When statisticians set the record straight, we fall into step

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Senior Fellow - Economy

By publishing on March 26, 2020 in the midst of the Covid-19 epidemic, an economic assessment based on an instantaneous estimate of the economic cost of confinement in France, the French National Institute of Statistics and Economic Studies (INSEE) sets the record straight: the value added generated by the economy would be 35% lower than in a normal situation.

Well done, INSEE!

This initiative is to be welcomed, and the courage shown by INSEE statisticians and economists acknowledged: they have published an estimate based on a large amount of data, though they lacked the data they would normally use to quantify production. As this estimate may be revised upwards or downwards in the coming weeks and months, INSEE may face criticism for being either alarmist or timid. Yet it seems to me that taking this risk, crunching the numbers and publishing it is a proof that, in the midst of the turmoil, INSEE is fulfilling its public service mission in providing information, whether it is to inform the general public or decision-makers. To my knowledge, no other government statistical office in the world has taken this risk.

Having paid this tribute, economists still have to get back to work to try to map out the trajectory of the French economy over the quarters, using a range of economic scenarios. As Jean-Luc Tavernier, General Director of INSEE, points out, the impact on growth will depend on the length of the lockdown. I would add that it will also crucially depend on the management of the end of the lockdown. There is a considerable difference between a well-managed exit that minimises the risks of an epidemic relapse, and a hazardous exit leading to another lockdown combined to a business downturn and a loss of confidence of economic actors.

Two strategies: mitigation or containment...

There is a considerable difference between a well-managed exit that minimises the risks of an epidemic relapse, and a hazardous exit leading to another lockdown combined to a business downturn and a loss of confidence of economic actors.

Before trying to quantify the worst and best case scenarios, let us consider the health strategies implemented in France and in countries with a similar level of development. The report submitted to the British government on March 16, 2020, by a team from Imperial College London led by epidemiologist Neil Ferguson, attempted to compute the cost in terms of human lives (rather than the economic cost, which also translates into human lives lost, but in the future) in two polar cases: a strategy to contain the virus ("suppression") through drastic containment measures, and an alleviation strategy ("mitigation"). The report's findings reveal that demand for intensive care hospitalization would exceed eight times the country's capacity, even with an optimized mitigation strategy. This led Prime Minister Boris Johnson to make a sharp shift to a containment strategy through an extended lockdown.

… that both depend on countries’ degree of preparedness

As the British case eloquently demonstrates, the debate over the best strategies for controlling Covid-19 infection was virtually decided by the means available to each state in terms of testing capacity and emergency care, particularly ventilators. Governments wise enough either to have built up enough stocks in anticipation of a pandemic or to ensure sufficient production capacity, were able to use the mitigation strategy. Indeed, this strategy allowed to limit both the immediate cost in human lives and the economic cost, and thus the loss of human lives in the future. To varying degrees and with national specificities, South Korea, Taiwan, Japan, Germany and Switzerland have been able to choose this option. On the other hand, Italy, Spain, France and the United Kingdom had no other choice but to impose lockdowns, as the high economic cost seems trivial compared to the humanitarian disaster that would result from a "soft" strategy.

90% to 4% decrease in activity, depending on the sector

INSEE estimates are a direct result of the quarantine observed over the past two weeks, and the changes in behaviour that it has triggered. Using a variety of sources - companies themselves, administrations, the French CB Bank card Group and many others - the Institute has estimated that the loss of activity would range from 90% in the construction sector to 50% in industry and only 4% in agriculture and the food-processing industries.

The biggest blow to the country's economy would be a 36% drop in marketable services, which generate 56% of the country's GDP. The shock is therefore very severe, at least twice as great as the Chinese figures suggested (a 15% to 20% drop in GDP in January-February). At first glance, the shock should be of the same magnitude in Italy, Spain and the United Kingdom. It is not certain that it will be much less in Germany, where industry was already affected by the fall in Chinese imports and world trade in general. The final impact will obviously depend on the duration of the lockdown, but also on the exit strategy. To shed light on this, we have built two very different scenarios: in V or W/L, depending on the type of recovery.

The final impact will obviously depend on the duration of the lockdown, but also on the exit strategy. To shed light on this, we have built two very different scenarios: in V or W/L, depending on the type of recovery.

