Let’s not fight the last economic battle

Generals are often criticized for fighting the last battle. Let us hope that the same will not be said of world and U.S. economic policymakers as they fight the economic fallout from the coronavirus epidemic. Rather than view the current economic crisis as simply a repeat of the 2008-2009 Great Recession, one must hope that they recognize that the current crisis might share some of the debt-deflation elements of the world economic depression of the 1930s. 

A crucial way in which the current economic crisis differs from that in 2008 is in its speed, severity and reach. Not since the Great Depression have we seen as rapid and deep a decline in world economic output and as sharp an increase in world unemployment as we are seeing today. At no time in the post-war period have we seen the world’s overall GDP decline by around 3 percent as we are likely to see this year.

According to the IMF’s latest economic forecast, for 2020 as whole U.S. and European output are expected to decline by around 6 percent and 7.5 percent, respectively. That would be approximately double the rate of output decline experienced during 2008’s Great Recession. Meanwhile, unemployment in these economies would rise to well over 15 percent, which would far exceed the peak unemployment levels experienced in 2009.

Another key difference between the current economic crisis and that in 2008 was their points of departure. In 2008, both U.S. interest rates and inflation were approximately double their corresponding levels at the start of today’s economic crisis. Meanwhile, at the start of 2020, world debt-to-GDP levels were around 40 percentage points higher than they were on the eve of the 2008 economic crisis.         

With interest rates lower today in all the industrialized countries than they were in 2008, the world’s main central banks will have very much less room to cut interest rates than they did during the 2008-2009 economic recession. At the same time, with inflation already below 2 percent in the major industrialized countries and with world unemployment likely to stay unusually high over the next two years, there is the very real risk that the world will move to a prolonged period of price deflation. 

The main factor that risks causing world price deflation is the very large gaps likely to characterize world labor and output markets. Further heightening the risk of deflation is the current collapse in international commodity prices and the wave of bankruptcies that must be expected in the wake of the worst recession in the post-war period.

One effect of deflation will be to nullify the supportive effect of recent central bank monetary policy easing. With central banks unable to reduce interest rates much below zero without inflicting serious damage to the banking system, deflation could render interest rates significantly positive in after-inflation terms.

A more serious consequence of deflation is that it could give further impetus to a wave of corporate and household bankruptcies and debt defaults as occurred in the 1930s. Already households and corporations are going to struggle servicing their debt mountains as their incomes and profits are decimated by a deep economic recession. The last thing they now need would be a further compression in their incomes and profits as a result of falling prices.

An economic recovery may be more difficult to engineer this time than in 2008 given the greater number of bankruptcies and debt defaults. This would seem to be particularly the case should deflation severely limit the monetary policy efficacy of the world’s major central banks.

All of this underscores the difficult challenges facing policymakers to restart the global economy, especially with budgetary policy likely to be the only game left in town. It would also suggest that as bold and swift as the world’s fiscal policy response has been to the coronavirus economic challenge, more budget stimulus around the globe might be needed soon to secure a global economic recovery.  

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.