How the pandemic has reshaped world economy and the challenges going forward
By Il Houng Lee (https://gsis.snu.ac.kr/faculty_directories)
What were the conditions before the pandemic?
When Covid-19 hit the news headlines, the world was still recovering from the global financial crisis (GFC). Relative to the period prior to the GFC, global growth has been sluggish throughout the 2010s. This slowdown was more pronounced in advanced economies(ADs) than among emerging economies (EMs), notably due to China’s strong performance accounting for a sizable share of EMs’ average growth. Global trade also exhibited similar trait as demand in ADs was subdued, the global value chain retracted, and growth in China relied relatively more on the tertiary industry than the export-oriented manufacturing sector.
The culprit for the sluggish demand in ADsisseen as a mixture of the fallout of globalization, technological progress, cross country imbalances, and excessive leverage. Notwithstanding the numerous literatures on the net impact (if any) of these factors as well as the ongoing debates, the fact remains that there were fewer quality jobs in ADs and more differentiated jobs in EMs.
In parallel, the world became more dependent on the future generation to maintain the level of consumption well beyond its earnings. This was partly enabled by not internalizing the cost of negative externalities into expenses, whereby the future generation is effectively-being taxed in terms of degraded natural environment for cheaper consumer goods for this generation. For the same reason, debt stock has been on the rise in most economies, i.e., for ADs in the immediate aftermath of the GFC, and for MEs during most of the 2010s, to maintain a living standard beyond its means. This gap will need to be filled by a correspondingly higher productivity or savings by the future generation.
Perhaps most challenging from the macroeconomic management point of view is the weakened investment-income-consumption cycle. This fundamental premise usually taken for granted when devising demand management strategy is in serious need of a review. Rising mark ups,[1]industrial concentration, especially in high tech areas can be observed from market capitalization of these company stocks and the rise of multinational firms, and the increasing number of smaller and medium sized enterprises’ (SMEs) interest coverage ratio falling below one allindicate income from investment becoming increasingly skewed towards fewer successful companies. Globalization of consumer product market has also raised the bar for market access for those with low skill and little start-up capital. Instead of competing within one’s locality, irrespective of size and type, all businesses are now exposed to global competition at the very outset.
Corresponding changes are mirrored in the labour market. The growing number of underemployed from losing industries and the falling participation rate from high entry barrier has contributed to widening income inequality. Rising asset prices has made wealth inequality even worse. These widening inequalities, and hence shrinking middle class, have weakened consumption, undermining the natural link from income to consumption. For the average household, debt accumulation was the obvious means to supplement consumption and leveraged investment in financial or physical asset the only way to claim some share in the booming asset market. The increasing weight of this debt in turn required lower interest rates just to keep the economy afloat.[2]
The net result of all this was a global economy that was highly leveraged, asset prices that were highly overvalued (see below), wealth and income (before transfer) inequalities that have worsened,[3]and a natural environment that was degraded to the point of no return. Moreover, there were no obvious positive factors that could be expected to contribute to global growth as was the case over the past several decades, e.g., the initial positive effects from privatization and smaller government, the synergy from integration in Europe and the FSU countries, and the boom in trade notably from China’s accession to the WTO. To make things worse, the US-Sino trade tension as well as national policies that encourage home bias have contributed to weaker trade flows.
[1]“Markups and income inequality: Causal links,” 1975-2011, Han M, J Pyun, Journal of Comparative Economics, Vol 49, Issue 2, June 2021
[2] It is no surprise that most macroeconomic models estimated a very low neutral rate given the structural characteristics which was probably also behind the decade long low inflation rate. Under inflation targeting framework, therefore, keeping policy rate low was inevitable.
[3] IMF Fiscal Monitor “A Fair Shot” April 2021
How did the pandemic affect these conditions?
The pandemic hit the services sector most, especially the SMEs and the self-employed businesses, followed by durable consumption good industries.[1]According to the ILO,[2]total loss of employment (largely in the form of inactivity rather than unemployment) amounted to 114 million jobs in 2020, effectively translating into an income loss of $3.7 trillion (or 4.4% of global GDP). The hardest hit sectors were accommodation and food services, arts and culture, retail, and construction. Even with income support measure, young workers, women, the self-employed and low- and medium-skilled workers suffered most. With higher-skilled jobs recorded growth, such as in information and communication, finance and insurance sectors, the pandemic has increased inequality within countries. A clearer picture will only emerge once government support is withdrawn, but developments in the labour market and in industries point to a further weakening of the investment-income-consumption cycle.
[1] Andre Dua et al. “US small-business recovery after the COVID-19 crisis” McKinsey & Company, July 7, 2020 https://www.mckinsey.com/ industries/public-and-social-sector/our-insights/us-small-business-recovery-after-the-covid-19-crisis
[2] ILO Monitor “Covid-19 and the world of work. Seventh edition (Updated estimates and analysis).”
