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Averting a prolonged economic crisis stemming from Covid-19

Iain Begg, European Institute, London School of Economics and Political Science, and Funcas Europe1

Introduction

As more and more countries implement a lock-down to counter the threat to life from Covid-19, it has become increasingly clear that a sharp downturn in economic activity will follow. At this stage of the pandemic, it is futile to project how severe the downturn will be or how long it will last, because too little is known about the trajectory of the virus. However, the nature of the economic challenge is now evident, as is the range of policy responses likely to be needed.

Moreover, the risk of an economic crisis inflicting damage on health and well-being, rather than the other way round, is now being recognised. If the economy falls too precipitously, funding for managing the immediate health crisis may not be directly affected, but money for other forms of social policy could be squeezed and future health budgets may be harder to afford. This calls for a tricky balancing-act: tough measures to curb the Covid-19 virus alongside carefully thought-out policies to prevent avoidable economic damage.

This policy note starts by looking conceptually at the diverse economic effects of the pandemic. It then looks at the nature of policy responses, comparing, inter alia, those in Germany and the US, two countries which have unleashed extensive programmes. The EU’s actions are also briefly reviewed, revealing concerns about how to overcome customary resistance to burden sharing, then the note concluded with reflections on what happens next.

The economic effects

As figure 1 illustrates, three main inter-related types of effects can be anticipated, calling for overlapping policy action. The first is a pause in economic activity resulting from the various forms of lockdown. In macroeconomic terms its effect will be a sudden, negative step-change in GDP, starting as a supply shock from the closure of places of employment, but rapidly translating into a fall in demand. Governments in Europe and other OECD countries are already accepting that the decline in GDP could be well into double-digits (comparing year-on-year) for the three months from March to May 2020, and could stretch into the summer if efforts to contain the contagion falter.

Parallels with a war-time economy are apt, in the sense that it is about action to fight an enemy – the virus – but should not be taken too far. During wars, there is usually a boost to economic activity as governments ramp-up spending on the military, with some diversion of labour from civilian employment to the military, leading to close to full employment. The health crisis has the opposite effect as substantial chunks of the economy are put into ‘economic hibernation’: policymakers in short have deliberately caused a recession. Nor is the present stage of the crisis about financial stability, for which the present generation of policymakers at least has experience they can deploy, although it could soon veer in that direction. The implication is that macroeconomic policy responses have to be customised to these exceptional circumstances.

There has been much discussion of the probable trajectory of the downturn, with some expectation that it will be ‘V’-shaped: a steep fall, quickly followed by an accelerating recovery. In an optimistic scenario – and in this regard, developments in China offer encouragement – recovery would occur within a few months. But for already heavily indebted countries, the sustainability of public finances could be compromised and financial instability accentuated.

Second, there will be very uneven effects on different segments of the economy, whether by sector of activity or locality. Airlines are close to a standstill, as is tourism, while non-food retailing, hospitality and other leisure activities face an extended period of closure. Companies in these sectors will quickly burn working capital, rendering them less able to bounce back when the curbs on business are relaxed, and some may not even survive. For localities at the epicentres of the infection (for example, Bergamo, Madrid, New York or Wuhan) recovery will be slow, and for entire countries, heavily reliant on an activity like tourism, the decline in revenue could be dramatic.

Although there is some offset from the few sectors expected to gain from efforts to contain the virus – not least health care and the industries supplying it with equipment, consumables and so on – the aggregate effect will be damaging. A key unknown will be whether the pre-virus structure of the economy will be largely restored when conditions normalise, or whether permanent shifts will occur. Sectors, such as education, which have (almost overnight) had to switch to online teaching may radically review their ‘business models’, reliance on global supply chains may be re-thought and airlines face an uncertain future.

Then there is the effect on households stemming from loss of jobs or a decline in disposable income. Where households have commitments to paying rents or mortgages, utility bills and other regular outgoings based on expectations of a certain level of income, a sudden stop in that income would have potentially devastating effects. But even if there is a degree of forbearance by banks, landlords or other creditors, it is unlikely to last long, although in the UK the manner in which companies have been pilloried for failing to accept responsibilities for workers or customers has been encouraging.

There is, as a result, a risk of a rise in poverty and social exclusion, with many attendant social problems. There is a well-established link between poverty and poor health, raising the deeply unsettling prospect of second wave of health problems deriving from the economic impact of Covid-19, rather than the virus itself. A rise in unemployment also tends to erode skills because extended detachment from the labour market can lead to a decline in the employability of workers: a phenomenon dubbed ‘hysteresis’ by labour economists.

