Economic resilience in uncertain times

Chiara Oldani, professor of economics, University of Viterbo ‘La Tuscia’ calls for fiscal pragmatism at a time when extraordinary circumstances demand an extraordinary response

This year started under very complex auspices, and since then major global risks have rapidly grown.

Similar to the Black Plague that spread from China to Europe in the 14th century, the COVID-19 virus first hit Asian and then European countries, and its long-term economic and financial effects remain largely unknown. Suddenly, the health status of populations around the world became the first source of financial risk.

Since the 2008 financial and economic crisis, most countries have been working to strengthen the monitoring and surveillance of banking and financial systems and increase their resilience. But unknown risks are still unknown. Traditional banking models cannot manage the consequences of epidemiologic events of such strength.

According to macroeconomic data on European and Asian countries, consumption, investment and trade had been rapidly hit by the reduction of personal mobility imposed by governments. The severe decrease in aggregate demand can present a danger to the economic stability of the euro area. Most macroeconomic forecasts expected unemployment rates to rise in the second half of 2020. The lack of coordination in the response by European countries to reduce contagion can fuel moral hazard among countries with respect to their budget limits. Countries with high levels of contagion of COVID-19 could form a coalition against countries with low levels and bargain for substantial changes to budget limits and austerity measures. Such changes would speed up the disruption in the European Union.

Keep calm, stay home

The mantra to ‘keep calm and stay home’ created certain conditions for panic on financial markets, which forced the US Federal Reserve to cut interest rates on 3 March 2020. Volatility in financial markets spiked and oil prices fell substantially. Losses in equity prices were the result of shrinking demand and slowing supply. In times of crisis, the banking system suffers because of reduced liquidity and increasing volatility – and it is likely that European countries will be forced to intervene to sustain the traditional banking system and, indirectly, to help the digital banking and finance systems avoid a meltdown. The European Central Bank, now guided by Christine Lagarde, has undertaken exceptional measures to sustain markets, liquidity and rates. The ‘general escape clause’ in the EU fiscal framework, approved by the European Commission, allows countries to manage exceptional healthcare spending, and the recovery fund will help finance their growing debts.

The long-term impact of COVID-19 on elderly populations and small firms in Europe and in Japan and beyond remains unknown. Although the spread of the virus will push up healthcare spending, higher mortality could reduce the burden on public pension systems. The net effects on public debt are not fully apparent. The freezing of consumption and production will hit small firms more than medium-sized and large ones, which can ask for public aid and layoff earnings, and can survive a shutdown lasting many weeks.

G7 leaders should consider implementing coordinated extraordinary policies to sustain aggregate demand, reduce market volatility and increase the resilience of ‘sick’ economies. Sick economies face increased public spending (to sustain banks, households and firms), and their resilience will depend on stable revenues to finance such expenditures. Global tax principles for digital firms are needed to create fair productive conditions and sustain aggregate demand – according to the Organisation for Economic Co-operation and Development, $240 billion in taxes is lost annually because of tax arbitrage by global digital firms. It is time for fiscal pragmatism.