What Hat Will We Wear During the Crisis?

Rafael Pampillón, Director of Economic Analysis at IE Business School

The stock and real-estate markets are experiencing a strong correction that will have various consequences. First, the poverty effect will drive down household consumption, especially of durable goods. Second, the loss of asset value will make it harder for companies to secure financing. Third, as a consequence of the aforementioned factors, business owners will become significantly less confident of their ability to turn a profit and will consequently scale back investments.

This contraction of the demand for consumption and investment, in tandem with a sharp drop in oil prices, will lead to a considerable decrease in inflation and economic growth worldwide over the coming months.

The worst possible scenario?

Is this a “black hat” scenario? In the olden days of the United Kingdom, if a judge wore a black hat, it traditionally meant that the accused was going to receive a death sentence. In these times of unease and uncertainty, it may be worthwhile to visualize approaches that highlight the threats hanging over the world economy, but also the strengths that play into the economic prospects for the remainder of the year. This is the only way to figure out what hat the judge will be wearing.

In the short term, until contagion slows down and a vaccine is approved, consumers and business owners will be facing high levels of uncertainty. Experience shows that once panic takes hold, a certain amount of time must pass before people change their behavior and the trend can be reversed.

Some degree of economic recovery can therefore be expected in the medium term. The catalysts driving the change of trend will be, first of all, a decrease in the number of infections over the coming weeks or months; secondly, a decrease in asset prices to levels indicating an economic recession; and thirdly, a decrease in attention paid to news about COVID-19, as tends to happen in all crises driven by natural causes.

What can the authorities do?

First, the solution to the current crisis must involve aggregate supply-side policies: relaxing labor regulations, encouraging remote work, promoting the fourth industrial revolution, opening up international trade, etc. In parallel, it will be necessary to apply expansionary monetary and fiscal policies: increasing credit, postponing tax deadlines for companies affected by the crisis, and increasing public investment in infrastructure and renewable energy sources.

In short, if we adopt the right economic policy measures, it seems likely that towards the end of this year, the judge will not be wearing a black hat after all. Episodes of uncertainty will wane, markets will recover, the global economy will be growing enough to bring unemployment down, and millions of people will continue to emerge from poverty. Never say that things were always better in the past. The future will be better.