The best-case scenario: a safe exit, a V-shaped recovery with a 10% drop in GDP this year followed by a strong rebound in 2021

Based on INSEE estimates, assuming that the lockdown would last two months and that a gradual but uninterrupted recovery would ensue, in parallel with other European countries - and benefiting from China's recovery, which is slightly ahead of time - we nevertheless reach an annual decline in GDP of more than 10% in 2020, followed by a powerful rebound in 2020 (+12%), which would allow GDP to return to its pre-crisis level by mid-2021. This is clearly an optimistic scenario, in which the excess savings accumulated during the period of quarantine would be partly spent, the damage suffered by businesses would be limited enough for investment projects that had been postponed to restart, and where a good synchronicity of European recoveries would ensure robust external demand for each of them.

The budget deficit would reach 10% of GDP or more, primarily due to the fall in tax revenues, VAT above all: in its estimates, INSEE considers that the level of consumption during the lockdown would also be 35% lower than normal. A necessary condition for this optimistic scenario to unfold is that fiscal policies do not seek to make up for the shortfalls caused by the crisis through spending cuts or tax increases.

Quand l’Insee remet les pendules à l’heure, on s’aligne - Graphique scénario en V

Financing deficits should not be a problem in 2020, since the ECB has put in place an ambitious bond purchase programme, the PEPP¹ -at least €750bn, which should be close to the increase in the monetary union’s deficits this year- without major constraints, since the self-imposed rule of a 33% holding threshold for a particular asset is lifted for this new purchase programme. The situation could be different in 2021, if the Eurozone countries were unable to agree on a collective financing of their efforts to combat the epidemic.

The worst-case scenario: exit followed by a relapse, a L/W profile with a risk of fateful social and political consequences

If the conditions for a smooth exit from the lockdown were not met, an epidemic relapse would be likely. In that case, there is a risk that authorities may initially prevaricate, due to a lack of available information (the virus seems to have a fairly slow mutation time, but it mutates all the same), before resorting to re-impose a total or partial quarantine. For the country's economy, this would constitute a disastrous scenario. The beginning of the recovery would be aborted, and bankruptcies would multiply despite all the measures taken to prevent them, as banks would not afford to extend credit lines ad libitum.

Larger companies deemed necessary for the security of the country or to maintain employment — transport or car industry for instance — could be nationalized, but this would hardly change the overall picture. We have simulated a weak recovery from quarantine, followed by a relapse and then weak growth, restrained by the damage done to business and the sharp rise in unemployment. To set the scene, GDP would fall by 16% in 2020, by a further 2% in 2021, and even if growth were to resume thereafter, the level of activity at the end of 2022 would still be 15% lower than at the beginning of the crisis, suggesting an unemployment rate of around 20%, an level unprecedented since the 1929 crisis. To close the employment deficit, real wages would in theory have to fall significantly, which is unlikely to happen in the absence of inflation. The government would most likely attempt a large-scale stimulus plan, which would obviously raise the question of how it would be funded by the financial markets.

Quand l’Insee remet les pendules à l’heure, on s’aligne - Graphique scénario en LW

No need to go any further to understand that, in such circumstances, the political and social fabric of the country and of Europe would be shaken. Faced with abysmal budget deficits in the countries of the South, devaluation would appear to be the only way out, because if saving Greece, or lending to Spain, Portugal and Ireland collectively were possible in 2012, the amounts at stake, if France, Italy and Spain were financially desperate, would exceed the credit capacity of savers in the North, and even the ECB's absorption capacity.

Hamiltonian Moment, or the bursting of the euro?

Supporters of a federalisation of the European Union, or of the Eurozone, believe that the crisis could offer the "Hamiltonian moment" they have long dreamed of. Alexander Hamilton was indeed the first Secretary of the Treasury of the young federation of American states fighting for their independence, who decided to take over the debts of the newly federated states in 1790. History may well prove them right, but it is equally possible that the euro will pay the price for the disaster, so as to give the affected countries some flexibility.

____

Of this scenario, which was deliberately darkened, just as the best-case scenario was deliberately brightened so as to have two extreme scenarios, we can say only one thing: it must be avoided at all costs. If tightening the lockdown, or extending it becomes imperative to ensure a smooth exit, if helping our neighbours not to sink into it at the risk of deepening deficits becomes necessary, it will all be worth it, even if the economic cost proves to be much higher than in the best-case scenario.

¹Pandemic Emergency Purchase Program. See press release dated 18 March

Copyright: VALERY HACHE / AFP