Munich Personal RePEc Archive How to Deal with a Coronavirus Economic Recession? Popov, Vladimir CEMI 18 May 2020 Online at https://mpra.ub.uni-muenchen.de/100485/ MPRA Paper No. 100485, posted 18 May 2020 21:27 UTC How to Deal with a Coronavirus Economic Recession? Vladimir Popov ABSTRACT 2020 world economic downturn associated with the restrictions intended to fight COVID-19 pandemic is a structural recession caused by adverse supply shock. It is similar to recessions caused (or aggravated) by post war conversion of defense industries, by oil price shocks (1973, 1979, 2007), and by the transition to the market in post-communist countries in the 1990s (transformational recession). Whereas traditional Keynesian policy (absorption of adverse supply shock by means of expansionary fiscal and monetary policy) can help, best results are achieved by government industrial policies promoting restructuring – transferring resources (capital and labor) from the contracting industries to the expanding. The experience of China and some other East Asian countries that seem to be more successful in overcoming the coronavirus recession provides additional evidence. Keywords: Structural recession, adverse supply shock, demand shock, conventional Keynesian response to recession, restructuring, industrial policy JEL: E32, E6, E65, O25, P20, P51. 1 How to Deal with a Coronavirus Economic Recession? Vladimir Popov The economic recession caused by the COVID-19 pandemic is likely to become the deepest since the Great Depression of the 1930s. Its magnitude is exceeding the scale of the Great Recession of 2008-09. Many economists have already suggested that COVID-19 global crisis will give an additional push to the growing state involvement into economic and social life. In words of Dani Rodrik, “there is nothing like a pandemic to highlight markets’ inadequacy in the face of collective- action problems and the importance of state capacity to respond to crises and protect people” (Rodrik, 2020). One area where the greater state involvement is desirable and likely, is the use of industrial policy as the anticyclical tool for fighting the downturns. This recession is different from most of the postwar recessions – it is caused by the supply shock, not by the demand shock, and the policies to bring the economy back to the equilibrium with full employment should differ from traditional Keynesian fiscal and monetary stimuli. East Asian countries, especially China, seem to be doing better than the others not only in fighting the pandemic, but also in overcoming economic recession. Their experience in economic policy making may be no less valuable than in the public health domain. Deeper than the Great Recession The postwar economic recessions were very mild – on an annual basis US GDP did not fall more than 1 to 2 percent. Even in the last recession of 2008-09, which is believed to be very special and is even called the Great Recession, the reduction of GDP totaled only 0.1% in 2008 and 2.5% in 2009 (fig. 1). The coronavirus recession is likely to cause a greater reduction of GDP. At the time of writing (May 2020) the released data for the first quarter of 2020 showed a 3.5% decline at annual rate in 2 the EU, 4,8% in the US and 6.8% in China. GDP in Hubei province (Wuhan, where the virus was first detected, is the capital) fell by nearly 40% (!) And in all other 33 administrative units of China (except only Tibet) the GDP in the first quarter fell as well. Chinese economy, however, started to recover already in March, so the second quarter is likely to be better than the first, whereas in Europe and the United States the major reduction of output is expected in the second quarter and may be even afterwards. Figure 1. US GDP annual growth rates, % US GDP growth (annual %) 8 6 4 2 0 -2 -4 -6 1966 1960 1968 1962 1970 1964 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 -8 2020 Source: World Development Indicators database. If the reduction of output in major Western countries in 2020 will total 5 to 10%, this will be the deepest recession of the postwar period and could be compared with the Great Depression of the 1930s. The US GDP at that time fell for full 4 years in a row and in 1933 was about 30% lower than in 1929. It recovered to the pre-recession 1929 level only in 1936, but then fell in the recession of 1937-38 (fig. 2). Unemployment rate in the US in the postwar period never exceeded 10% of the labor force (fig. 3), whereas at the end of the Great Depression it exceeded 20% of the labor force (fig. 3). In April 2020 the US unemployment rate rose to 14.7% and was expected to rise even more in May. However, the nature of the 2020 coronavirus recessions is very different from that of the Great Depression of the 1930s and of most postwar recessions. 