Comment: Global economy hit by severest shock since 1930s

Fast policy response necessary to reduce impact of secondary rounds

Reuters – Recessions often start with a small drop in activity which then progressively deepens over subsequent months as the second- and higher-round effects on the economy start to occur.

But the current business cycle downturn looks very different. In terms of its scale and sudden onset, there is no parallel since the end of the Second World War.

The initial shock from the coronavirus outbreak and the shutdown of much of the transportation and business system is both large and sudden.

There are no government statistics yet on the scale of the current downturn, but taking the oil industry as a proxy for economic demand, consumption appears to have fallen by around 10 million barrels per day, or 10 per cent, within the space of a single month.

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The first-round shock to the system is enormous even before any second- and third-round impact on business and consumer spending.

In 1945, demobilization and the conversion from wartime to peacetime production caused industrial output to drop by 30 to 35 per cent progressively over 12 months.

In the 1974-75 recession, U.S. industrial output fell by around 15 per cent over roughly 20 months, according to data from the U.S. Federal Reserve.

In 2008-09, U.S. industrial output declined by almost 20 per cent from its pre-recession peak, but the decline was stretched over a period of roughly 18 months.

All these magnitudes and durations are approximate because peaks and troughs in industrial production do not correspond precisely with the official business cycle dates, which take into account other factors as well.

But the current downturn could easily prove the steepest since 1945. In scale and sudden onset, it looks more like the dynamics of the 1930s Depression or the violent business busts of the late 19th and early 20th centuries.

Recessions can be a lot like epidemics in that a small initial disturbance — the infection of a single patient or failure of a single business/sector — grows exponentially as it is transmitted through the rest of the system.

In recent years, economists have drawn on research from epidemiology to understand how a single bank or business failure can set off a cascading failure as it spreads across the economy.

The initial infection or business failure may be relatively inconsequential; it is the network of connections by which it is transmitted across the population or the economy that turns an isolated problem into a pandemic or recession.

In the case of the economy, recessions are transmitted through real changes in the flow of spending and income, namely sales, orders, employment, wages and debt payments.

But transmission can be accelerated by changes in the stories individuals and businesses construct about the immediate future and the impact on their decision-making.

Economist John Maynard Keynes called them “animal spirits” (General Theory of Employment, Interest and Money, 1936). For Robert Shiller, they are “narratives” or “stories” (Narrative Economics, 2017).

By whatever name we call them, narratives have the power to amplify and accelerate the transmission of recessionary or expansionary forces through the economy because they can become self-fulfilling.

In most cases, it is the shape and structure of the network, and its behaviour when shocked, rather than the scale of the original disturbance, which determines the magnitude of the eventual epidemic or recession.

Some major shocks have failed to produce recessions or only mild ones. Some minor shocks, singly or in combination, have resulted in major business downturns.

Stock market crashes. Real estate bubbles. Bank failures. Credit contractions. Poor harvests. Sharp sudden changes in oil prices. Policy errors. All have been blamed singly or in combination for triggering recessions.

Awkwardly, these same disturbances have sometimes occurred without being followed by a downturn, illustrating the difficulty of modelling and forecasting a highly networked economy.

It is the lack of a simple, obvious, proportional relationship between the cause of a downturn and its eventual size and duration that is the main reason why business cycles have proved so hard to explain, model and predict.

And in most cases, it is the second- and third-round effects of a business downturn on wages, investment, confidence and lending that are the most important in determining the length and depth of the slump.

The more tightly coupled the system is, the more leverage is applied, and the smaller the shock absorbers, the more severely an initial disturbance is likely to cascade across the network.

With the current shock, the policy response from central banks and finance ministries is the fastest on record, which could help reduce second- and third-round effects and prevent the crisis worsening.

In the same way social distancing is designed to reduce or eliminate the person-to-person transmission of an epidemic, monetary and fiscal policy can reduce or prevent second-round effects of an economic shock.

Policy responses aim to reduce the level of immediate financial interdependency across the economy, creating shock absorbers or firebreaks to prevent cascading failures.

As with health policies intended to control the spread of an epidemic, the faster and more comprehensive the monetary and fiscal response, the greater the probability of controlling the eventual recession.

Coronavirus and the measures introduced to suppress the epidemic have created an economic shutdown that has no precedent for 90 years.

Now central banks and governments will have to find similarly unprecedented measures to support the economy until normal business and transportation activities can resume.

John Kemp is a Reuters analyst. The views expressed here are his own.

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