What were the key policy responses?
Policy responses focused on keeping the economy afloat, maintaining the economy’s productive capacity, and protecting the most affected group of population. Fiscal policy, the scope of which in ADs exceeded that of the GFC period aimed at supporting demand, including through fiscal transfers to households and to businesses. On the monetary policy side, interest rates were further lowered to alleviate the debt burden and support economic activity. Some central banks extended direct lending to businesses and provided guarantees. Relaxed regulatory forbearance and moratorium also became a common feature across countries.[1]
These policy measures were well implemented. In most countries, growth quickly stabilize after the initial sharp fall in the first quarter of 2020. IMF staff estimated6policies to have contributed to about 6% to global growth in 2020. In the absence of these policies, growth could have contracted by more than three times the actual downturn. Accordingly, EMs (excluding China) with less policy space saw a larger decline in growth, and low-income developing countries yet to see the bottom of the decline.
[1]IMF World Economic Outlook “Managing Divergent Recoveries” April 2021
What is the price tag effect, including the side effects, of these policies?
These policy efforts were not for free. While they were critical in averting a major downturn in economic activities, the bill entailed further worsening of the underlying economic condition that prevailed before the pandemic. More specifically, the world is even more leveraged, asset prices are highly overvalued, wealth and income (before transfer) inequality has further worsened, and most likely the investment-income-consumption cycle has been further undermined. If so, macroeconomic policies to support recovery will have a short-lived policy effect upon implementation and could even worsen the structural distortions over the medium term.Total credit to the non-financial sector in G20 countries (market exchange rate based) as percent of GDP has risen from 247% to 292% during 2020 alone.[1]The same indicator for the ADs stood at 321% at the end of 2020.[2] Similarly, government gross debt in G20 ADs rose by 18 ppts of GDP to 131%. Such a level has not been seen since the end of WW2. Even more worrisome is the fact that these high levels are the result of the longest spell of debt accumulation, i.e., from the early 1970s, in the last century.3 Previous episodes of debt peaks were each during the hights of the two world wars and the Great Depression; in all three cased, they were followed by a rapid deleveraging, indicating a correction. Asset prices have further surged. Even before the pandemic, global market capitalization[3]at end 2019 had reached 113.9 % of GDP, which compares with 116.4% in 1999 and 114.1 in 2007, i.e., the two previous peaks before stock market crash. Since then, key stock prices have further surged in most key markets, although their performances were differentiated by sector, economic, and geo- political developments. Between January 2020 and June 2021, Dow Jones and US 30 Futures indices both rose by 21%, while the technology-heavy Nasdaq Composite index rose by more than 60%. Equities in Europe and Asia recorded strong growth with DAX and CAC rising by 18% and 10% respectively, and Nikkei and Shanghai rising by 23% and 17%, respectively. These surges were partly fuelled by leverage expansion, well above the increase in the value of their underlying assets.[4]Property prices have also followed the surge, albeit with some delay, reflecting the lack of alternative investment opportunities. Housing prices in key countries measured as a ratio to income and rent[5] have both either reached or surpassed their levels at the global financial crisis. Countries such as the US and the UK, whose ratios had increased sharply between the beginning of 2000 and the GFC reached their previous peak, while in Germany where it saw a small decline prior to the GFC rose by 40%.The average ratio for the OECD overall has surpassed the GFC peak by 8%, or by 38% when compared with the early 2000.In China, housing prices started to rise sharply since January 2021, rising by 15% (Jan-May average year on year).[6][1]BIS Data http://stats.bis.org:8089/statx/srs/table/f1.1?f=xlsx[2] For G7 (unweighted average), credit to non-financial sector during 2020 rose by 41 ppt, which compares with 0.4 ppts per annum over the previous few years (BIS data). [3] World Bank data https:// data. worldbank.org / indicator /CM.MKT. LCAP.GD.ZS[4] For example, debit balances in customers’ Securities margin accounts in the US alone rose by 34% in 2020, and further by 11 ppts during Jan-May 2021 (FINRA statistics).[5]OECD data https://data.oecd.org/price/housing-prices.htm
[6] CEIC data https://www.ceicdata.com/en/indicator/china/house-prices-growth
What will it take to cement a recovery?
