So far, not so V: The shape of recessions and the Covid-19 pandemic

By Cassi Ainsworth-Grace

“So far, so V” said the Bank of England’s chief economist Andy Haldane in his June 30th speech. British economic growth would see an initial sharp, short-lived drop in GDP, hitting a low in quarter two, before recovering strongly into the third and fourth quarters of 2020. The August Monetary Policy Report reaffirms this forecast, although the expected V-shaped recession in economic activity is rather more lopsided. This forecast has been reassessed as uncertainty surrounding health and job security seems likely to persist well into 2021, and labour market mismatch has an impact as the process of hiring will be slower than that of redundancy. Clearly, the initial expectations of the Bank of England for a V-shaped economic recovery have proven too optimistic. In the second quarter of 2020, the UK saw the biggest percentage drop in GDP growth out of all the G7 economies.

In many ways, this V-shaped recession is the best-case scenario. The decline in economic activity is abrupt, deep, but most importantly, short-lived, with a strong rebound that roughly mirrors the initial fall in magnitude. Yet, our infatuation with the optimistic “so far, so V’ makes a few unrealistic assumptions: that the economy can be reopened all at once, consumers will simply resume normal behaviour and recovery is virtually symmetrical.

The V is by no means the only candidate for the classification of this recession. Others have taken to the idea of a U-shaped recession. Instead of a short-lived low, there is a drawn-out period of poor growth, before the economy rebounds with a gradual resumption of normal behaviour. This alphabetical forecast seems to have grown in popularity, with 54% of companies in favour, according to the findings of EY’s capital confidence barometer. Whilst the decline took place over just a few months, the recovery may creep into 2021.

Some posit a more extreme cycle aligned to a ‘W’, or a double-dip recession. If social distancing measures are ended prematurely, a secondary wave of infections would potentially push the economy back into lockdown, sending the economy into a second period of decline. This pattern may even reoccur as the economy tumbles back down with every new round of illness, for as long as a vaccine remains undiscovered.

A few have suggested that instead of a letter, the economic recovery may conform more closely to a Nike Swoosh, or a flat checkmark. A rapid down, followed by a slower, more stunted climb back up, the recovery period stretched perhaps up to 14 months or more. Finally, the ‘L’ or ‘I’. Under this classification, future economic activity would be significantly stifled, sitting beneath its pre-pandemic level for a drawn-out period of time. This is by far the most sinister. A deep, and lengthy recession may leave behind significant economic scarring on potential GDP with the collapse of business investment, permanent job losses and significant business closures.

It seems economists and investors have an appetite for alphabet soup to describe the shape of a business cycle. It is neat, near universal and easy to conceptualise. Yet, as Katie Martin of the Financial Times emphasises in a recent article, willing a chart or graph to look like a letter “does not make the trajectory or the signal real.” Assigning a letter to this present economic cycle, whilst usually a great tool for characterising an economic cycle, is seemingly less and less appropriate.

Simply put, this pandemic is not a cyclical event.  Our normal business cycle starts with a market and economic low, with a collapse in consumer and investor confidence that is eventually overcome as markets and the economy rallies. The developments in the past months are not part of these usual ups and downs, but are the results of an exogenous health crisis, external to the normal cycle. Whilst the economy can reopen, and investment and consumption can resume, although only in a muted way, a renewed spike in the number of cases will cripple what success is made. Economic growth will ultimately remain subject to the whims of the virus.

Normal recovery solutions of flooding the economy with liquidity will have little lasting impact on economic activity. The $3 trillion US stimulus legislation pumped money into the financial system, increasing liquidity levels by temporarily lifting the cash balances of businesses and people. Yet it is likely that these recipients are not going to be spending the money until there is an indication that general circumstances are improving and Covid-19 is under control. Traditional policy solutions can lift lagging investor and consumer confidence for a period, for economic growth to sustainably recover, the virus itself must be brought under control. Increased liquidity will not produce a vaccine.

And if there is a rebound, it will not be even. Rather, there will be a level of permanent impairment in certain sectors of the economy, as the long-lasting changes to our way of life disrupts consumer facing industries, activities involving crowds, and our reliance on offices. The rise in remote work is a shift that may not be reversed. Indeed, about one-half of all Americans who were working before the global surge in Covid-19 cases were doing their jobs on a remote basis by May. Although sectors like manufacturing, residential construction and consumer goods are likely to be more resilient, many restaurants and other small businesses will never reopen, and recovery in hospitality, travel, tourism and other consumer-facing sectors will be piecemeal.

To make matters more confusing the headline unemployment rate in countries like the UK do not truly reflect the true extent of labour market disruption in the market, and in particular exclude the rising number of the underemployed. As furlough and job-keeping schemes are unwound, the Bank of England estimates there will be 2.5 million people unemployed in the UK by Christmas. Additionally, companies may be more reluctant to hire, dragging out the period of high rates of joblessness. Persistent unemployment will deepen the scarring in the labour market, and means it is tricky to be precise about where the labour market will stand by the end of the year, even if GDP recovers as predicated.

Labour market recovery may also be potentially stunted with an acceleration of automation. With more being done digitally, and companies functioning with fewer staff, some jobs may simply never return. In the past, firms have done most of their job-cutting during troughs in the business cycle, and in the following rise in growth substituted their labour for capital and automated processes. As a consequence, labour market recoveries following economic downturns have grown more feeble in recent decades. Yet, this lasting pain may also have the opposite impact, delaying deployment of new technological developments as the pool of investment funds dries up alongside investor confidence.

Despite all this, investor confidence can, and has, rebounded, as global equity markets recover from the initial drop. As a result, equity markets are pricing in a more V-shaped recovery than the economy. As equity markets are ‘forward looking’, there seems to be a level of investor optimism of the pace of underlying economic recovery in the next 12 months.

In light of all this, it is nowhere near outlandish to suggest that the global economy will be crippled with a severe and protracted pain. A simple letter seems a far cry from the reality of our economic circumstances. Only time will tell what shape the recession will truly take.

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