April 9th 2020
The coronavirus pandemic continues to wreak havoc in markets. Almost a quarter of the world population is under lockdown. Economists are busy trying to estimate the damage to the world economy. The predictions so far indicate that the economic impact of coronavirus will be worse than the Great Recession of 2007-2008. Here, we use the income-side approach to GDP to assess the economic effects of Covid-19.
We use the Bureau of Economic Analysis (BEA) data on the components of the US Gross Domestic Income. Our focus is mainly on the ‘Compensation of Employees’ and the ‘Corporate Profits with inventory valuation and capital consumption adjustment’. We make a simplifying assumption that the rest of the components of the Gross domestic income will change in the same proportion as the profit component.
Economic growth scenarios under coronavirus:
Our estimations yield the following scenarios:
- In the base scenario quarterly GDP is expected to fall 7.8% in 2020 Q1 and 26% in 2020 Q2. The base assumption for the length of the lockdown and the pandemic peak is three months.
- In the optimistic scenario quarterly GDP growth falls 6% and 20% in 2020 Q1 and 2020 Q2 respectively.
- In the pessimistic scenario quarterly GDP growth falls 10% and 30% in 2020 Q1 and 2020 Q2 respectively.
Most economists use macroeconomic models based on the spending-side approach to GDP to come up with forecasts and predictions. This approach calculates GDP using the following formula: GDP = consumption + government spending + investment + net exports. The difficulty with the GDP spending side approach is the great uncertainty with regard to calculating the components of GDP. Do we know the extent of the shock to consumption, investment, exports and imports? The simple answer is no. The government spending is a policy instrument and we may have better knowledge of that. In contrast, the shock to the other components are harder to predict. Furthermore, macroeconomic model parameters come from an era that does not have a pandemic of a comparable size. This is because there is hardly any reliable economic data, for example from the Spanish flu era. As a result, pandemic simulations do not always yield realistic estimates for GDP.
Income approach to GDP measurement
Here we pursue a more direct, ‘income-approach’ to the prediction of GDP. We make assumptions about how the income components of GDP may be impacted by the current pandemic in certain sectors and then we aggregate over the whole economy. Our method is direct and pragmatic. By not relying on any parameters based on pre-pandemic era, our approach has an advantage over more sophisticated spending-side models .
The BEA data has a fairly detailed disaggregation of the industries and services for the years prior to 2018. Therefore, we use the sector distribution of incomes in 2017 to calculate the losses in 2019.
Growth scenario assumptions:
We use the following assumptions:
90% drop in compensation of employees and net surplus (profits) in the following sectors:
- Retail trade (excluding the Food and Drink)
- Transport
- Hospitality (Restaurants and Hotels)
- Art & Entertainment, Motion Pictures
All the other sectors are assumed to have a 30% drop in incomes and profits. We assume that only one third of 2020 Q1’s incomes are affected as the major shock took place in March. We assume that the epidemic already peaks and starts abating in the third month of 2020 Q2. In other words, we assume the lockdowns to be over by June and the economy to be up and running. According to our estimates, the US economy is expected to experience a 26% drop in 2020 Q2. This shows that the coronavirus impact will be worse than the Great Recession. We use these growth estimates in our stock market forecasts .
Comparison with Historical Benchmarks:
It is difficult to compare the coronavirus pandemic with any of the historical events. The scale of the damage is many folds worse than the SARS epidemic of 2003-2004. A potential benchmark is the Spanish flu pandemic of 1918, that killed 20-50 million worldwide and almost 700,000 in the US. Although the mortality rates of the Spanish flu were comparable to the coronavirus (about 2%), the supply side shock of the Spanish flu was much more severe; the mortality rate was the highest for men below the age of 40, which created labour shortages and wage increases. Furthermore, it is impossible to disentangle of the economic impact of the WW1 from the pandemic. Finally, the scant economic data of the period makes it hard to conduct a reliable comparison of the impact on economic growth.
The data on real GDP growth in the post WWII era shows us that real GDP never contracted by more than 10% since 1958 Q1 (the Eisenhower Recession). The financial crisis (a.k.a. Great Recession) caused the second largest drop (-8.4%) in 2008 Q4. The quarterly drop in non-farm business sector employment was most severe (-6.4%) in 2009 Q3. Consequently, the US unemployment rate reached 10 %.
The expected impact of the Covid-19 on the US GDP growth is larger than that of the 2007-2008 financial crisis. One can consider the Great Depression of 1929-1932 as a possible benchmark. During the Great Depression period, which started with a stock market crash of October 29, 1929 (Black Tuesday), GDP contracted four years in a row (1930-1933) by 8.5%, 6.4%, 12.9% and 1.2%.
