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All set for a fast recovery after the ‘Great Lockdown’

Summary:
In 2005, Hurricane Katrina hit New Orleans in the US state of Louisiana. The hurricane caused enormous material destruction and about 2,000 people perished. While Katrina obviously cannot be compared to Covid19 in terms material devastation and death it nonetheless is comparable in terms of the sudden the “shutdown” of the economy. Katrina was a very clear case of a supply shock. Production facilities were simply shut down. And in the same way as today, it happened from one day to the next. But nothing really had happened to the fundamentals of the economy – this to a large extent is also the case in terms of the Covid19 around the world. Katrina was a huge, but very short-lived economic shock If we look at how things were going for Louisiana’s economy in 2005-6, then you will see that

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In 2005, Hurricane Katrina hit New Orleans in the US state of Louisiana. The hurricane caused enormous material destruction and about 2,000 people perished.

While Katrina obviously cannot be compared to Covid19 in terms material devastation and death it nonetheless is comparable in terms of the sudden the “shutdown” of the economy.

Katrina was a very clear case of a supply shock. Production facilities were simply shut down. And in the same way as today, it happened from one day to the next.

But nothing really had happened to the fundamentals of the economy – this to a large extent is also the case in terms of the Covid19 around the world.

Katrina was a huge, but very short-lived economic shock

If we look at how things were going for Louisiana’s economy in 2005-6, then you will see that in economic terms, it was a huge negative shock, but the shock was also very short-lived.

We can see that by looking at various indicators of the labor market.

Recently, there has been a lot of focus on US initial jobless claims figures, which have spiked in recent weeks and US unemployment is like to soon hit double digit-figures. This clearly is deeply worrying, but if we look at what we saw in Louisiana in 2005 it might be that we should be less concerned for the longer-term consequences.

When the shock (the hurricane) hit, there was a strong spike in initial claims that is very similar to what we have seen recently – both in speed and scale.

But as the graph below shows, it was a very short-lived shock, and after a few weeks, claims began to subside, and after 3-4 months we were back to normal.

All set for a fast recovery after the ‘Great Lockdown’

In this context, we must keep in mind that there was enormous material damage in New Orleans, which greatly affected production in the area affected by the hurricane.

There is no material damage to Covid19. When the lockdowns around the world comes to an end, production can be re-started immediately. Yes, there will of course be a prolonged shock to relative demand for e.g. restaurants and air travel, but it does not change the overall nominal demand in the economy – only the composition of demand. And remember here – nominal demand in the economy is essentially determined by the demand and supply for money. More on that below.

If we look at unemployment in New Orleans, we see that unemployment from one month to another (August to September 2005) rose to more than 15% (more or less what is expected in the US now). But it was a very short-lived shock. 4-5 months later, unemployment had fallen back to the pre-shock level. A similar picture can also be found in employment.

These figures should make you optimistic that the shutdown shock will generally have a very short-term effect on economic activity in the United States – and in the world in general.

So yes, US unemployment is rising sharply right now, but if the lesson from Katrina tells us something, then we should not be surprised if unemployment has dropped back to levels not far from pre-corona levels when Americans vote at the US presidential elections in November.

All set for a fast recovery after the ‘Great Lockdown’

That being said, there is a loss of production and activity in the economy, no matter what, it will take time to recover. So, if we look at the economic activity in Louisiana, it took just over a year to get back to “normal”.

But again, it must be remembered that there was very extensive material damage that made production difficult for many months. We do not have that challenge today.

Therefore, when some claim that it will “take years” to get through the Lockdown crisis, I actually think we have to be a lot more optimistic.

All set for a fast recovery after the ‘Great Lockdown’

The Corona shock is primarily a lockdown shock to the economy – in the same way as Katrina was in Louisiana in 2005. And as soon as we move out of the lockdowns around world economic activity very will quickly pickup and return to pre-crisis levels.

Market economies – when allowed to – adjust very clearly to supply shocks – whether it is a hurricane or a pandemic.

It looks like we will avoid a major demand shock

It should, however, be remembered that for the price system to work well so the economy swiftly adjusts to changes in relative prices (as demand in certain sector maybe more permanently drops – for example tourism, restaurants and major sports events) it is necessary that nominal demand is kept on track. It is primary a task for central banks to ensure this.