Putting these three dimensions of the economic effects together, two main consequences – shaded in red in the chart – loom for the longer-term. The first can be thought of as ‘macro-prudential’, an expression that came to prominence in 2009 as the financial crisis was unfolding. Governments are already facing huge increases in public debt to GDP ratios, arising from the combination of the decline in the denominator and the (entirely justified) exceptional spending envisaged. These debts will have to be serviced and, eventually, repaid or refinanced by governments burdened with much more fragile public finances, creating solvency risks. Likely knock-on effects for financial intermediaries could see a further manifestation of the ‘doom-loop’ identified a decade ago.

Second, hysteresis has long been a concern from a labour market policy perspective. It can be countered by a mix of active labour market policies, a well-judged regulatory framework, support from employment agencies and appropriate incentives for workers. But in previous economic downturns there have been pronounced differences in the impact on unemployment. Policymakers have, nevertheless, found ways to limit the effect. In the present context, a more troubling scenario would be if the phenomenon of hysteresis extends to many employers because their detachment from their markets – something they have not previously experienced in anything like this form – for what could be a lengthy period has a similar effect in eroding their ability to compete.

Figure 1. A conceptualisation of the economic effects of Covid-19

The policy responses

Governments, central bank and other public agencies have been reassuringly quick to react and have torn-up many a rulebook in the process. Suddenly, huge amounts of money have been made available for a fiscal stimulus, governments previously insistent on letting markets prevail are countenancing large-scale interventions, and radical social policies are firmly on the table. The European Commission has waived obligations under the various EU rules on budgetary policy or state aids. These measures continue to evolve and, despite some contestation on the detail, have received support from political parties across the political spectrum.

Throughout Europe, governments are putting together programmes, combining emergency loans, grants, extra funding for health care and assorted other measures. They are evolving on a daily basis, as the ramifications of the lock-down and the ensuing threats to the economy become clearer. In essence, the challenge is to reconcile effective containment of the virus with minimising economic damage, recognising that a weakened economy will also adversely affect health and potentially have other negative social consequences.

Many common features can be discerned in these programmes, but there are also notable differences, especially in the headline totals for money made available. Germany (see box 1) has enacted a comprehensive package which can be expected to serve as a template for others. It includes provisions not only for supporting economic activities hit by the health restriction, but also policies capable of limiting the hysteresis referred to in figure 1. France has announced a range of measures, including support for small businesses and the self-employed. One component, known as ‘dispositif de chômage partiel’ has similarities to the German policy of short-time working aimed at preserving employment.

The UK has moved rapidly from a mild fiscal stimulus – partly to honour election commitments but partly also to mitigate potential risks from Covid-19 – announced just a few weeks ago when the new Chancellor of the Exchequer introduced his ‘normal’ budget, to a succession of measures unprecedented in peace time. Income guarantees were offered to workers laid off by companies, then, in response to concerns that this measure neglected the self-employed (and, perhaps learning from across the channel), a further provision for cash grants was rolled-out for the self-employed, albeit limited to those with profits under £50,000, though still likely to cost around £9 billion.

Because of the importance of tourism to its prosperity, Spain, currently faced with one of the most severe health emergencies among EU member states, could also face a significant economic challenge if a return to normality is delayed into the summer. As Torres and Fernandez argue, the package of measures adopted to date by the Spanish government and central bank aims to maintain employment and create the conditions for a rebound. These measures initially included provisions amounting to 8% of GDP for support for the business sector and 1.6% of GDP to support workers, together with a moratorium on mortgage payments. Further support for vulnerable groups was announced on March 31st, including protection against eviction and help for the self-employed, but these may need to be further reinforced if the economic damage endures or intensifies.

