COVID-19: The Black Swan Event of 2020
Faced with the Coronavirus pandemic that has spread around the globe, it is clear that the world economy has now entered a recession. But what exactly is a recession? Why do they happen? And how long will it take for global economies to return to pre-COVID 19 levels?
A recession is a significant decline in economic activity that lasts for months or even years. Experts declare a recession when a nation’s economy experiences negative gross domestic product (GDP), rising levels of unemployment, falling retail sales, and contracting measures of income and manufacturing for an extended period of time. Generally speaking, a recession is generally defined as two or more consecutive quarters of decline in real GDP.
The Business Cycle
Recessions are considered an unavoidable part of the business cycle. The business cycle is the downward and upward movements (“boom and bust”) of gross domestic product around its long-term growth trend and is typically divided into four stages:
Stage 1: Peak
At its peak, the economy is running at full steam. Employment is at or near maximum levels, real gross domestic product (GDP) is growing at a healthy rate, and incomes are rising. All this positive economic activity is reflected in stock prices, with share prices for many companies and industries rising to all-time highs. To show their gratitude to shareholders for their continued support and investment, companies may increase dividend pay-outs. Confidence is sky-high, and investors are bullish.
Less encouragingly, prices tend to be rising due to inflation. Even so, most businesses, workers, and investors are enjoying the boom times.
Stage 2: Recession
The adage of "what goes up must come down" applies perfectly here. After experiencing a great deal of growth and success, income and employment begin to decline due to a myriad of factors. It could be an external event that triggers the downturn, such as a pandemic, a trade war, or a supply shock. It could also be caused by a sudden correction in overheated asset prices, or a reduction in consumer spending due to inflation, which in turn can lead firms to lay off employees.
During a recession, stock prices typically fall. The markets can be volatile with share prices experiencing wild swings. Investors react quickly to any hint of news—either good or bad—and the flight to safety can cause some investors to pull their money out of the stock market entirely.
Because wages and prices are inelastic, or initially resistant to change, cutting payrolls is a common response in a recession. Rising unemployment pushes consumer spending down even further, setting off a vicious cycle of economic contraction. As aforementioned, a recession is generally defined as two or more consecutive quarters of decline in real GDP.
Stage 3: Trough
The trough is the part of the business cycle when output and employment bottom out before they begin to rise again. At this point, spending and investment have cooled down significantly, pushing down prices and wages.
Troughs can be challenging to pinpoint while they are happening, but they are recognizable in hindsight. Troughs are the point where business activity moves from contraction to recovery. A sign that the trough has occurred—or is about to occur—is when stock prices begin to rally after a significant decline. This rebalancing of the economy makes new purchases attractive to consumers, and new investments (in the form of labour and assets) attractive to firms.
Stage 4: Recovery and Expansion
During a recovery or expansion, the economy begins to grow again. As consumers spend more, firms increase their production, often leading them to hire more workers. Competition for labour emerges, pushing up wages and putting more money in the pockets of workers and consumers. That allows firms to charge more for products, sparking inflation that starts low and slow but may eventually bring growth to a halt and start the cycle over again if it rises too high. Over the long-term, however, most economies tend to grow, with each peak reaching a higher high than the last.
How severe will the 2020 recession be?
Initial predictions as to the severity of the 2020 recession are extremely concerning. Chancellor Rishi Sunak has warned that the U.K. is facing a “severe recession, the likes of which we haven’t seen.” In fact, the International Monetary Fund (IMF) estimates that the global economy will shrink by three per cent this year. This would make this year’s recession worse than the great recession of 2008. The primary cause of the great recession was the credit crunch (2007-08) where the global banking system became short of funds, leading to a decline in confidence and a decline in bank lending.
However, some economists believe that while the economy may suffer a sharper downturn this time around, the effects will not be felt for as long as those following the 2008 crisis. Morgan Stanley’s Chief Economist, Chetan Ahya, argues that the economy is “bottoming out,” and that the length of the recession will be much shorter than anticipated. He writes that "the trigger for this recession is an exogenous shock in the form of a public health crisis, rather than the classic, endogenous adjustment triggered by rising imbalances." It is also important to note that this did not start out as a financial crisis, and the banking system is in better shape today than prior to the 2008 financial crisis.
Given the uncertainty surrounding Covid-19 and the possibility of a second wave of infections, it is difficult to predict how long the recession will last and what methods are best to replenish the economy. A reliable way of controlling Covid-19, such as a vaccine, would help create a strong recovery. But, until a solution is found, there are few remedies available. In the last recession, central banks cut interest rates to support the economy. That meant that people and businesses could borrow more easily and had more to spend. But interest rates are already close to zero in many places, and it may not be possible to cut them much further. Governments around the world are already borrowing huge sums to support their economies through tax cuts and higher public spending - such as furlough schemes, support for businesses, and even direct cash payments to citizens.
But at what cost? Will all that borrowing be fatal to recovery? Have governments found suitable solutions, or just brushed the problems of a recession under the carpet to be dealt with at a later date? What are your thoughts? It would be great to hear your opinion below in the comments section!