Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate February 24th.
February 26, 2020 — At the start of the year, the economic mood was tending toward the optimistic. True, growth had slowed a bit in 2019. US GDP grew 2.3 % in 2019, down from 2.9 % in 2018. World growth was weak in 2019 as well: 2.9% according to IMF estimates, down from 3.6 % the year before. Still, there had been no recession. And forecasts as recently as January called for world growth to rebound in 2020.
Now, just since January, there is new reason for pessimism. Recessions are exceedingly difficult to forecast and the wise economist avoids trying. But the odds of a global recession have risen dramatically. The reason is the coronavirus that originated in Wuhan, technically named COVID-19.
Early appraisals of the economic impact of the virus were reassuring. The historical record from other similar epidemics, such as the 2003 SARS virus, is relatively sanguine: an individual country may take a hit to GDP in a given quarter (an estimated minus 2 % for China in the 2nd quarter of that year), but the macroeconomic impact is limited in time and space. Typically, the country’s economy bounces back quickly in the subsequent quarters, as consumers release pent-up demand and firms rush to fill back orders and re-stock inventories. The result is that it can be hard to discern an impact in the country’s GDP for the year as a whole. The same pattern usually holds for the effects of a much broader class of natural disasters such as hurricanes.
This coronavirus, however, has now become a more serious case than 2003 or other precedents. It could well push the world into recession. One criterion for global recession sometimes used by the IMF is world growth below 2 ½ %. (Unlike growth in advanced countries, global growth very rarely falls below zero – with the exception of the Great Recession of 2008-09 — because developing countries average higher trend growth.) Another, much tougher, criterion is negative growth in per capita GDP.
Why this time could be worse
It is not just that the number of reported deaths this time far exceeds the corresponding number of SARS casualties. The economic effect is likely to be substantially bigger for a number of reasons.
To begin with, the Chinese economy is more vulnerable. Its growth has been substantially slower in the most recent decade than in the preceding one. A slowdown from the 10 per cent growth rates of earlier decades was only natural and had hitherto been accomplished without a hard landing. But high levels of outstanding bad loans leave the economy vulnerable to a shock like the current one. Some signs already point logically to a sharp slowdown in economic activity, presaging growth significantly below the official 6.1 % rate last year.
Next, the virus might spread to other countries in a more major way. Korea and others in the region have already been hard-hit, responding with some emergency measures. It is not necessary for a high proportion of the population to be infected in order to impact a high proportion of a country’s economy. The effect of contagious disease tends to be disproportionate (even though understandable), in the sense that healthy people refrain from travel, shopping and work, even when such individual decisions are voluntary.
For another thing, the world economy is more dependent on China today than it was in 2003. Back then, China constituted only 4 % of global GDP. In 2020, it makes up 17% (at current exchange rates). Long supply chains mean that output in other countries can be held up by disruptions of one or more stages of value-added in the production process in China.
Which economies are vulnerable?
Many parts of the world economy are vulnerable. Commodity-exporters are high on the list, as China tends to be their largest customer. This means Australia and most of Latin America, Africa and the Middle East. Chinese booms in 2003-08 and 2010 boosted world commodity prices and the subsequent Chinese slowdown had already worked to dampen commodity markets since 2015. Even developing countries that are not commodity-exporters are likely to be hit through financial channels, as investors have now moved sharply to a “risk-off” footing.
Japan has already suffered a jolting drop in GDP in the most recent quarter [minus 6.3%, annualized]. This resulted from an October increase in its consumption tax. The negative effect was as predictable as were the recessionary effects of earlier hikes in the consumption tax in April 1997 and April 2014. Adding on top of this the loss of trade with China now makes likely a Japanese recession, defined as two quarters of declining GDP.
European manufacturing is vulnerable. Europe is more dependent on trade — linked even more extensively to China through a web of supply chains — than is the United States. Italy has been hit directly by the contagion. Germany narrowly escaped recession last year, but might not be so lucky this year in the absence of some fiscal expansion. The reality of Brexit may finally have the long-feared negative economic impact in the United Kingdom.
What about trade policy?
The common story at the start of 2020 was that earlier fears of a recession in 2019 had arisen from the trade wars launched by Donald Trump the year before, but that significant negotiating progress had recently been made (specifically ratification of the USMCA and Phase 1 of an agreement with China). These agreements, it was said, had alleviated risk concerns among businesspeople and had restored a positive economic outlook.
I don’t buy this story. True, the agreements with China and Mexico/Canada are improvements relative to the alarming path that Trump had previously threatened, including his threat to withdraw from NAFTA and his plans to put tariffs on the remaining imports from China. But the new agreements are fragile. They are no improvement relative to where we were two years ago.
To the contrary. The various changes made by the USMCA relative to NAFTA are generally small. Their net impact is likely, if anything, to be negative. This is especially true of the uncertainty about the longer-term future of the FTA.
The China “Phase I” deal leaves high tariffs in place. Moreover, it is a fragile creature with low credibility on both sides. Claims that China will buy an extra $200 billion of US exports are unlikely to translate into higher US exports. China may not be able to deliver on this promise and, even if it does, the result would be to divert US exports from other customers.
The stock market appeared remarkably unconcerned about risks arising from US trade policy, the coronavirus, or anything else, continuing to climb in the first eight weeks of this year. Finally on February 24 it began to fall, evidently registering that the virus was serious after all.
By measures such as P/E ratios, the market is still high. Maybe investors have had it wrong. They correctly point out that a comparison of stock yields with interest rates says the stock market is not too high. But this just means that the bond market is even higher than the stock market. Investors may take too much comfort from the Federal Reserve’s three interest rate cuts last year. It is self-evident that, should the US economy falter, there is nowhere near enough room for the Fed to cut interest rates by 500 basis points as it has in past recessions. It would not be able to save us.
Even if a recession does not materialize in the near-term, Trump’s trade policy may signal a long-term break in post-war history, a definitive end to the six-decade era in which international trade steadily rose as a share of the economy, accompanying an historic period of prosperity and peace. We may be looking at a new trend of decoupling from China in particular and de-globalization in general – almost unthinkable until recently. In this, the coronavirus could be just more fuel for the fire.
This post written by Jeffrey Frankel.