Covid shock vs global financial crisis

The pandemic is not as bad as the 2008-09 global downturn

The worst crisis in centuries. The worst crisis in a century. Worse than the global financial crisis (GFC). As lockdowns everywhere ground the global economy to a halt, the characterisations of the pandemic were extreme. The last one came from the International Monetary Fund’s (IMF’s) managing director.

More than six months on, these characterisations appear wide of the mark. The immediate impact of the pandemic has been greater than that of the GFC. According to the IMF, the world economy is poised to shrink by 4.4 per cent in 2020, with the pandemic having begun at the beginning of the year itself. This is worse than the 0.6 per cent shrinkage in the economy in 2009, the first year after the GFC. (The crisis peaked in September 2008, so the impact was mostly felt in the following year).

However, the true measure of the impact of a crisis is how much the output potential deviates from that before the crisis and over what period. The IMF’s projections show that in the period up to 2025, potential gross domestic product (GDP) in 10 advanced economies will remain below what had been projected in the January 2020 World Economic Outlook (WEO) by an average of 3.5 per cent.

Compare this with the effect of the GFC. One rigorous study showed that the output potential in 23 Organisation for Economic Co-operation and Development (OECD) economies had fallen by 8.3 per cent in 2015, that is, full seven years after the crisis. (Laurence M Ball, “Long-term damage from the great recession in OECD countries”, NBER Working Paper 20185). Another study estimated the median output loss in 19 OECD economies at 5.5 per cent in 2014, that is, six years after the crisis (Patrice Ollivaud and David Turner, “The effect of the GFC on potential output”, Economic Studies, Vol 2014). The loss of output potential in the pandemic promises to be much lower than in the GFC.

True, the pandemic has not yet run its course. But there are sound theoretical reasons to believe that the impact of the pandemic will turn out to be less severe than that of the GFC.

Economies suffer the most when subject to banking crises. According to economists Kenneth Rogoff and Carmen Reinhart, it takes eight years on an average for an economy to emerge from a banking crisis.

The good news is that banking systems have held up in the pandemic, unlike in the GFC. The IMF’s Global Financial Stability report (October 2020) shows that banking systems are well placed to weather the shock of the pandemic. The IMF has estimated the impact of the crisis on a sample of 350 banks from 29 jurisdictions accounting for 73 per cent of the global banking assets. It turns out that capital will decline following the pandemic but remain comfortably above the regulatory minimums. This is in stark contrast to the multiple bank failures, including large bank failures, we saw in GFC.

Following the GFC, there was a push for more stringent capital requirements under Basel III norms. In addition to the 8 per cent capital required previously, banks are now required to hold 2.5 per cent as capital conservation buffer. Counter-cyclical capital requirements could be as high as 2.5 per cent and there is another 2.5 per cent for systemically important financial institutions. Many banks have chosen to be well above the new regulatory requirements of capital. Higher capital cushions have clearly made a big difference to banks’ ability to weather the present crisis.

There is another reason that the pandemic is likely to prove less lethal. There is a pronounced change in attitudes toward public debt among policy-makers in the advanced economies.

Illustration: Ajay Mohanty

The IMF’s latest WEO urges the advanced economies to spend their way out of trouble even though public debt in the advanced economies is poised to rise steeply. Carmen Reinhart had advocated austerity after the GFC, saying that high levels of public debt undermine economic performance. Now, as chief economist at the World Bank, she is all for greater public borrowing.

The IMF argues that greater borrowing makes sense given the steep fall in interest rates. But the fall in interest rates is not a recent phenomenon. Interest rates peaked in the US in 1981 and have been declining since. It is not the fall in interest rates alone that matters. What is material is that the difference between the growth rate, g, and the interest rate, r, has widened. This makes higher borrowings sustainable.

After the GFC, there was a reluctance to act on this important structural change. Then, too, the advanced economies resorted to fiscal stimulus. However, the retreat from stimulus was under way by 2011, just three years after the GFC. The debt-to-GDP ratio in the advanced economies at the time was 105 per cent. Today, policy-makers have shed their timidity in respect of public borrowings. They are ready to spend more even though the ratio of public debt-to-GDP is poised to rise to 125 per cent by 2021! This will go a long way towards containing the impact of the pandemic.

We are, however, yet to see a formal repudiation of the other holy cow of economic policy in advanced economies, the 2 per cent target for inflation. In August 2020, the US Federal Reserve made a modest departure: It announced that it would look at an average inflation target of 2 per cent. This means the Fed will allow inflation to exceed 2 per cent for an unspecified period without raising interest rates.

Many economists have been urging that the Fed target an inflation rate of 4 per cent as that gives greater scope for cutting the nominal interest rate. Assuming a 2 per cent real interest rate and an inflation target of 2 per cent, the nominal interest can only be 4 per cent. With an inflation rate of 4 per cent, the nominal interest rate can go up to 6 per cent, so the scope for cutting rates is greater. However, the Fed is unwilling to ditch the 2 per cent inflation target.

Proponents of Modern Monetary Theory (MMT) have long urged that the only real restriction on public borrowing and spending is the inflation rate. With inflation rates staying low for several years, policy-makers have shown themselves willing to adopt the MMT prescription on borrowings. Perhaps it will take another crisis for them to give themselves greater flexibility on monetary policy as well.

The writer is a professor at IIM Ahmedabad. ttr@iima.ac.in