I must, however, admit that I was very worried about this in the beginning of this crisis, as inflation expectations (in the bond markets) dropped very sharply both in the US and the euro zone and that financial distress increased sharply.

Fortunately, however, the Federal Reserve (and partly also the ECB) was quick to respond and although US inflation expectations are still a little too low (way below Fed’s 2% inflation target), the situation has largely stabilized.

All set for a fast recovery after the ‘Great Lockdown’

At the same time, major fiscal easing has been adopted in both the US and Europe. So, the risk of a negative demand shock in my opinion now is quite small.

The risk of premature monetary tightening is still there but I believe the risk of that is substantially lower today than in aftermath of the 2008 shock.

Say Law’s and the Fed will ensure a swift recovery

The IMF has dubbed this crisis the Great Lockdown. I think this very well captures the nature of this crisis. It’s primarily a negative supply shock, which at some point also partly looked to developed into a demand shock.

One could illustrate this in a simple AS-AD framework, but I actually think it more fitting to think of this as Say’s Law in action.

John Maynard Keynes formulated Say’s Law to mean that “supply creates its own demand”. Or rather production creates demand.

The Great Lockdown happened because households around the world more or less simultaneously decided to redraw from the labour market – either because of their own voluntary actions or because of government curfews or a combination of these.

In that sense on can also think of this as the first global Real Business Cycle (RBC) recession. But there has always been one problem with RBC models – it is hard to generate year-long recessions in these kinds of models. Recessions are not a result of people of going on vacation – except this time it is actually is. This is an unplanned and partly involuntary “vacation”.

But one can actually question whether this is a recession in the way we normally think about it. Nick Rowe has defined a recession as a situation where there is a general glut (excess supply) of newly-produced goods.

A negative demand shock creates such a general glut, but that is not the case with a negative supply shock – and it not the case with the Great Lockdown.

In the Great Lockdown the problem is not general lack of demand, but lack of production. Changes in relative demand also create problem for certain sector (air travel, restaurants, sport events etc.), but that is not the reason for the crisis – specific sectoral problems is no the reason for the overall decline in economic activity.

Therefore, once we emerge from the “lockdown” phase production­ will pick-up fast and then Say’s Law will take care of demand.

However, as uncertainty might remain heightened for a longer period, we should not rule out that there also will remain a heightened demand for money and safe assets. This could cause money-velocity to decline and push down nominal demand growth.

To avoid this, it is the task of central banks to offset this velocity shock by expanding the money base. Luckily the Federal Reserve seems to have gotten the message and has responded well during this crisis and so far, have succeed in stabilizing market inflation expectations.

The Fed has not done a perfect job, but certainly good enough in my view to ensure that this is not about to turn into a major negative demand shock.

So, in conclusion as long as the Fed keeps nominal demand on track and keep inflation expectations stable then we should expect that Say’s Law will ensure a fast recovery in the US economy (and likely the world economy).

As Hurricane Katrina shows us natural disasters can hit an economy very hard and send economic activity down very sharply and unemployment up extremely quickly, but economic activity also returns fairly quickly.

The imitate contraction in GDP in most countries in the world during this crisis is likely to be larger than during the Great Recession in 2008-9, but duration of the crisis is likely be much shorter – likely months rather than years.

So, let me stick my neck out and give you a forecast on US unemployment – unemployment will rise sharply in April maybe above 15% and is likely to remain elevated in June and July, thereafter unemployment will drop fast and will likely be back to the ‘structural’ level around 5-6% in November. The only conditions I have for this forecast is that the Fed ensures that market inflation expectations does not drop below present levels.

PS I believe that we could best understand the Great Recession by reading Milton Friedman, but to we should rather read F. A. Hayek to understand the mechanism in play during the Great Lockdown – that goes both for his warnings against totalitarianism (“Road to Selfdom“), his opposition to economic planning (The Socialist-calculation debate) and his deep understanding of the The Price System as a Mechanism for Using Knowledge.  2008 was primarily about monetary policy failure – today’s crisis is mostly about regulatory overkill.

Lars Christensen
International economist, Money Doctor, Founder of Markets & Money Advisory, Research Associate Stellenbosch University [email protected] +45 52 50 25 06

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