Covid economic scarring is not inevitable, but it is becoming likelier with a second wave of the virus and “fiscal fatigue” setting in. Central banks are determined to ensure scarring does not materialise, but fiscal decisions matter more. The risk is that politicians, worrying too much about “the long term”, are embracing a deafest attitude that will ultimately be self-fulfilling. Economic scarring is highly likely without an adequate fiscal offset.
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No scarring? – Consensus thinks COVID-19 is a “bump in the road”, with no lasting scarring. GDP stays below where it would have been but gap stays the same. This would be very unlike 2008. After the Global Financial Crisis, the shortfall in activity kept increasing.
Too optimistic – Yet we know most OECD economies are stuck with a serious shortfall in demand. “Reopening” was incomplete.
Scarring can take various forms – weak capital spending could hurt efficiency and undermine long-term growth. Companies have been forced to invest in digital technologies, but this looks “one off”. Traditional forms of capex down substantially across the OECD.
Zombification - Even if policy prevents a “credit event”, corporate zombification could further hurt productivity. The authorities face difficult trade off. Do they support demand, allowing zombification, even if this hurts longer-term efficiency?
People will spend more time unemployed – 1980s showed powerful hysteresis in labour markets. People who have been out of work for long spells lose skills and face discrimination from employers. Recent euro crisis had lasting impact on youth income prospects.
Fiscal policy is the problem: Monetary policy can’t solve this crisis. Only fiscal policy can put money directly into the real economy and target most vulnerable sectors. The risk is that ideology gets in the way. A defeatist attitude to supply damage could make scarring inevitable. Governments need to be flexible. US budgetary outlook looks particularly complicated after divided election result.