Darker Outlook, Less Visibility

The window for social distancing—the only known approach to effectively addressing the disease—is short. In Hubei province it was missed, but the rest of China made sure not to miss it. In Italy the window was missed, and then the rest of Europe missed it too. In the United States, which was constrained by insufficient testing, the early window was also missed. As the disease proliferates, social-distancing measures will have to be enacted more broadly and for longer to achieve the same effect, choking economic activity in the process.

Another wave of infections remains a real possibility, meaning even countries that acted relatively quickly are still at risk every time they nudge their economies back to work. Indeed, we have seen resurgence of the virus in Singapore and Hong Kong. In that sense, only history will tell if their early and aggressive responses paid off.

At present, the economic outlook for late actors looks bleak, having caught politicians, policy makers, and financial markets off guard. What happened in March was not part of the risk calculation. Forecasts won’t help much here. For example, consensus estimates for initial unemployment claims in the United States were around 1.6 million for the week ending March 27, but the figure came in at 3.28 million—a historically unprecedented figure at the time, about five times greater than the largest weekly increase during the global financial crisis. Notoriously unreliable at the best of times, forecasts look especially dubious now, as there are simply too many unknowable aspects:

• The virus’s properties are not fully understood and could change.
• The role of asymptomatic patients is still imperfectly understood.
• The true rates of infection and immunity are therefore uncertain, especially where testing is limited.
• Policy responses will be uneven and often delayed, and there will be missteps.
• The reactions of firms and households are uncertain.

Perhaps the only certainty is that any attempt at a definitive forecast will fail. However, we think examining various scenarios still adds value in this environment of limited visibility.

Examining the Shape of the Shock

The concept of a recession is binary and blunt. All it says is that expectations have flipped from positive to negative growth, at least for two consecutive quarters.

We think the bigger-scenario question revolves around the shape of the shock—what we call “shock geometry”—and its structural legacy. What drives the economic impact path of a shock, and where does Covid-19 fit in?

To illustrate, consider how the same shock—the global financial crisis—led to recessions with vastly different progressions and recoveries in three sample countries (see figure 12-1).

FIGURE 12-1

Economic shock: Three examples

The concept of a recession is binary and blunt. The bigger-scenario question revolves around the shape of the shock and its structural legacy. To illustrate, consider how the 2008 global financial crisis delivered recessions in three sample countries, yet followed vastly different shapes in terms of shock progression and recovery.

Sources: Statistics Canada, NBER, BEA, Hellenic Statistical Authority,BCG Center for Macroeconomics analysis

• V-shape.  In 2008, Canada avoided a banking crisis: Credit continued to flow, and capital formation was not significantly disrupted. Avoiding a deeper collapse helped keep labor in place and prevented skill atrophy. GDP dropped but substantially climbed back to its precrisis path. This is typical of a classic V-shaped shock, where output is displaced but growth eventually rebounds to its old path.
• U-shape.  The United States had a markedly different path. Growth dropped precipitously and never rebounded to its precrisis path. Note that the growth rate recovered (the slopes are the same), but the gap between the old and new path remains large, representing one-off damage to the economy’s supply side, and indefinitely lost output. This was driven by a deep banking crisis that disrupted credit intermediation. As the recession dragged on, it did more damage to the labor supply and productivity. The shock to the U.S. economy in 2008 followed a classic U-shape—a much more costly version than Canada’s V-shape.
• L-shape.  Greece is the third example and followed by far the worst shape—not only has the country never recovered its prior output path, but its growth rate has declined. The distance between the old and new path is widening, with lost output continuously growing. This means the crisis has left lasting structural damage to the economy’s supply side. Capital inputs, labor inputs, and productivity are repeatedly damaged. Greece can be seen as an example of an L-shape, by far the most pernicious.

So what drives “shock geometry” as shown above? The key determinant is the shock’s ability to damage an economy’s supply side and, more specifically, capital formation. When credit intermediation is disrupted and the capital stock doesn’t grow, recovery is slow, workers exit the workforce, skills are lost, productivity goes down. The shock becomes structural.

V, U, and L shocks can come in different intensities. A V-shaped path may be shallow or deep. A U-shape may come with a deep drop to a new growth path or a small one.

Where does the coronavirus shock fit in so far? The intensity of the shock will be determined by the underlying virus properties, policy responses, and consumer and corporate behavior in the face of adversity. But the shape of the shock is determined by the virus’s capacity to damage economies’ supply side, particularly capital formation. At this point, both a deep V-shape and a U-shape are plausible. The battle ahead is to prevent a clear U trajectory.

Understand the Damage Mechanisms

Keeping the above geometries in mind, this leads to two questions about the Covid-19 shock:

• What is the mechanism for damage to the supply side?
• What is the policy response to prevent such damage?

Classically, financial crises cripple an economy’s supply side. There is a long history of such crises, and policy makers have learned much about dealing with them. But the coronavirus extends problems in liquidity and capital to the real economy—and does so at unprecedented scale. As though the twin risks of financial and real liquidity shocks were not enough, they are also interrelated, raising the stakes.

Let’s look in more detail at the two paths through which Covid-19 could deliver structural damage in a U-shaped scenario (see figure 12-2):

• Financial system risks.  The unprecedented Covid-19 shock has already generated stress in capital markets, triggering a forceful response from central banks. If liquidity problems persist and real economy problems lead to write-downs, capital problems can arise. While from a policy perspective we may know the solutions, bailouts and recapitalization of banks are politically controversial. In the case of a financial crisis, capital formation would take a huge hit, driving a prolonged slump with damage to labor and productivity as well.
• Extended real economy “freeze.”  The truly unprecedented possibility. Months of social distancing could disrupt capital formation and ultimately labor participation and productivity growth. Unlike financial crises, an extended freeze of this magnitude that damages the supply side would be new territory for policy makers.

FIGURE 12-2

Two economic supply-side threats from Covid-19

The Covid-19 shock uniquely raises liquidity and capital risks in both the financial system and the real economy simultaneously.

Source: BCG Center for Macroeconomics analysis

The financial and real economy risks are interrelated in two ways: First, a prolonged Covid-19 crisis could drive up the number of real economy bankruptcies, which makes it even harder for the financial system to manage. Meanwhile, a financial crisis would starve the real economy of credit.

It is fair to say the risk profile of the Covid-19 crisis is particularly threatening. While there is a policy playbook for dealing with financial crises, no such thing exists for a large-scale real economy freeze. There is no off-the-shelf cure for liquidity problems of entire real economies.

Innovating Out of the Shock

It is important to recognize that none of the shock scenarios outlined above will be inevitable, linear, or uniform across geographies. Countries will have considerably different experiences for two reasons: the structural resilience of economies to absorb such shocks (call it destiny) and the capacity of medical researchers and policy makers to respond in new ways to an unprecedented challenge (call it innovation). Can they create novel interventions, at unprecedented speed, that will break the intractable and unattractive trade-off between lost lives and economic misery?