Economic implications of the pandemic - Paul De Grauwe London School of Economics
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Economic implications of the pandemic Paul De Grauwe London School of Economics
• Great Recession was only a negative demand shock produced by banking crisis • Corona-shock: How does – sudden stop in supply Corona-shock – leading to major decline in revenues compare with the – and strong decline in Great Recession demand of 2008-09? • The combination of supply and Greater intensity demand shocks produces deflationary spiral • Threatening further downward movements in GDP
Percent change GDP from 2019Q4 to 2020Q2 0 -5 -10 -15 -20 -25 Spanje Frankrijk Italië VK Eurozone Duitsland VS Wereld China Japan Korea Source: OECD
Decline in GDP during Corona pandemic at least twice as large as decline during Great Recession Percent change in GDP during Great Recession (2008-09) -1 -3 -5 -7 -9 -11 -13 -15 Source: OECD
Comparison Corona-recession with previous recessions Index industrial production World (EU+US+CHINA) 100 95 90 85 Index 80 75 70 Juni 1929=100 April 2008=100 65 February 2020=100 60 0 5 10 15 20 25 30 35 40 45 Months SourceSource: De Grauwe and Ji, (2020), A tale of three depressions, VoxEU, https://voxeu.org/article/tale-three- depressions Note: The February 2020 line relates to the aggregate industrial production of China, US and EU
• The intensity of the downward movement is much greater and faster than that of the Great Depression and of the banking crisis of 2008. Difference – This has to do with fact that Corona shock produced combination of supply and demand shock with • A second difference has to do with the revival. We see that once the lockdowns Corona in the European Union, the US and China were released, industrial production rebounded strongly. pandemic • Almost perfect V-recession – This revival was made possible by the fact that the European governments responded in the right way. – Their response was even stronger than during Great Recession.
• Slower recovery in 2008-09 compared to Corona-pandemic also due to the fact the Great Recession was produced by banking crisis • Banks became reluctant to lend and therefore slowed down the recovery • This has not yet happened during Corona crisis • Conclusion: once vaccination programs have their effect and people perceive the pandemic is over we can expect strong and quick recovery
EU, China, US compared Index industrial production 110 • China experiences strongest 105 recovery (Nov-2020) 100 • also because downturn was not as pronounced 95 • Surprisingly EU-recovery is stronger than US 90 • despite deeper decline in first half of 2020 85 EU US China 80 75 70 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Source: De Grauwe and Ji, (2020), A tale of three depressions, VoxEU, https://voxeu.org/article/tale- three-depressions Note: The February 2020 line relates to the aggregate industrial production of China, US and EU
• Authorities have been forced to support economy and stop Policy deflationary spiral • This policy of support has reactions: necessitated large increases in government budget deficits fiscal • and government debt levels policies • larger than what happened during the financial crisis in 2008-09
Change budget deficit 2019-20 (percent GDP) 0 -2 -4 -6 -8 -10 -12 -14 -16 Source: OECD, Economic Outlook, 2020
• Central banks have also taken extraordinary steps to make sure that enough liquidity is Role of flowing into the system • We know that when economy central is gripped by deflationary spiral there is a scramble for liquidity banks • That if nor accommodated reinforces the downward spiral (Fisher debt deflation)
Central banks' balance sheets (trillion national currencies) 8 7 6 5 4 3 Federal Reserve 2 European Central Bank 1 0 Source: OECD, Economic Outlook, 2020
Percent of government bonds held by central bank 50 45 40 35 30 25 20 15 10 5 0 Source: OECD, Economic Outlook, 2020
• Thus, governments and central banks supported the economy so that it could rebound relatively easily when the lockdowns were lifted. – More fundamentally goverments saved the market system – That was at risk of implosion as a result of deflationary spiral
• No • We are lucky • We are now in regime where r < g • Implications – Debt dynamics is favourable Is there a need – Government debt to GDP ratio will tend to decline for austerity to automatically without the deal with surge need for austerity (higher taxes and/or lower spending) in government • This contrasts with previous debt? periods when r > g and government debts were on explosive path (Ponzi game) • Necessitating either – austerity or – inflation
Application of Domar model (assuming primary budget balance, i.e. no austerity) 30-year bond yields Germany: -0.18% France: 0.32% UK: 0.87% Spain: 0.90% Italy: 1.51% 1+ = − 1 + −1 PBt is assumed to be zero
Percent of GDP in 30 years of 100 debt today 30-year bond yields (Nominal growth GDP=2%) Germany: -0.18% 110 France: 0.32% 100 UK: 0.87% Spain: 0.90% 90 Italy: 1.51% 80 70 60 50 40 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Italy Germany France Spain UK
• We do not know how long this new regime r < g will last • But we now have an important capacity to lock in this new regime for at least the next 10 years and more • As a result, after the pandemic there is no need for austerity as the surge in debt as percent of GDP will decline automatically
• It appears that much has been done to support the economies from collapsing. – By allowing surge in deficits and debt levels – And massive monetary accomodation Issues for • Issue for the Eurozone: – Great divergence in impact of Eurozone Corona crisis – Great divergence in ultimate effect on government debt levels (see graph) – There is a serious risk that when pandemic is over a new sovereign debt crisis will be triggered
Government debt (forecast) in 2021 (percent BBP) 250 200 150 100 50 0 Source: OECD, Economic Outlook, 2020
– When panicky investors sell the government bonds of countries that are perceived to be on unsustainable debt trajectory (Greece, Italy, Spain) – and buy government bonds of “safe countries” such as Germany and the Netherlands – This crisis would destabilize the Eurozone – Weak countries pushed into bad equilibrium • Forcing the weak countries into renewed austerity preventing their recovery – Ultimate effect of this would be political: populists would have an easy ride in their claim that the Eurozone is a bad arrangement.
• Happily the European Union agreed to set up a common fund (Next Generation EU) aimed at providing assistance • In the form of loans • and grants • European Commission will be able to borrow up to €750 billion on the markets. These are “Eurobonds” • In addition ECB set up a pandemic facility (of €1250 billion) to provide liquidity support in government bond markets
• Will all this be sufficient to prevent a new sovereing debt crisis after the pandemic? • When it appears that some member countries are severely weakened and others are not • Unclear what the answer is. • A new sovereign debt crisis in Eurozone cannot be excluded. • To avoid this further steps towards political and budgetary union are inevitable
• The existence of national government budgets and debts The long is at the core of the fragility of a monetary union. road to fiscal • We cannot rely on only the ECB and political to solve this problem. union • The key is that parts of the national budgets and debt should be consolidated into one central component.
• Long run success of the Eurozone depends on continuing process of political unification. • Political unification is needed because Eurozone has dramatically weakened • the power and legitimacy of nation states Conclusion • without creating a nation at the European level. • This is particularly true in the field of stabilization • Happily a small step has been taken with the Next Generation EU programme • More will be necessary
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