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The Covid-19 pandemic and the economy: We are fighting a new war


Managing the spread of the coronavirus and re-starting economic activities are actually two sides of the same coin, argue Prof Guglielmo Maria Caporale (Brunel University London) and Prof Mario Cerrato (Adam Smith Business School, University of Glasgow). In this article originally published on the Policy Scotland blog, and reproduced here with permission, the authors propose that these problems are tackled by a simple health policy strategy based on a three-pronged approach.

The Covid-19 pandemic is a crisis that in many respects, is comparable to a war with a more dangerous, invisible enemy. It is a highly transmissible virus; its reproduction number, i.e. how many people each individual with the virus is likely to infect is rather high – the Imperial College Covid-19 Response Team consider a reproduction rate of 2.4 – and its fatality rate is close to 70% for people in their 70s although much lower for other age groups. Further, the number of casualties related to Covid-19 varies considerably across countries; for instance, the death toll to date has been much higher in Italy than in Germany. Virologists are warning that it may take a very long time to develop a vaccine, and it is very likely that over this period other virus outbreaks will occur. 

Trade-offs are therefore unavoidable and difficult choices will have to be made between containing the spread of the virus and allowing economic activity to continue. As managing the spread and re-starting economic activities are, in our view, two sides of the same coin, in this note we start with a simple health policy strategy based on a three-pronged approach to deal with the current pandemic: expanding intensive care units, using technology effectively for testing and contact tracing purposes, and planning for dynamic lockdowns.

Health policy considerations in Europe

The capacity of a health system is limited and therefore managing a pandemic represents a huge challenge that requires significant investment to enhance it, increase critical supplies (e.g. ventilators), train additional doctors and nurses (resorting to international co-operation in the presence of short-term constraints), and participate in international efforts to develop new treatments.

A combination of viral tests and antibody tests is essential to identify, respectively, individuals who are positive and those who have developed an immunity. Contact tracing is also crucial. South Korea and Singapore are both using systems based on Bluetooth to check if a person with Covid-19 has been in contact with other people. This could be the key to a return to a more normal life in the near future but there are concerns that this intervention violates the personal freedom of residents – a notable trade-off.

Finally, planning for dynamic lockdowns should be an essential component of a successful exit strategy. This includes the ability to quickly restrict access to and movement throughout an area (e.g. a city or parts of it), for a limited time in response to a virus outbreak, while monitoring other areas. Total lockdowns of the type imposed so far clearly cannot be the answer to the Covid-19 pandemic in the future because of their unsustainable economic costs, whilst dynamic lockdowns allow policymakers to save lives without bringing the economy to a standstill.

Covid-19 is likely to push the world economy into a recession. As a result of national lockdowns the rate of growth of real GDP has fallen sharply in all European countries, and a future recovery will depend crucially on designing appropriate policies to live with the virus without compromising significantly economic growth. Policymakers will need to respond quickly and to adopt unconventional measures in order to guarantee the functioning of key sectors (which might require partial nationalisation or re-conversion of certain sectors to help fighting the virus), provide sufficient economic resources to households (through cash transfer, unemployment benefits etc.) and businesses (through emergency loans fully guaranteed by the government, and wage support schemes to keep people in their jobs).

Economic policy responses so far

In the case of Italy fiscal rules have been suspended and €55 billion has been committed to boost economic activity (Reuters 13/05/2020) which will increase the budget deficit to approximately 10% this year and above 3% next year (Reuters, 23/04/2020). 

Further, the European Central Bank has taken action by purchasing assets, removing the 33% limit on a country’s bond purchases, and expanded the use of credit claims as collateral. Debt mutualisation through the creation of new “Corona-bonds” has also been mooted. However, this is opposed by countries such as Germany and the Netherlands on the basis of the no-bailout clause in the Maastricht Treaty. In short, “Corona-bonds” would require more integrated fiscal policies in the EU. A temporary solution suggested by some might be a European Safe Bond based on joint safe assets but without joint liability. At present, agreement has only been reached on a common response plan worth more than €500 billion (Reuters, 18/05/2020), but not on using shared debt to help the hardest-hit countries.

In the UK the Bank of England has cut interest rates from 0.75% to 0.25% and then to 0.1%, and has increased its holdings of UK government and corporate bonds by £200 billion which will help the corporate sector to overcome liquidity problems and pay workers and suppliers. The UK government, on the other hand, has injected a fiscal stimulus which is quantifiable at around 3% of GDP, compared to 2% of GDP during the global financial crisis with the aim of alleviating the recessionary effects of the coronavirus crisis (Bloomberg, 23/03/2020). This will raise the budget deficit from the planned £55 billion to £200 billion in the fiscal year starting in April as the economy shrinks.

Supply and demand-side shocks

The Covid-19 shock has mainly affected the supply side of the economy by disrupting supply chains and requiring new health policies. There has also been a demand side shock caused by the uncertainty resulting from the current pandemic, which will lead to job losses and lower investment. In the absence of an appropriate policy response the combination of the two types of shock will push the economy into a prolonged recession. This may also jeopardise the stability of the banking and financial system, especially in countries where the household and corporate sectors have accumulated excessive debt and leverage amongst financial institutions has increased. The majority of policies that have been announced in Europe and the UK rely on the financial sector (mainly banks) providing loans to households and firms. This will lead to more debt for both these categories and financial institutions will have to accept some poor collateral. For such schemes to work, governments and Central Banks need to provide a credible full public guarantee and regulators a temporary waiver of the Basel standards for loan categorization.

The commitment of European Central Bank, Bank of England and regulatory authorities has been significant but more can be done. The European Investment Bank could also help with a guarantee to banks offering loans to firms. The recapitalisation of some banks with taxpayer support might be an option, and perhaps both the UK and the Euro area should give some thought to the creation of a bank restructuring agency similar to the European Stability Mechanism. Despite the moral hazard issues inevitably arising in this context, such policies are the only way to avoid a wave of bankruptcies, a spread of the crisis to the entire financial sector and a prolonged recession. The risk that the Covid-19 crisis becomes a deep economic crisis and that it feeds into the banking and financial sector is very real. Policymakers should act in a co-ordinated manner, quickly and without hesitation.

The Covid-19 crisis is affecting the supply side of the economy because of its health policy implications and the supply chain disruption. Its supply side effects are also feeding into firms and household demand with a very significant impact on the EU and UK economies. The demand side impact can be mitigated by appropriate policy responses. If policymakers do not act quickly (possibly in a co-ordinated manner) and put in place the necessary economic as well as containment measures (for living with the virus), the combination of supply and demand shocks will affect substantially the economy as well as the banking and financial system and jeopardise the wellbeing of future generations.


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