A recession is starting

There are still many questions about the likely path of the coronavirus in coming months (and even years). But there is now no doubt that the US and Europe will follow China in seeing a major hit to economic output which will likely be counted as a recession. If the rate of new infections can be brought down, as it seems to have been in China, there is still a chance of a short downturn and an early recovery as people start working and spending again. This also depends on timely action by central banks to maintain liquidity and large-scale action by fiscal authorities to support businesses.

The recovery will likely still be muted rather than V-shaped as people continue to shun the travel and hospitality industry, and because some businesses will be damaged or go bankrupt. Also, investment will likely stay weak for a prolonged period. But big government stimulus will help. However, if the virus cannot be rapidly controlled, or if it re-emerges as people come together again, social distancing may need to continue for months or even years, keeping the economy on a slower recovery track.

Three questions on the virus

There are three key questions on the virus: First, can Europe and the US achieve an effective social shutdown similar to the one China executed? If they can, and the massive increase in public awareness in recent days makes this more likely, I would expect the number of infections to tail off within a few weeks, as it has in China, perhaps helped by a seasonal effect.

Secondly can China (and later the rest of the world) prevent a renewed rise in infections, as people go back to work? Hopefully the answer to this question is yes, with China’s new infections down to 21 today and still falling. It may require continued social distancing, preventing the economy from bouncing back strongly.

Thirdly, will a vaccine prove possible (it is not possible for all viruses) and when might it come? Many reports say it will take a year or more, which would be too late to deal with a seasonal rise in infections next winter (assuming there is seasonality).

The West is 6 weeks behind China

A few weeks ago I identified 4 scenarios for the virus. The first was containment to China, the second a spread to the rest of Asia. We have now moved to Scenario 3 where the virus has taken hold in the US and Europe. This puts the West where China was about 6 weeks ago. In this situation fears of the virus, as well as government restrictions, keep people at home and reduce spending, even though the absolute numbers infected are relatively small compared to the population.

China for example has reportedly suffered about 81,000 cases and 3226 deaths (March 17th). Even if these numbers are wrong by a factor of 100, (which is surely too extreme), 8 million cases and 322,000 deaths are not huge numbers for a country of 1.38 billion people, especially if compared to ordinary flu rates. In particular, this rate of infection is not enough to provide ‘herd immunity’ – a concept favoured by many virologists and initially taken up by officials in governments including the UK, Germany, Holland and Switzerland. But it is enough to overwhelm intensive care services in hospitals.

We saw in China that the measures to contain the virus caused an almost total economic shutdown in some parts of the country and a partial shutdown in the rest. Yesterday China reported miserable economic numbers for January-February. (China always combines these two months because Lunar New Year varies between the two months, making comparisons impossible otherwise). Industrial output declined 13.5% from a year earlier (vs being 6.9% up in December), retail sales fell 20% and unemployment jumped by 1 ppt. This is consistent with a fall in GDP of 15% or more (measured over just those 2 months) and a fall in Q1 GDP of around 10%.

The West is following China’s measures

Most of Europe and parts of the US and Canada are progressively following China’s example, with Italy in the lead. This points to a sharp drop in output for a few weeks as the travel and hospitality industry seizes up and people restrict spending. Many workers will be temporarily laid off and self-employed and gig workers will mostly earn far less. Some countries are telling all but essential workers to not work at all, so people simply stay home. This is similar to what happened in China, where many factories were closed around the country, because workers had travelled to their home villages for Lunar New Year and could not return due to travel bans.

In China work is returning to normal now and output is recovering. The government has employed a raft of support measures to keep businesses going and support the financial system. But there are bound to be casualties among businesses and an increase in bad loans. China’s pre-existing problems with excessive debt have been made worse – more on this in a later blog. But the critical question, as already noted, is whether the infection rate will pick up again.

Expect major government support

Western governments are only now struggling with the scale of economic support that may be required for some sectors and individuals. How to target it and how to deliver it? New Zealand has just announced a package worth 4% of GDP. (New Zealand has only 12 cases but with a population of 4.8 mn this would translate into 166 cases in the UK or 818 cases in the US, about where they were 10 days ago.) The NZ package includes covering wages for those required to isolate (unless they can work from home), extra money for low income people, and wage subsidies for businesses where revenue is down 30% or more from last year.

In France President Macron has said that no businesses will be allowed to fail, while in the UK, a £330 bn package of loans, grants and tax cuts has just been announced after the measures presented in the Budget just last week already hopelessly inadequate. The US is also groping towards new measures and I would expect the pace to pick up sharply in coming days.

Long-run solutions to the virus?

The long-run solution to this virus is likely to be some combination of the following three possibilities. One is that we find a vaccine. Another is that the current wave is flattened out, probably with seasonality helping, but social distancing is maintained to some extent. The third is that, after a time people give up on social distancing and accept a higher death rate. We eventually achieve herd immunity, probably after enduring a succession of waves of the virus over 2-3 years (as occurred in the Spanish Flu in 1918-20), but hopefully with governments able to massively ramp up the number of ICUs to help people who suffer a severe illness.

A recession now for the West

None of these help the economy near term and I would be surprised if GDP in Western economies exceeds Q4 2019 levels for some time, meaning that this will count as a recession in the US and Europe, even if GDP only actually drops for one quarter. But they do offer hope for 2021. Meanwhile governments are likely to throw money at people and maintain interest rates near zero.

There may well be other consequences of this huge shock to the economy and to our normal lives. As an economist here are some that occur to me. Will China finally face the end of its bubble economy? Will the European Union face impossible fiscal strains that blow apart the euro, or will it finally bring in the fiscal and banking union it needs to stay together? Will there be other political shocks around the world?

In the favourable scenario where China leads the way to a reasonable recovery, perhaps fears will rapidly subside and these risks will fade. The key things to watch over the next couple of weeks will be threefold. First China's infection rate as it attempts to normalise. Secondly, the effectiveness of the West's shutdown which should start to show up in the case statistics in a week or so. Thirdly the size and effectiveness of government economic and financial support.