Containing the economic recession

In responding to the coronavirus epidemic’s threat to the U.S. and global economies, policymakers would be well advised not to underestimate the global economic damage likely to flow from that epidemic. It will also be important for them to distinguish between what is beyond their control and what they might be able to control. 

At this stage, what should be clear is that policymakers will not be able to prevent a meaningful U.S. and global economic recession over the next two quarters. However, what is still very much subject to their control is their ability to design and coordinate economic policies in a manner that might prevent the economy from going into a downward deflationary spiral. 

By now there is no room for doubt that the coronavirus pandemic is dealing both the U.S. and global economies a massive supply-side shock. Literally tens of millions of workers – most notably in China, Italy and Spain, but also starting now in the United States – are being locked down and restricted from going to work. This is seriously curtailing economic activity and is disrupting global supply chains in a big way. Meanwhile, air transportation is being curtailed, events and cruises are being canceled, and schools and universities are being closed.

Already before the coronavirus epidemic struck early this year, the world economy was slowing largely as a result of the U.S.-China trade war. Major economies like those of Germany, Italy and Japan were all in recession, while major emerging market economies like those of China and India were experiencing abrupt slowdowns. Even the U.S. manufacturing sector was in the throes of a trade-war induced recession.

Against this background, it is difficult to see how the coronavirus supply-side shock will not soon tip the U.S. and global economies into a meaningful recession. This would seem to be especially the case after the recent 25 percent drop in global equity prices that has wiped out around $13 trillion in global household wealth. 

These developments are inducing investment banks like Goldman Sachs to anticipate that the U.S. economy will contract at an annualized rate of 5 percent in the second quarter this year. One must expect that the slump in activity could be worse in other countries like Italy. That heavily indebted country is now being hit by a perfect storm of the cessation of foreign travel, a total lockdown of its population and a slump in its main European trade partners. 

Global economic policymakers need to recognize that there is nothing much they can do to halt the supply-side shock. No amount of interest rate cuts, tax reductions or public spending increases are going to prevent the coronavirus epidemic from having workers locked down, global transport systems upended, events canceled and international supply chains dislocated. 

But there is very much that economic policymakers can and should do to prevent the second round effects of the supply-side shock from allowing an otherwise short recession to morph into a major global economic recession like that experienced in 2008-2009.

Among the second-round effects that need to be offset through aggressive fiscal and monetary policy measures is the slump in aggregate demand that the coronavirus epidemic will have occasioned. In particular, monetary and fiscal policy in the United States will need to make good on the slump in household demand that will be occasioned by the wiping out of around $7.5 trillion in U.S. stock market wealth. 

According to the Fed’s own estimates, if sustained, such a reduction in household wealth alone could subtract more than 1.5 percent from GDP. This has induced the Fed over the weekend to slash its policy rate to between 0 percent and 0.25 percent and to further increase its balance sheet by $700 billion. But it remains to be seen whether this will be sufficient to stabilize the equity market.

With interest rates already now at the Fed’s zero bound, the burden of further supporting the U.S. economy will have to come from fiscal policy. At a minimum, it would seem that the U.S. economy would need targeted and timely fiscal measures of the order of between at least $500 billion to $1 trillion to stabilize the economy. 

The onset of an economic recession, coupled with acute problems in the U.S. shale oil and transport sectors, is bound to occasion a wave of corporate defaults. That in turn must be expected to exert considerable pressure on the U.S. and global financial systems. It’s imperative that bold measures are adopted by the Federal Reserve in coordination with the world’s other major central banks to prevent such pressures from leading to a U.S. and global credit crunch that would deliver another body blow to the weakened U.S. and global economies.

Yet another fallout from a coronavirus-induced global recession is bound to involve a sharp reversal in capital flows away from the emerging market economies that could cause real stress in those economies. Alleviating such stress will require prompt large scale International Monetary Fund support, if the emerging market economies’ troubles are not to feedback onto the global economy.

Judging by Treasury Secretary Mnuchin’s most recent comments that the U.S. will avoid a recession this year, it is not clear that the Trump administration grasps how large a fiscal policy stimulus is needed or how important global economic policy coordination will be if the virus’s economic damage is to be limited. This hardly leaves room for optimism that the U.S. and world economies will avoid a hard economic landing later this year.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.