The Perfect Storm: Interventionism, Inequality, Decoupling and Zombies

Not only that, but pandemics typically evolve in the context of waves that can lead to surprises if public health measures are abolished prematurely. In short, until a vaccine is available, appropriate therapeutic solutions are found, or societies achieve herd immunity, social distancing will have to continue to be implemented at some level. These considerations suggest that 2020 will be a lost year in terms of economic growth for many countries.

Macroeconomic outlook is grim

The IMF, for example, predicts a global economic contraction in the order of 4.9% in 2020. To put this in perspective the global recession observed in 2009, amid the global financial crisis (GFC), led to a contraction of 0.7% of global GDP. One of the main differences between these two events concerns the geographical distribution of the recession. The initial negative impact of the GFC was concentrated in the industrialized countries that experienced a contraction of 3.7% in 2009. The economies of developing countries, in turn, slowed down significantly, but still registered a positive growth of 2.8%.

This time, however, the recession has a much broader global reach and the IMF expects industrialized countries to contract 8.0% and developing economies to contract 3.0%. Latin America and the Caribbean will be one of the most affected regions, reflecting the poor performance of its two largest economies (Brazil and Mexico), and is likely to have a negative growth on the order of 9.4%. In short, this recession is likely to be the most dramatic contraction of the world economy since 1870.

Radical measures are the norm

Governments around the world have adopted measures of fiscal expansion in response to the pandemic. On average these measures have exceeded 6% of GDP; in the USA, for example, they are estimated to amount to more than 11% of GDP. In Australia, the fiscal measures announced will add up to 7.2% of GDP, with most of these actions (e.g., sizable wage subsidies and income support to households) being executed in FY2019-20 and FY2020-21.

Even Germany, a traditional pillar of fiscal conservatism, has announced fiscal programs that translate into an expansion of roughly 8% of GDP. And in the case of Brazil, the estimate of the size of announced fiscal measures is of 11% of GDP with their impact in 2020 contributing to a primary deficit of 6.5% of GDP.

Central banks have also adopted expansionist policies bringing policy rates to historically low levels and even, in some cases, adopting negative interest rates. On top of that, heterodox policies, such as quantitative easing, have become the norm and even the acquisition of private bonds to facilitate the adjustment of financial markets has been announced (e.g., in the USA).

As a consequence, the assets of the main central banks (including the Fed, the European Central Bank, the Bank of Japan, the Bank of England, and the Swiss National Bank) increased by US$6 trillion since the beginning of the year, more than twice the expansion observed in 2008-09. The liquidity “tsunami” associated with these monetary policies has stemmed a financial crisis in the short run.

The reactions of markets to the shock of the pandemic and the adopted fiscal and monetary policies provides a study in contrasts. Financial markets have recovered partially from the dramatic adjustment in March, a movement that has been interpreted as a signal that a rapid recovery (in a V shape format) will occur.

Labor markets, however, are behaving in a very different manner and many countries are now experiencing double digit levels of unemployment. Given the hysteresis that typically characterizes adjustments in labor markets, this signals a much more protracted recovery (e.g., in a U or W shape format).

State intervention and deglobalization

The pandemic so far has generated a significant increase in state interventionism as well as an increase in economic inequality. In short, capital has fared much better than labor amid the crisis. In the same vein, large well-capitalized firms are able to withstand the ongoing liquidity crisis, but the impact on small and medium enterprises has been dramatic. Moreover, social distancing has accelerated the transition to the digital economy, a structural shift that favors human capital (education) and which will further widen economic inequality.

Another important side effect of the crisis has been a contribution to the trend in favor of de-globalization. This trend was already in play in the aftermath of the GFC and the rise of populist leaders around the world that typically favored protectionist policies. The pandemic, however, has been fostering additional protectionist policies (e.g., export controls) and affecting the service sector in a significant manner, with a dramatic impact on tourism, international transport and the movement of labor.

Companies are reconsidering their participation in global value chains and there is a renewed emphasis on investing in resilience, in contrast to a world that formerly was driven by efficiency considerations. Covid-19 has also strengthened the trend toward decoupling between the two largest economies in the world amid geopolitical and technological frictions.

In several countries, this is being magnified by negative consumer sentiment against China.  Australian consumers, for example, are among the most critical of the role of the Chinese government in controlling the spread of Covid-19. The specter of a new “Cold War” that may restructure the world economy in terms of two major competing spheres of influence can no longer be dismissed. This poses significant geopolitical challenges for middle powers like Australia and Brazil that, even though broadly aligned with the USA in ideological terms, have become increasingly linked to the Chinese economy in terms of trade and capital flows.

A systemic crisis for capitalism?

The inevitable question is whether this will pave the way for a systemic crisis of capitalism. The answer is YO, i.e., both yes and no. Market economies are resilient and able to adapt to endogenous shocks (as in the case of the GFC) and exogenous shocks (such as earthquakes, wars and pandemics). The unprecedented combination of a health crisis and interventionist policy responses, however, will definitely move the equilibrium between market and government roles in favor of what could be characterized as a new version of “state capitalism.” An additional concern in this context is how to pave the way for normalization of market activities as the number of “zombie” companies increases, reflecting government support to companies that are too large to fail (e.g., some traditional airlines).

Alternatively, one could argue that the pandemic will accelerate the transition to stakeholder capitalism: the recognition that firms have to more effectively balance their profit motivation with social, environmental and ethical considerations. This trend, which was already gaining strength in the last decade, is now leveraged due to concerns about the social crisis generated by Covid-19.

It is important to recognize, however, that the dramatic increase in government and corporate debt amid the crisis will put a lot of pressure on policy makers for years to come. Gross public debt in industrialized countries is expected to surpass, on average, the mark of 120% of GDP by the end of 2020. Many emerging economies (e.g., Angola, Argentina, Brazil and Sri Lanka) will surpass a 90% ratio. Australia is an outlier in this regard, with the gross public debt/GDP ratio expected to reach a comparatively small 59.4% of GDP by the end of 2020.

As I and colleagues have discussed in previous analyses, these high levels of debt are likely to have long term implications for sustainable growth rates. How governments manage the process of exiting these interventionist policies and of avoiding a crisis of deglobalization will be critical variables in determining the future shape of capitalism.

By Carlos A. Primo Braga, Associate Professor, Fundação Dom Cabral and former Director, Economic Policy and Debt, The World Bank.

This article is an updated version of a text originally prepared for the International Advisory Council Newsletter, Fundação Dom Cabral, July 7, 2020.

The views expressed here are the authors, and may not necessarily represent the views of the Institute for International Trade.