Having witnessed the 2008 financial crisis and the subsequent eurozone debt crisis, Europe’s policymakers should already realize what the Covid-19 pandemic could mean for the economy. To avert a self-perpetuating downward spiral, the European Central Bank will need to start thinking outside the box. Da “Project Syndicate”.
The coronavirus pandemic has triggered a combined negative supply and demand shock of unprecedented intensity. Both are having a significant impact on the production of goods and services, and because everyone’s income ultimately derives from production, household incomes are quickly falling. With many economies already in a downward spiral and heading toward recession, the danger is that the downturn will become a self-perpetuating and ever-deepening rout.
The twin supply and demand shocks are likely to trigger many “domino effects.” Companies with large fixed costs that suffer a sudden fall in income will quickly face financial difficulties, or even bankruptcy. When that happens, the banks and other entities that have lent money to these companies will also be in trouble. That is why massive economic shocks often can lead to banking crises.
But the falling dominoes don’t stop there. Governments, too, can face fiscal dangers when they step in to mitigate the crisis. In the case of the current pandemic, national governments will need to save businesses from bankruptcy by granting financial support and subsidies, assist workers by funding temporary unemployment schemes, and possibly even come to the rescue of large banks. Worse, all of this must be done at a time of declining tax revenues, which means that government deficits and public-debt levels will skyrocket.
We saw how these domino effects work during the 2007-2008 financial crisis. The difference now is that the initial shock did not start in financial markets and then spill over into the real economy. Rather, today’s shocks emerged from the real economy and have toppled financial markets. But, as in the past, this crisis demands urgent measures to put more space between the falling dominoes. Think of it as macroeconomic “social distancing.”
