Sounding for the bottom

Kim Byun-yeon
The author is an economics professor of Seoul National University.

How big will the economic fallout be from the coronavirus (Covid-19) pandemic? Ben Bernanke, who chaired the Federal Reserve from 2006 to 2014 and oversaw the 2008 financial meltdown, prophesied a V-shaped cycle in the U.S. economy — slipping into a sharp recession and rebounding “fairly quick.” Others project a more stalled U-shaped recession in which the economy stays at the bottom for a longer period. Some predict the worst-case scenario of an L-shaped recession where recovery won’t happen for a very long time.

History offers useful tips from past crises. Over the last century, the world saw several critical points — the Spanish flu pandemic from 1918 to 1920, the Great Depression from 1929 to 1939, two oil crises from the 1970s to 1980s, and the financial meltdown in 2008. There were regional crises too: a recession in the socialist bloc in the early 1990s after the collapse of the Soviet Union and the 1997-1998 Asian financial crisis.

An L-shaped recession, the most feared, is an unlikely scenario. Major policy failures and flaws in economic systems can cause such a serious downturn. The Great Depression is the best example. The United States worsened the disaster by raising interest rates when it should have done all it could to boost aggregate demand. Other countries could not adopt loose monetary policies as they could not decouple from the United States. The global economy finally got out of the recession after policymakers took advice from British economist John Maynard Keynes to boost the aggregate demand —not the classical theory of supply and demand — to drive economic output and implement deficit spending to smooth business cycles. The transition naturally took time. So did the regime changes in the socialist bloc. The transition to capitalism and policy flip-flops caused a whopping 40 percent plunge in Russia’s national income over eight years from 1990.

But the Covid-19 disaster does not stem from systematic problems. Economic experts know what tools to use on different types of shocks. Therefore, the fallout from the pandemic won’t likely lead up to an L-shaped recession, where the global economy contracts for at least four years and shrivels by more than 15 percent.

A V-shaped turnaround is the best scenario. Bernanke observes that the steep fall is caused by the suspension of business and economic activities to contain the spread. It is like intentionally shutting off the electricity to prevent a fire. Once the power is back on, things can return to normal.

A U-shaped recession often results from a serious financial crisis or confusion during industrial transitions. The Asian crisis and global financial meltdown are such cases. A financial sector that made money by selling derivatives backed by subprime mortgages — and the corporate sector that expanded through debt financing — needed some time to change their risky practices. The fallout from oil disasters lasted longer as industries had to become more energy-saving. If the coronavirus impact spills over to the financial sector, a U-shaped recession may be inevitable.

Whether the global economy will go into a V-shaped or U-shaped curve depends on the battle with the virus. If companies in America and Europe can return to normal business within the next three to four months, a quick rebound is possible — as long as companies and financial institutions can hold tough for the duration on government support. If a business shutdown lasts longer, governments could run out of capital to sustain them. If the economy sinks and a credit crunch aggravates the crisis, we are headed for a U-shaped recession. Think of it this way: If the circuits are destroyed, the machine cannot run even after the juice is turned back on.

The government should be speedy and bold to sustain corporate and household viability. At the same time, it must prepare for a longer stagnation because it is not enough for the government to hold off a shock. It should capitalize on available resources from the private sector. It must bring out surplus capital by offering incentives and creating a state fund to draw donations from the private sector with an offer of 50 percent tax deductions. At the same time, the number of confirmed patients must come down through reinforced social distancing. The faster we return to normal lives, the faster the recovery will be. As quarantine is the best economic policy for now, practicing social distancing will be the best way to protect our society and economy.