Stock market recovery leads economic recovery
The stock market usually recovers well ahead of GDP as it was the case in the 1958 recession (see Fig 2). We do not have quarterly GDP numbers for the Great Depression, and the S&P 500 did not exist prior to 1957. Nevertheless, a similar pattern is observed in the annual data. Fig 3 shows the Dow Jones Industrials recovering by 1933 in a sharp V shaped movement after falling by nearly 50% in 1931. When Franklin D. Roosevelt took office in March 1933, GDP growth turned positive after years of deflation and 24.5% unemployment at its peak (source: Bureau of Labor Statistics).
Fig 2: the 1958 Recession and the S&P 500 growth. (source: BEA, Markettrends.com)
Fig 3: The Great Depression and the Dow Jones Industrials growth (source: BEA, Markettrends.com)
The Great Depression period experienced dramatic drops in GDP that was never encountered in the downturns of the post war era. The Covid-19 crisis is likely to cause a quarterly contraction that is also severe by historical standards. However, in contrast to the Great Depression, where the banking system was very vulnerable to panic-driven bank-runs, the US banks are currently well-capitalized and well-supervised under the Dodd Frank Act. The financial regulation in the aftermath of the Great Recession made the US banking system much stronger.
Can the stimulus package succeed to revive economic growth?
Unlike the Great Depression era, the Fed has become accommodative very quickly and slashed the federal funds rate by 1.00 percentage points to a range of 0-0.25% in March. Further liquidity is on its way as the US senate agreed on a $2.2 trillion stimulus package, which includes offering $1,200 per adult and $500 per child dependent to most households as a blank check excluding high incomes. The United States has done this twice before during the Great Recession, and also in 2001, when the majority of Americans received a $300 check.
The ‘helicopter money’ type of stimulus to stimulate GDP growth is no doubt a more direct approach than the usual Keynesian policies such as cutting taxes. The influx of money for low-income people and for people with no incomes will create immediate relief in paying food and rent bills. However, the impact of the pandemic on consumer sentiment is different than that of an ordinary recession caused by a business cycle.
Paradox of Thrift
Currently, US consumers are anxious about their health and the future of their jobs. In the week ending March 28, the advance figure for seasonally adjusted initial claims was 6,648,000, an increase of 3,341,000 from the previous week’s revised level. This marks the highest level of seasonally adjusted initial claims in the history of the seasonally adjusted series (source: US Department of Labour). It is possible that some consumers will postpone spending until there is more certainty with regard to the pandemic. Postponing spending can trigger the Keynesian ‘Paradox of Thrift’, where increasing saving propensity might slow down economic recovery.
Pessimistic scenario and the Spanish flu
It is possible that our base scenario is not pessimistic enough and earnings and profits in the manufacturing sectors of the economy may drop more than 30%. As a plausibility check, one can refer to the reports from the Spanish flu. Because of the scarcity of economic data, a study by Thomas A. Garrett (2007) * used the newspaper articles from the fall of 1918 as anecdotal evidence for the economic impact of the pandemic. From these newspaper reports, it appears that commercial business had declined 40% or more. Our pessimistic scenario incidentally corresponds to a 40% drop in incomes and profits.
Clearly, the US economy in 2020 is quite different than the Spanish flu era. The service sector has outgrown manufacturing industries and the contribution of agriculture to GDP has become negligible over time. The service sector currently constitutes about 68% of the US GDP (source: BEA). The health care services aside, the Covid-19 crisis made a big negative impact on the service sector employment and the so-called ‘gig-economy’ (e.g. Uber drivers). As a result of the two to three month long lockdown on the major US cities, both the loss of output and employment are expected to exceed that of the global financial crisis.
V-shaped versus U-shaped recovery
Many economists believe in a sharp V shaped recovery in contrast to the global financial crisis where the recovery was slow. The problem with the coronavirus crisis is that it is both a demand-side and a supply-side shock. It is clear that the generous stimulus package of $2.2 trillion can only be effective if the spread of the virus is under control. One could argue that the US consumer sentiment is indexed to the spread of the virus. Consumer and investment spending can continue to stay dormant during uncertain times.
What seems clear is that the stock market would probably recover in a V-shaped manner. However, the current crisis may have a lasting impact on aggregate supply by reducing the demand for labor permanently. The lockdowns forced the economy to operate in a different fashion. It speeded up the digital transformation for some companies. The home-office phenomenon exposed the inefficient parts of the factors of production. It led to faster transition to labor-saving technologies. In the aftermath of the coronavirus crisis, the US companies will strive to increase their earnings for their shareholders. It is quite possible that a non-negligible part of the work force redundancies will be permanent.
Fig 4 shows that during the financial crisis of 2007-2008, profits recovered much quicker than the unemployment rate. The latter indeed peaked when the company earnings recorded its highest quarterly growth. We believe that the unemployment rate will likely to stay above 10 % till the end of 2020. Therefore, additional stimulus packages might be needed to reduce unemployment.