Box 1 Germany’s array of measures

An emergency aid package was approved by the Bundestag on the 25th of March, with only the hard right AfD abstaining, comprising a headline total of €750 billion (over 21% of GDP) and a raft of other measures. Within this total, €156 billion (just under 4.5% of GDP) is for increased public debt, breaching the previously sacrosanct debt ceiling by some €100 billion. This required a separate vote of the Bundestag and ends the policy of schwarze null (black zero) central to German fiscal policy for many years. A look at some of the detail of the projected debt increase is revealing:


  • A 20% boost, worth €3 billion in the health ministry’s budget (it should be noted that this is separate from the actual funding of health care) and €3.5 billion for direct support of efforts to stop the spread of the virus
  • Up to €50 billion to help the self-employed and businesses employing ten or fewer staff
  • Just under €8 billion for the Labour Ministry
  • A contingency fund of €55 billion for dealing with future consequences of the pandemic, allowing the government to act rapidly, should the need arise
  • A possibly optimistic projection of just a €33 billion decline in government revenue

The remainder of the financial package also has notable features. A huge economic stabilisation fund (up to €400 billion) for lending to companies in financial difficulty will be established, with powers to guarantee the debts of companies. In addition, €100 billion will be available to fend off hostile takeovers of German companies made vulnerable by large drops in share prices, including by direct purchase of the company’s equity.

A key element of the package will be a fresh impetus for a policy pursued during the financial crisis: Kurzarbeit, compensating firms for reducing working hours rather than firing staff. This policy was credited a decade ago with preventing German unemployment rising dramatically and can be seen as a way of limiting hysteresis. Some other features of the German approach deserve to be highlighted:


  • Tenants hit by a loss of income will be protected against eviction
  • Adults having to curtail work to look after children during closures of schools will receive cash benefits, and rules on qualifying for income support when unemployed will be eased
  • Companies will be able to defer some tax payments

In the US, an initial headline figure of $1 trillion was quickly doubled and agreed unanimously in the Senate – see box 2. It is interesting to note many of the same sorts of measures as in the German package. With the Federal Reserve having already announced $4 trillion in renewed quantitative easing, the fiscal and monetary stimulus in the US could attain 30% of GDP. Nevertheless, critics have warned that more will be needed and the toxic politics of a US election year have seen unseemly disputes about whether certain states have been ‘punished’ for being the wrong political ‘colour’ or for criticising the President.

Box 2 The US response

After initial proposals in mid-March from the administration for a package worth $850 billion – more or less equivalent to the Obama stimulus in 2009 – a deal was struck barely a week later for one exceeding $2 trillion (roughly 10% of GDP and likely to double the federal deficit). A politically intriguing component was a commitment for a cash payment to all tax-payers earning less than $100,000 per year – in effect a form of basic income. However, in contrast to Germany and other European Countries, this would be a single payment. Other features are as follows:


  • $100 billion for testing, equipment, supplies and training for the health sector.
  • An extension by three months of the period for which unemployment benefits can be claimed, taking the maximum up to nine months. This will cover segments of the labour force not previously eligible, including ‘gig’ economy workers and the self-employed, and could cost up to $250 billion.
  • Payment of taxes can be deferred.
  • Loans for larger companies disproportionately hit by the crisis, up to $425 billion with a further $75 billion for specific industries, such as airlines and hotels.
  • Emergency loans for small businesses, up to $367 billion.
  • Perhaps reflecting the well-known phenomenon of pork-barrel politics, there is even $10 billion more for the military.

The EU level

As in 2008/9, when the G20 engineered a collective fiscal stimulus to counter the macroeconomic effects of the global financial crisis, there are expectations of some contribution from the EU. Its scope to act is, however, constrained by the limited size of its budget and its hypothecation to a few lines of spending, as well as by regulations requiring adherence to due process.

Instead, the EU level of governance has to act in other ways. Manifestly, fiscal targets have gone out of the window: although there are escape clauses in the Stability and Growth Pact and the other fiscal commitment introduced following the sovereign debt crisis of a decade ago, they are not attuned to a downturn of the anticipated magnitude. The EU would, quite reasonably, be castigated if it sought to enforce rules, but cannot entirely neglect its obligations to adhere to common rules.

What the EU can do is to boost the firepower of the European Stability Mechanism (ESM) and to work with ECB to provide additional liquidity. More lending by the European Investment Bank, above all to maintain public investment, could also be helpful. A more contentious prospect is deploying the instrument – so far never used – established in parallel with Mario Draghi’s ‘whatever it takes’ speech: outright monetary transactions (OMT).

But there is an evident and possibly intractable governance challenge: both OMT and support from the ESM are supposed to be contingent on accepting a tough structural adjustment programme, aimed at boosting the competitiveness of recipients of such financial support. If a member state seeks support from these sources purely to manage the consequences of dealing with Covid-19, requirements on structural reform will look odd. Yet for the creditor countries the absence of such requirements would be considered unacceptable and could see resort to legal challenges.

