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The world faces a major contraction in economic activity. The scale of the likely decline, and the timing and magnitude of any upturn, are hotly debated. But of even greater importance are the long-term effects of the crisis.
The 2008–09 financial crash illustrates the risks. In its wake, growth in the advanced world has run at less than 70% of pre-crisis rates. Europe has fallen even further behind, with euro area growth running at 54% of previous levels. The failure to return to pre-recessionary rates of growth in Europe and the US during the recovery has caused a greater loss of GDP than was inflicted in the financial crisis itself.
This outcome is consistent with research undertaken by the International Monetary Fund. Its analysis of the period 1974 to 2012 shows that all types of recession, irrespective of cause, lead to permanent output losses. The damage to productive capacity incurred in the downturn cast a long shadow.
There are four main ways in which this crisis could affect future growth.
First, rising debt levels are likely to weigh on activity. Government debt will need to be repaid, financed by higher taxes or whittled away through inflation. More indebted corporates and households have less headroom for investment, risk taking or discretionary purchases. A period of balance sheet repair is likely, with an intensified focus on cutting costs and paying down debts.
Second, the crisis could deal another blow to globalisation, one of the great engines of modern growth. The response to COVID-19 has been largely national in character. In some areas, such as border restrictions and medical exports within the EU, international cooperation has been notable by its absence. The crisis has strained relations between the West and China and put pressure on supply chains. President Macron has talked of need for greater independence through rebuilding French agriculture, health, manufacturing and technology. The vulnerabilities exposed by the financial crisis changed attitudes to financial regulation; COVID-19 could do the same for globalisation and for supply chains. Theory and history demonstrate that greater economic nationalism is likely to weaken growth.
Third, major downturns can have lasting effects on behaviour. Experience shapes us all. US research shows that CEOs who experienced the Great Depression early in life were more reluctant to take on debt and leant more heavily on internally generated funds. COVID-19 seems likely to sharpen the corporate sector’s focus on cost control and building cash. Having been exposed to the shock of a sharp contraction in the economy, consumers and corporates may seek to protect themselves by strengthening their balance sheets – devoting more income to saving and debt reduction, and less to spending. Without a vaccine the risk of a resurgence of the disease, and renewed restrictions on activity, will remain. That uncertainty is likely to inhibit planning and investment.
Fourth, despite the best efforts of governments around the world, unemployment and insolvencies will rise. The result is an erosion of future productive capacity. In a modern economy this is as much about the loss of non-tangible capital - skills, relationships, network and so on - as it is about the destruction of financial capital. The effects can be significant. Researchers in North Carolina found that being unemployed at the age of 21 depressed wages for at least ten years relative to those who have not been unemployed at this age. According to a Yale study, those entering the labour force at a time of recession, even if they find employment, are also likely to see enduring depressed earnings.
The world had a growth problem before COVID-19. A great effort will be needed to ensure this crisis doesn’t make it worse.
Ian Stewart is a Partner and Chief Economist at Deloitte where he advises Boards and companies on macroeconomics. Ian devised the Deloitte Survey of Chief Financial Officers and writes a popular weekly economics blog, the Monday Briefing. His previous roles include Chief Economist for Europe at Merrill Lynch, Head of Economics in the Conservative Research Department and Special Adviser to the Secretary of State for Work and Pensions. Ian was educated at the London School of Economics.