Today we are pleased to present a guest contribution written by Ayhan Kose and Franziska Ohnsorge, respectively Director and Manager in the World Bank’s Prospects Group. The findings, interpretations, and conclusions expressed in this blog are entirely those of the authors. They do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.
The COVID-19 pandemic has already triggered deep recessions in many countries. These recessions are likely to leave lasting scars that depress potential output for years to come through multiple channels, including lower investment, erosion of human capital, and a retreat from global trade and supply chains. The long-term damage will be particularly severe if recessions are accompanied by financial crises.
The COVID-19 pandemic has tipped the global economy into its deepest recession since the Second World War. In 2020, the highest share of economies is expected to experience contractions in annual per capita GDP since 1870 (Figure 1).
Figure 1. Economies in recession
Source: Bolt et al. (2018); Kose, Sugawara, and Terrones (2019, 2020); World Bank. Note: Data for 2020-21 are forecasts. Shaded areas refer to global recessions. Figure shows the proportion of economies in recession, defined as an annual contraction in per capita GDP. Sample includes 183 economies, though the sample size varies significantly by year.
If history is any guide, COVID-19 and the resulting global recession will leave lasting scars. Deep recessions have been associated with highly persistent output losses in both advanced economies and emerging market and developing economies (EMDEs). A wide range of factors led to these losses during recessions: depressed capacity utilization discouraged investment and led to a legacy of obsolete capacity; elevated uncertainty and expectations of weak growth became self-fulfilling and depressed investment; weak investment delayed the adoption of capital-embodied productivity-enhancing technologies; and protracted unemployment caused losses of human capital and reduced job-search activity.
The COVID-19 started as a health crisis but it quickly turned into an economic crisis. For now, massive policy stimulus has prevented the economic crisis from morphing into a financial crisis despite the serious disruptions caused by the measures needed to stem the spread of the pandemic. When recessions are accompanied by financial crises, they tend to cause even more severe and longer lasting output losses. In addition to the damage caused by deep recessions generally, financial crises tighten credit conditions—including for productivity-enhancing technologies embodied in new investment, and for research and development spending—and they curtail access to bank lending for creative firms.
To quantify some of these effects, we analyze the impact of recessions and financial crises on activity in our latest Global Economic Prospects report (World Bank 2020). Specifically, we present estimates of the impact of recessions and financial crises on potential output—the output an economy can sustain at full employment and full capacity—several years after the event by using a local projections model (Jordà 2005). Our study extends earlier work on the implications of recessions for potential output by examining the combined impact of recessions and financial crises (World Bank 2018).
We employ a sample of 75 EMDEs for 1982-2018. Potential output is measured based on the production function approach (Kilic Celik, Kose, and Ohnsorge 2020). Recessions are defined as years of negative output growth. Financial crises include banking, currency, and debt crises (Laeven and Valencia 2018).
Our findings indicate that past recessions left a legacy of lower potential output: five years after the average recession, potential output was still about 6 percent below baseline in EMDEs. Financial crises—including those which were not associated with outright recessions—were also associated with lower potential output over the medium term, but the effects were more modest: potential output was about 4 percent below the baseline five years after the crisis (Figure 2).
Figure 2. EMDE potential output after recessions and financial crises
Source: World Bank. Note: Cumulative potential output response five years after the event, based on local projections model. Bars show coefficient estimates, vertical lines show 90 percent confidence bands. The dependent variable is cumulative slowdown in potential output after the beginning of event. Sample includes 75 EMDEs.
Recessions that were accompanied by financial crises, however, were associated with larger potential output losses in EMDEs than recessions without financial crises or vice versa: Five years after a recession-cum-crisis, potential output in EMDEs remained almost 8 percent below baseline (Figure 2).
Thus far, thanks to the unprecedented policy support, the global economy has averted financial crises. After the WHO declared the COVID-19 a pandemic in March, financial markets went through a period of exceptional volatility. Global equity markets declined abruptly. Flight to safety resulted a sharp increase in the volume of negative-yielding debt, while spreads on higher-risk debt markedly widened. Capital flows to EMDEs turned sharply negative and spreads on sovereign and corporate bonds soared. Policymakers responded these developments and the pandemic with overwhelming fiscal and monetary policy support (Figures 3 and 4). Their early actions have stabilized financial markets and prevented worse economic damage of the pandemic so far.