An alternative approach would be to accelerate the creation of a European safe asset with sufficient backing from all member states to enable borrowing at favourable rates. With interest rates at historic lows and the willingness of the ECB to revive its bond buying, liquidity should not be a problem. No-one can seriously believe there is a risk of runaway inflation, but mutualisation of debt remains a tricky issue in some member states. In addition, thought does need to be given to an ‘exit strategy’, especially if it is countries with already high debt (Italy, for example) which are worst affected economically. The term ‘Coronabonds’ has now entered the lexicon and could provide recalcitrant governments or vested interests with enough political cover to justify a step change in euro governance.

In this regard, the failure of the March 26th European Council, an informal video meeting, to make progress on sharing the debt burden will be regarded by many as a disappointment. However, the can has only been kicked down the road for, by previous standards, a brief time. The EUCO statement applauds ‘the resolute action taken by the European Central Bank to ensure supportive financing conditions in all euro area countries, and calls on:

‘the Eurogroup to present proposals to us within two weeks. These proposals should take into account the unprecedented nature of the COVID-19 shock affecting all our countries and our response will be stepped up, as necessary, with further action in an inclusive way, in light of developments’.

Reading between the lines and bearing in mind the abrasive reaction of many Spanish and Italian politicians to the procrastination, some sort of proposal could well emerge soon. An expression to consider in this context is ‘never let a good crisis go to waste’. In the meantime, the ECB has further eased the terms governing its purchases of debt.

What happens next?

A next phase will be administrative: governments now have to ensure their more innovative measures reach the intended beneficiaries and are not caught-up in bureaucratic tangles. Provision of unambiguous guidance will be crucial, especially for welfare claimants with poor access to online services. Governments will, in addition, have to work out when and how to return to business as usual when – as it surely must – the health emergency abates, while also planning an economic, as well as heath, response to a possible second wave of infection.

Beyond the obvious longer-term challenges of dealing with the sustainability of public finances and managing the re-awakening of economies from hibernations, several other difficulties will have to be anticipated. They include:

  • Enduring disruption to supply-chains and the possibility that the large corporations at the core of these networks will come to regard reliance on too limited a set of sources as overly risky in a world where there could be a further wave of infection. This could lead to changes affecting regional and local economies, though in an unpredictable manner.
  • A renewed upsurge in non-performing loans (NPLs) as companies which have had to suspend their business activity try to re-launch with much depleted working capital. Ample liquidity from the ECB, the experience of dealing with the previous crises and the avowed commitment of the leading central banks to continue to do ‘whatever it takes’ should limit the threats to the financial system, at least in the short- to medium-term. However, at some stage, so-called ‘zombie’ companies may have to be liquidated with knock-on consequences for the balance sheets of banks or investors.
  • How to deal with the likely intensification of hysteresis both in the labour market, but also in the corporate sector, in the wider sense discussed above. The German kurzarbeit model can be the basis for a solution for some workers, but governments will need to be prepared to offer support for workers to make the transition to a new status in the labour market.
  • Resolving tensions around how to share the burden of mitigating the economic effects of the crisis. Through stimulus packages, governments have made taxpayers shoulder an open-ended burden, while central bank actions favour borrowers at the expense of savers. But should shareholders expect to lose their equity in distressed companies before the state steps in, or bank depositors be ‘bailed-in’ as envisaged in agreements concluded after the financial crisis? To what extent should workers be expected to take pay cuts, directors to lose bonuses or welfare recipients to have benefits lowered? If the downturn knocks several percentage points off GDP, these will be very contentious distributive choices.

Last word…

The economic challenge from the Covid-19 outbreak is huge, as is the required policy response. Governments and central banks deserve credit for acting quickly and decisively, and for recognising that the economic challenge is unlike those faced in the recent past. But continuing vigilance is needed and an understanding of the most critical economic risks, summarised here under the headings of ‘macro-prudential’ and ‘hysteresis’, will be crucial if what began as a health crisis is to avoid metamorphosing into a more profound economic crisis.

For Europe there is two-pronged challenge. The EU has to show that it can pull together and find ways of overcoming obstacles to collective action. At the same time, European countries can both learn from each other and offer lessons for other parts of the world.

1The author thanks Raymond Torres for his comments.