The IMF baseline scenario projects the ADs to recover their pre-Covid19 per capital GDP by 2023, and emerging and developing countries with limited policy space to take longer to do so. Permanent loss of capital stock, including human capital due to education and employment gaps will leave a permanent scar. The number of bankruptcies has declined both in absolute terms and relative to previous crisis,6but once the blanket loans and credit guarantees are rolled back, the situation could quickly unravel. Moreover, the pandemic is still lingering on with the potential for the fourth wave still very alive.It is unclear whether even a careful timing and phasing of policy withdrawal alone can moderate these negative effects. The Fed managed to raise its policy rate well in the years leading to the pandemic despite the initial taper tantrum in 2013. The carefully planned and pre-announced normalization by the Fed sustained financial market stability, but did not induce a fundamental structural change in the US or the global economy. Moreover, rolling back financial forbearance and moratorium inevitably will have to be gradual, further delaying needed restructuring and imposing deadweight on the economy even long after the pandemic ends.On the positive side, much progress has been achieved in the tech sector as can be seen in the increasing share of value added in GDP[1]from professional scientific and information and communication sectors especially since 2015. Furthermore, in parallel with the tech sector innovation, greater concern for climate change is opening a new avenue that has yet to be fully explored. Digitalization of payment system is reducing domestic as well as cross border settlement cost that would help businesses. It remains a question as to whether development of these new areas will have a positive effect on income and wealth distribution.
[1]OECD data https://data.oecd.org/natincome/value-added-by-activity.htm
What are the potential challenges?
On top of the pandemic induced challenges discussed above, the heightened geopolitical risk from increased tension between the US and China could dampen technological innovation. Depending on the nature and the scope of US-Sino technology-competition, innovation could noticeably slow from loss of global synergy.This is particularly so as joint research among top 5 countries (according to the SCIE ranking) and China has grown in scope since the GFC.[1]This, in turn, will have adverse impact on global trade and transition to Industry 4 i.e., Fourth Industrial Revolution.Irrespective of who stays ahead of the other, global trade could be further undermined by this divide of technology especially if this tension will lead to product incompatibility among different group of countries. This is because growing “Internet of Things” implies that most devices will be linked ever more closely with one another, and thus compatibility of product and services will become increasingly more important. Together with growing reshoring policies,[2] including on security of supply concerns as experienced during the COVID-19 pandemic, and strategic independence more broadly, trend toward more regionalized production structure could strengthen, thereby accelerating the reshaping of the global value chain. The outcome will be negative to all parties.Slow progress in innovation will also stall the ongoing transition from labour and physical capital-intensive manufacturing sector to Industry 4, i.e., smart manufacturing involving yet to be fully explored areas of data sciences, cloud computing, advanced robotics, artificial intelligence, and virtual and augmented reality. To the extent that a noticeable share of Chinese manufactured consumer goods is exported to the US and the EU, impediment to trade could slow China’s move to Industry 4. This is particularly so since demand by conscientious consumers worldwide would be an important incentive for Chinese traditional industries to upgrade their production modality using greater interface between human and AI, robotics and automation.Finally, the weakened investment-income-consumption cycle remains the main economic challenge. Whatever economic stimulus is provided, the positive impact will be short lived and to keep the economy afloat, continued support will have to be provided in the form of government transfers or credit from financial institution. This in turn will keep fuelling asset price valuation, widening wealth inequality and increase the deadweight of the economy. Interest rates will have to be kept low to neutralize the large debt burden, which in turn will lead to inefficient resource allocation, creating a vicious cycle.[1] KIEP Research Paper (19-25), “How competitive is Chinese industries?” (In Korean); Feb 2020
[2] European Parliament, “Post Covid-19 value chains: options for reshoring production back to Europe in a globalised economy,” Mar 2021 https://www.europarl.europa.eu/RegData/etudes/STUD/2021/653626/EXPO_STU(2021)653626_EN.pdf
Where do we go from here?
To correct the structural distortion, the most obvious place to start is to ensure the world economy is running on a level playing field.It should be grounded on fair competition, to include minimizing the scope of policy arbitrage across countries such as the ongoing discussions on the Inclusive Framework on Base Erosion and Profit Shifting by the OECD/G20 and minimum corporate tax. Simple (to the extent possible) and transparent rules, clear and strong intellectual property rights (important for Industry 4), market-determined flexible prices, a regulatory environment that ensures that all agents price their cost of production fully reflecting risks, and a macroeconomic framework that will ensure assets are valued according to their real value, i.e., net present value of their future stream of returns.Efforts should focus on lowering market access to the general (and potential) work force by overhauling the education system and refocusing vocational training all tailored to implementing transition to Industry 4.[1]Evolution in the distribution system, catering, and health service provision are all hinting to a growing need for a new generation of work force. Establishing an ecosystem that nurtures creative thinking would need to accompany the changes in the education system, including providing a breeding ground for the rise of digital nomads and human cloud workers.The world has paid a very high price to deal with the pandemic in terms of human life and financial expenses.The only positive side effect from all this is the heightened awareness of the danger of climate change. However, unless this awareness also extends to accepting the fact that the world cannot continue to live on borrowed resources indefinitely, it will not be possible to ensure a recovery that is sustainable.[1] The US-Sino tension is an important policy challenge, but an issue beyond the scope of this paper.