Figure 3. Fiscal support measures
Source: International Monetary Fund, World Bank. Note: AEs, MICs, and LICs refer to advanced economies, middle-income countries, and low-income countries, respectively. Announced measures are as a share of nominal GDP and are derived from the IMF Policy Responses to COVID-19 and World Bank estimates, and are subject to change. Aggregates calculated with 2019 nominal GDP weights. Discretionary fiscal stimulus includes expenditure and revenue measures. Data are as of June 12, 2020 for most countries, and up to July 9, 2020 for others.
Figure 4. Unconventional monetary policy measures
Source: International Monetary Fund, World Bank. Note: COVID-19 reflects recent increases in central bank balance sheets since January 2020 and is expressed as a share of 2019 nominal GDP. Global financial crisis reflects the increase in central bank balance sheets between August 2008 and December 2009 as a share of 2008 nominal GDP. Last observation is May 2020.
However, the COVID-19 pandemic can be expected to trigger even steeper long-term output losses for three reasons. First, this pandemic is, by its very nature, global and, as noted above, is affecting a record share of economies around the world. Second, the global economy entered this global recession on a weak footing, with global growth at a post-crisis low and debt at a record high in 2019 (Kose and Ohnsorge 2019; Kose et al. 2020). The pandemic has increased financial fragilities that may yet tip countries into financial stress. Many countries will face much larger debt burdens going forward due to the costs of necessary stimulus measures they put in place this year. Third, the global economy was already experiencing a trend slowdown in potential growth prior to the pandemic. The pandemic may exacerbate this slowdown by disrupting schooling, lowering investment, and chipping away at important engines of long-term EMDE growth, including trade integration and global value chains.
The likely long-term consequences of the pandemic highlight the need to lay the foundation for stronger potential growth. As the global economy recovers, policy makers need to do considerably more to improve future growth prospects. They need to credibly undertake comprehensive reform programs to improve institutions and policy frameworks that can ensure an eventual return to robust growth. In addition, they need to expand investment in education and public health.
Bolt, J., R. Inklaar, H. de Jong, and J. L. van Zanden. 2018. “Rebasing ‘Maddison’: New Income Comparisons and the Shape of Long-Run Economic Development.” GGDC Research Memorandum 174, University of Groningen, Groningen.
Jordà, Ò. 2005. “Estimation and Inference of Impulse Responses by Local Projections.” American Economic Review 95 (1): 161-182.
Kilic Celik, S., M. A. Kose, and F. Ohnsorge. 2020. “Subdued Potential Growth: Sources and Remedies.” In Growth in a Time of Change: Global and Country Perspectives on a New Agenda, edited by H.-W. Kim and Z. Qureshi. Washington, DC: Brookings Institution.
Kose, M. A., P. Nagle, F. Ohnsorge, and N. Sugawara. 2020. Global Waves of Debt: Causes and Consequences. Washington, DC: World Bank.
Kose, M. A., and F. Ohnsorge, eds. 2019. A Decade Since the Global Recession: Lessons and Challenges for Emerging and Developing Economies. Washington, DC: World Bank.
Kose, M. A., N. Sugawara, and M. E. Terrones. 2019. “What Happens during Global Recessions?” In A Decade after the Global Recession: Lessons and Challenges for Emerging and Developing Economies, edited by M. A. Kose and F. Ohnsorge, 55-114. Washington, DC: World Bank.
Kose, M. A., N. Sugawara, and M. E. Terrones. 2020. “Global Recessions.” Policy Research Working Paper 9172, World Bank, Washington, DC.
Laeven, M. L., and M. F. Valencia. 2018. “Systemic Banking Crises Revisited.” IMF Working Paper 18/206, International Monetary Fund, Washington, DC.
World Bank. 2018. Global Economic Prospects: Broad-Based Upturn, but for How Long? January. Washington, DC: World Bank.
World Bank. 2020. Global Economic Prospects. June. Washington, DC: World Bank.
This post written by Ayhan Kose and Franziska Ohnsorge.