing investment and consumption. Most central banks have done this successfully and brought interest rates down to 0% or even negative rates. Next, central banks have to be blunt and inject enough liquidity to keep markets alive because frozen markets will lead to bankruptcies and have a major impact on investor confidence. Yet again, especially in developed countries, central banks have done this well by injecting billions of dollars into their financial markets. The “Great Shutdown” has also led to a severe decline in foreign exchange reserves due to increased capital outflow fuelled by uncertainty, and decreased export income. Since this is a problem affecting many countries, coordination between central banks and the establishment of currency swap schemes that will help nations get the foreign currency they need is another blunt policy that we need immediately in order to minimize the long term effects of this shutdown. Furthermore, since many businesses are being forced to shutdown due to cashflow issues, central banks should bluntly provide access to credit so that these businesses will be protected and be ready to restart.

Despite these blunt monetary policies however, central banks should be smart and ensure that financing is only going where it is needed. Secondly, we have to avoid giving out too many loans to help people out in the short term and then end up burdening businesses and households with loan repayments after the crisis in the long run. Providing income contingent loans instead of traditional loans could be a “smart” solution to this problem. These loans would be provided by the government and then paid back through an increase in the payee’s marginal taxation rate so that the loan repayment is contingent on income post-pandemic. These income-contingent loans have had a lot of success in Australia as the primary form of student debt, but they haven’t been implemented yet as a response to the current COVID-19 recession.

In addition to monetary policy, government intervention will have to come in the fiscal space through changes to government spending and taxation. Although governments will have to be blunt with their fiscal policies and engage in blunt deficit spending between 5-10% of GDP to offset the impact of this recession, they have to be smart with their fiscal policies just like in the monetary space. As mentioned above, they should build surge capacity and “surf the curve” by increasing government spending on healthcare, where it’s needed most. Secondly, rather than providing welfare payments to the unemployed, which is the norm during a traditional recession, governments should implement partial unemployment schemes that will minimize the separation between employees and employers in order to avoid frictional rehiring processes that will slowdown the economic recovery post-pandemic. Similarly, governments can grant tax deferrals and subsidies for companies that are struggling to make payments in order to keep them from shutting down. The key when it comes to fiscal policy is that governments should stay away from blanket expansionary fiscal policies like tax cuts and stimulus cheques that will put more money in everyone’s pockets. This is because putting money in pockets is worthless since we don’t want people to go out and spend during the pandemic in the first place as it will increase the spread of COVID-19. However, governments should keep fiscal stimulus at the ready so that they can hit the accelerator pedal when the economy is restarting once the pandemic settles down.

Although the policies governments will have to implement in order to minimize long term economic damage and “hit the pause button” will require a lot of deficit spending, it’s important to understand that, especially for developed countries, long term debt is not a major concern because even low levels of economic growth will offset the interest rate payments. Therefore, the long term economic consequences of failing to enact deficit spending that will solve today’s problems will far outweigh the debt repayment burden we would face as a result of the deficit spending. Despite this however, deficit spending will be far more challenging for developing nations because they may already be in debt and will likely have a difficult time trying to secure credit. In fact, over 90 countries have already reached out to the IMF in search of credit. Nevertheless, whether it be through increased budgets for the IMF and World Bank or increased direct lending to developing countries, everyone should gain access to credit because we can’t point fingers at anyone or demand austerity when the crisis was caused unintentionally by a non-human actor. Governments may also be forced to implement increased progressive taxation, where high-income earning households pay a higher proportion of their income in taxes than low-income earning households, in order to finance their deficit spending after the pandemic pans out.

Reemergence

Although lives should always be prioritized over livelihoods and although the aforementioned forms of government intervention will minimize the long term effects of the “Great Shutdown,” we can’t stay closed forever without avoiding long term economic consequences on both the demand and supply sides. Moreover, especially in emerging economies, governments don’t have the resources to implement the aforementioned monetary and fiscal policies for an extended period of time. Therefore, we must look into strategies that will help us restore economic output while maintaining public health by reducing the size of the hollowed out portion in our PPF and restoring normalcy as seen above. However, if this reemergence is not planned carefully then we run the risk of a 2nd or even 3rd wave of COVID-19 that may be more virulent than the current disease.

Therefore, the process of reopening and re emerging from this “Great Shutdown” has to come gradually phase by phase so that the impact of any missteps can be kept to a minimum. We will have to decide on what we reopen by weighing the economic importance of the institution against the risk of further infections. Similarly, we will have to consider the density of the workplace, the location away from central hubs, and the ability to enact workplace-level prevention policies. This will likely mean that people who cannot work from home will be higher on the list. Therefore, the construction and manufacturing sectors will likely reopen first because they are very important for economies and do not allow for working from home. Schools and educational institutes on the other hand are unlikely to reopen immediately because the risk of further contagion is high since children are very effective vectors of infectious diseases.

Although we can restore economic output to a certain extent by evaluating risk against importance, the next stage of reemergence relies on increased testing. Testing is vital because it gives us enough knowledge to micromanage the spread of the disease rather than macromanage it with blanket social distancing policies. Until a vaccine or cure is developed, regular testing will allow us to isolate the infected, release the immune and minimize the economic impact of the disease. Testing is especially important, when trying to restore economic output without risking subsequent waves of the disease, because a significant proportion of COVID-19 patients are asymptomatic. We can understand the importance of testing by comparing COVID-19’s impact on the Lombardy and Veneto regions of Italy. Both regions applied social distancing and locked down retail areas, but only Veneto put in place a testing regime. As a result by March 26, Veneto (with a population of 5 million) had 7,000 cases and 287 deaths, while Lombardy (with a population of 10 million) had five times the number of cases and 5,000 deaths.

Therefore, just like how airport security measures were implemented post 9-11, testing will probably be a part of our lives for many years to come. There are two types of tests that can be used: the first is called a PCR test and the second is called an antibody test. While a PCR test will tell us if you have COVID-19, an antibody test will tell us if you had COVID-19. Since, we don’t know if having the antibodies gives you immunity against the disease yet, have tests are probably the safer bet to get started because they enable action in terms of isolation, quarantine and contact tracing.

Although risk evaluation and mass testing can effectively restore economic output, restoring normalcy in the long run and completely reemerging from the COVID-19 relies on rallying innovation to find a vaccine or cure for the disease. Despite the importance of innovation however, the usual way of rewarding innovation breaks down during a pandemic because governments and donors will put pressure on innovators to reduce prices once the innovation goes into manufacturing. Foreseeing this and other uncertainties about the future, innovators and businesses may not invest enough into research and development on treatment, vaccines and other crucial innovations. This problem can be solved using mechanisms called Advanced Market Commitments(AMCs) that aim to reduce the uncertainty that disincentivizes innovation. An AMC is a contract between a donor/sponsor and an innovator that specifies the price and volume of the innovation that will be purchased from the innovator before research and development is done. Thus, there is a guaranteed payoff and revenue for innovators, but, in return, providers agree to cap the price they charge for the vaccine. Obviously, if there are no candidates that pass certain quality standards, the contract is never paid out.

In addition to AMCs, governments need to be failure tolerant a pursue a wide variety of solutions to ensure speedy success. Although safety regulations should remain tight, administrative barriers within approval processes for innovations should be minimized as well. Eventually, when a vaccine is developed there will likely be shortages during the initial stages of deployment, which will force governments to ration doses. Nevertheless, incentivizing innovation globally through AMCs and high levels of fault tolerance will be the key to completely restoring normalcy and reemerging from the COVID-19 pandemic.