History suggests we can expect a rapid recovery once Covid is beaten
The current pandemic-induced economic crisis isn’t like the financial crisis of 2008. They are very different things, says John Stepek. And the recovery will look very different too. It will be much quicker. Here’s why.
The good news on vaccines appears to be flowing thick and fast. There is solid evidence that they work, whatever the variety and there is increasing evidence that one jab offers a decent amount of protection (both from the AstraZeneca and the Pfizer versions), which means we can get people covered more quickly if everyone goes down the UK route of delaying second doses (I'm not a fan of Tony Blair, but he was absolutely right on this one).
But what does it mean for the economy? Can we get back on our feet after a thump this hard? The good news is that history gives grounds for optimism.
We're always fighting the last war
The last big recession and economic crisis that most of us will remember is the 2008 financial crisis and its related nastiness (the queues outside Northern Rock in 2007; the subsequent eurozone crisis). Even if you're living in Greece – where a lengthy depression is a much more recent memory – it's still all part of the same broad crisis.
One thing about big horrible economic events – like big horrible events of any nature – is that they imprint themselves on your mind. That's a survival mechanism. Your mind clings onto this stuff so that you can try to make sure it doesn't happen again, or that if it does, you're prepared. As a result, when you see another big horrible economic event, you tend to compare the two. So 2008 and its consequences can't help but have an outsize influence over how we perceive the current slump.
We see exactly the same thing from people whose formative years were during the rampant inflation of the 1970s. Even as interest rates and inflation began their secular decline in the early 1980s, a damaging inflationary spike was always just around the corner for many people.
Like many of our survival instincts, honed over millennia of evolution, this one becomes a problem when it comes to dealing with the abstract financial world, because not every financial crisis is the same. And usually, you don't get two of the same ones in a row, partly because the solutions to the first often in some way trigger the next.
This is relevant to today. I still see a lot of people marvelling at the idea that we might expect a big rebound once vaccines get out there and economies re-open. Even if they don't realise it, this is at least partly because they're being influenced by their memories of the 2008 collapse. That took ages to recover from (if we ever did). And in many ways this collapse was worse. So how would we recover quickly from this one?
This is important. Investing for a world that will take another decade to get back to its feet is very different to investing for one that might rebound by the end of next year. Particularly when you take account of the fact that even more money has been printed during this crisis than was printed post-2008. So why are we more likely to bounce back a lot faster from the Covid crisis than we did from 2008? You can sum it up in a word: banks.
There are two main types of economic crisis
In his latest Klement on Investing newsletter, Joachim Klement highlights a paper from a couple of European Central Bank researchers, Natalia Martin Fuentes and Isabella Moder, called “The scarring effects of past crises on the global economy”. The pair looked at what you could split into two broad types of economic crisis. One you might want to categorise as geopolitical crises: previous epidemics, major wars, and also the 1973-1974 oil embargo of Western countries by oil cartel Opec. The other category is financial crises: economic collapses caused by the banking system being bankrupt.
Obviously, there's a lot of variation within these categories. Some geopolitical crises are much worse than others (most past epidemics have been more localised than this one), while banking crises vary in scale too. But, to cut a long story short, when geopolitical disaster hits, the economy takes a smack in the face and falls to the ground hard. However, it then jumps back to its feet, shakes itself down, and gets back to work. In other words, the economy bounces back quickly, and there tend to be “no longer-lasting scarring effects”.
A financial crisis is very different. A financial crisis is more like a debilitating illness (forgive the metaphor). You go to bed wiped out. You lie there for a day. You feel a bit better. You get up and do some work for an hour. You're wiped out. You go back to bed. Three weeks later you're still repeating the same cycle. As the researchers note, “financial crises are associated with a very persistent downward shift in potential output. The results for past financial crises... suggest a loss of around 5% even after eight years.” So the economy doesn't bounce back. If anything, it remains permanently weakened (there are “long-lasting scarring effects on the level of potential output”.)
None of this is new, by the way. We've known all of this for a long time (since before the last financial crisis, in fact). It takes longer to recover from financial crises because they are created by the build-up of imbalances over a long period of time. Your banking system topples over because there's too much debt in all the wrong places, and it's very hard to reconfigure and recover from that quickly. The banks end up sucking up all the spare capital and there's not much left for everyone else.
The exogenous shocks (ie ones that emanate from outside) are much quicker to recover from. They happen, they do their damage, and then they go away, at which point everything bounces back. Covid has been extraordinarily damaging, but it will go away. It is going away. It will change some things, yes. But some of those changes might even make us more productive. There's greater use of digital technology – never mind the paperless office, we now have the office-less office. Much more importantly, we've also accelerated medicine development to an incredible extent – that surely has to have a beneficial knock-on impact in future.
Meanwhile, governments have gone further than ever before to cushion the impact of his particular exogenous shock. Again, to be clear, that isn't to say that it's been sunshine and roses for us all – it hasn't. And it isn't to say that their handling has been perfect – it certainly hasn't. But we're talking “big picture”, “relative-to-history” here, which is the right perspective to use if you're wondering what all this is going to mean for the economy in the longer run. So – don't expect a repeat of 2008. Expect a quick recovery. And invest accordingly.
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