3 Figure 2. Figure 3. Source: Unemployment in the United States (Wikipedia, https://en.wikipedia.org/wiki/Unemployment_in_the_United_States). 4 Typology of recessions Economists distinguish between demand driven recession and supply side recession. The former is due to the shocks of demand – for instance, entrepreneurs decide to cut their investment on whatever reason, or foreign countries stop purchases of national products, so exports goes down, or households decide to postpone purchases of consumer durables. The government in this case can step in to stimulate effective demand through the expansionary fiscal and monetary policy – this is the standard recommendation of the Keynesian stabilization policy A supply side recession is usually associated with the increase in costs of production (wage increases, increase in prices of imported materials, extra costs due to unfortunate events, such as earthquakes, epidemics, wars, etc., creating bottlenecks in supplies and raising the costs of production and delivery). A particular case of the supply side recession is a structural recession caused by the need to reallocate resources, labor and capital, from one industry/region to another (Popov, 2009). The textbook theoretical framework is the AS-AD model (see, for instance, Mankiw, 2006). The AS curve characterizes positive relationship between output and prices (the higher the prices, the larger the supply of goods), whereas AD curve characterizes the negative relationship between the demand for goods and prices. The demand is the aggregate demand; it could be increased by the expansionary fiscal and monetary policy (AD moves to the right). The supply is the aggregate supply; in the long run the AS curve is vertical (given full utilization of production capacities and labor and the level of productivity), but in the short run AS curve is positively sloped (firms respond to growing prices by expanding output and employment, but eventually this causes wages to increase, so costs catch up with growing prices and output returns to the equilibrium level). 5 The negative demand shock moves the AD curve to the left, as shown on figure 4 below. Luckily, the government and the central bank can respond to the shock by expansionary fiscal and monetary policy, and can return the AD curve back at its initial position, as shown in fig. 4. Figure 4. Demand and supply shocks and government reaction A. Adverse demand shock and government reaction P AS AD AD’ Y B. Absorption of the adverse supply shock P AS’ AD’ AS Y AD’ There is an agreement among economists that the Great Depression of the 1930s was caused by the demand factors (the debate is whether it was poor monetary or fiscal policy that failed to put back the AD curve). 6 The negative supply shock moves the AS curve to the left (adverse supply shock). Increase in costs force the entrepreneurs to increase prices to compensate for increased costs, but at higher prices they can sell less output (so the AS curve moves to the left). The government does not have the powers to affect the position of the supply curve in the short run. The only thing the authorities can do to restore output is to increase aggregate demand (moving the AD curve to the right, restoring output at a cost of higher prices – fig. 4). This is called the absorption of the adverse supply shock. Structural and general recessions A general recession is the output decline in most industries (sectors, regions), whereas a structural recession is the fall in output in one industry/sector/region, which is not compensated immediately by the increase in output in another industry/sector/region. Structural recession – the one that is caused by the decline of one (non-competitive) sector and the rise of another (competitive) sector – would not be a recession at all, if the transfer of resources (capital and labor) from the first sector to the second sector would be instant and effortless. But in reality such a transfer of resources is associated with higher costs (retraining of employees, replacement of fixed capital stock), so the structural recession (whatever the initial reasons are – supply or demand shock) becomes a typical supply-side recession (Popov, 2009). The characteristic feature of the structural recession is the existence of unemployment and unloaded production capacities in some industries and the good profit opportunities in the other industries; resources eventually flow from the former to the latter industries. Not all supply side recessions are structural. Imagine that workers ask for higher wages in all regions and industries, so that profits contract by the same amount in all companies, so they fire employees and cut output. When unemployment grows, real wages fall, profits increase and output is gradually restored to the previous level.