Thursday, April 08, 2021

Medium term economic impact of the Covid crisis

The world economy will bounce back from the Covid shock of 2021. The IMF estimates global growth at 6 per cent in 2021 consequent to the decline of 3.3 per cent in 2020. But the effects of the shock will linger over the medium term. Global output in 2024 will be 3 per cent below what it had been projected before the pandemic struck.

The good news is that the impact of the Covid shock is far less than that of the global financial crisis (GFC). The IMF estimates (in World Economic Outlook, April 2021), global output was down by 10 per cent over a similar period, consequent to the GFC. I may be allowed to pat myself on the back a little bit: I had said in a post a few months ago that the pandemic shock- touted as the 'worst in a century' (or even centuries)- was likely to prove far less lethal than the GFC. The reasons the IMF gives are the ones I had given: the financial sector had not collapsed and the policy response had been stronger than in the GFC.

Chapter 2 of WEO is worth reading. It gives a good account of how exactly the pandemic has impacted economies and how the impact of recessions in general tend to linger and impact mediium-term output.

As is well recognised by now, the pandemic impact economies on both the supply and demand sides:

  • On the supply side, lockdowns reduced effective productive capacity. Some businesses also experienced lower productivity because they had to reorganize production to increase the physical distance between workers. These initial sectoral supply shocks spilled over to affect supply in other sectors through links in production networks.  
  • Demand fell due to reduced mobility and as precautionary savings rose amid heightened uncertainty. The initial supply shocks also propagated to a decline in demand. This propagation was amplified in many cases by liquidity-constrained households and firms forced to cut back on outlays, leading to more layoffs and further declines in private spending.

 How do recessions, in general, result in permanent damage to economies. The WEO explains:

  • First, unemployment may remain high even after the recession (Blanchard and Summers 1986) and couldresult in a smaller labor force as discouraged workers exit. Human capital accumulation and future earnings can be affected by skill deterioration during extended periods of unemployment, delayed labor market entry for young workers, and negative effects on educational achievement in the longer term.
  • Weak investment could result in slower physical capital accumulation and affect productivity through slower technology adoption. 
  • Productivity could also be permanently affected by the loss of firm-specific know-how as a result of bankruptcies and their spillovers (Bernstein and others 2019), the effects of a decline in research and development and innovation during the recession,and an increase in resource misallocation (see, for example, Furceri and others 2021).

 Two other points are worth noting. There are ordinary recessions, pandemic recessions and financial crises- induced recessions. These follow an ascending order of severity of impact on the economy. Secondly, in the Covid crisis, advanced economies are likely to be less impacted than developing economies. One reason is that advanced economies have been able to provide stronger policy support (perhaps because rating agencies are willing to tolerate higher debt in advanced economies) and they have had better access to vaccines and therapies. 


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