How harmful is Covid-19 for long-term growth ?

Economic opinion

The shock of the pandemic to European economic growth was the biggest since the Second World War. The wealth that was lost as a result will probably not be fully recovered even after the recovery. However, whether the pandemic will also have an impact on long-term growth remains uncertain. Indeed, all three components of potential growth - the labour supply, the capital stock and total factor productivity - may be permanently impacted. A crucial factor, both from a human and physical point of view, is the total duration of the pandemic and the associated health measures. The shorter the period of disruption, the more likely it is that the Covid-19 pandemic will not have a detrimental effect on potential growth. The government’s continued support measures also contribute to this. The acceleration of digitalisation, among other factors, may even raise the long-term growth potential.   

The Covid-19 pandemic caused the sharpest economic contraction in many economies since the Second World War. Especially thanks to the start of vaccination campaigns, the likelihood that the pandemic will be a temporary shock has increased significantly. Attention will then gradually shift from the question of how the economy can survive and recover to how many scars will remain in the long term.

Short versus long term 

It is important to make a distinction between the short term, the period in which the pandemic measures are in force, and the period thereafter, when normal economic dynamics can resume without hindrance. In the short term, the question is how large the so-called output gap, the difference between the actual and sustainable output of the economy, is at present. This estimate gives an idea of the magnitude of the required fiscal policy stimulus. Is it modest (as is probably the case in the euro area), or on the contrary, very abundant (as is probably the case in the US) ?

On the other hand, the debate about the actual output gap, and hence about potential GDP, is to some extent an abstract one. Indeed, it is not unambiguous whether the drop in economic activity due to the pandemic measures is the result of a negative supply or demand shock (or both). There is something to be said for both interpretations. Even a glance at the evolution of inflation so far does not provide a conclusive answer, as the pandemic caused a statistical distortion of the reported inflation figures. Paul Krugman, for example, argues on this basis that the concept of the output gap, and hence potential GDP, is temporarily a useless concept as long as economic growth is affected by restrictive pandemic measures.

Impact on long-term growth

When the pandemic is over, the concept of potential growth becomes meaningful again. The wealth lost due to the pandemic may not be fully recovered. For example, the increased unemployment rate and the under-utilisation of capacity of capital goods resulted in an irrecoverable deadweight loss in terms of cumulative real GDP. However, the impact of the pandemic on the level and growth rate of future annual GDP is uncertain.

The pandemic may have a lasting impact on potential growth through its three components: labour supply, capital stock and total factor productivity. The duration of the pandemic is crucial in this respect, as are the support measures taken by governments. For example, an analysis by Bodnar et al. (ECB Economic Bulletin 7/2020) points to the risk that, the longer the pandemic lasts, the more rapidly temporary unemployment could be transformed into structural unemployment (the danger of “hysteresis”). According to this study, the risk of such a “hysteresis” effect is even higher than during the financial crisis as a larger number of sectors are now affected by the pandemic measures. Moreover, the pandemic may also have a negative impact on the participation rate of the working age population. Indeed, there is a risk that the unemployed may be discouraged to such an extent that they permanently withdraw from the labour force.

Regarding the second component, the capital stock, the main risk is that the investment shortfall during the pandemic would lead to a permanently lower growth path of the capital stock and, through that channel, to a slower potential growth of the whole economy. Again, the duration of the pandemic, and the uncertainty associated with it, plays a crucial role in investment decisions. On the other hand, slower private investment growth in the coming years will be partly compensated by higher public investment, including under the Next Generation EU programme. However, the impact of this is very heterogeneous across countries. 

Finally, there is an unclear net impact of the pandemic on total factor productivity. That impact may be negative if the pandemic reinforces the already existing trend towards increased protectionism and deglobalisation. Permanently disrupted international production chains would hamper the efficient international allocation of production factors and thus lead to lower productivity growth. On the other hand, there are also possible positive indirect effects of the pandemic on productivity growth. Accelerated digitalisation is one example. The upcoming wave of public investment can also contribute positively, especially when it comes to infrastructure investment. Investments leading to higher energy efficiency could also significantly boost productivity and thus potential growth over time.

It is impossible to quantify all these future effects. In an attempt to find some reference points, Fuentes et al. (ECB Economic Bulletin 8/2020) make a comparison with the economic impact of past shocks, in particular past epidemics, the oil shocks of the 1970s, wars and financial crises. Using data from 117 countries for the period 1970-2017, the authors conclude that past epidemics, oil price shocks and wars had little long-term impact on potential growth, unlike financial crises, in which the impact on investment and the capital stock was greater. That conclusion suggests that the long-term impact of the Covid-19 pandemic depends largely on its impact on investment growth.

The results of a December 2020 survey by CEPR indicate that the expected impact is limited. Two-thirds of European panel members expected potential GDP growth in 2025 to be unaffected by the pandemic. 81% expected no change or at most a decrease of 0.5 percentage points.   

Many policymakers are taking the same wait-and-see approach for the time being. The US central bank’s policy committee, for example, marginally lowered its forecast for the long-term growth rate of the US economy from 1.9% to 1.8%. ECB chief economist Lane also indicated that he expects a limited long-term impact (FT, 16 March 2021). He emphasised the unique nature of the pandemic, which he said is different from the financial crisis. With sufficient policy support, Lane believes long-term economic damage can be contained.

Finally, the European Commission’s latest Ageing Report of November 2020 also makes the implicit assumption that the pandemic will not leave any economic traces in the longer term. Potential growth in the euro area will decline over the next decade, but this will be due, according to the report, to the decline in the working-age population. This message is important. Europe’s ageing population will continue to weigh on its economic growth potential in the years ahead, perhaps even more so than the effects of the pandemic.  

Disclaimer:

Any opinion expressed in this KBC Economic Opinions represents the personal opinion by the author(s). Neither the degree to which the hypotheses, risks and forecasts contained in this report reflect market expectations, nor their effective chances of realisation can be guaranteed. Any forecasts are indicative. The information contained in this publication is general in nature and for information purposes only. It may not be considered as investment advice. Sustainability is part of the overall business strategy of KBC Group NV (see https://www.kbc.com/en/corporate-sustainability.html). We take this strategy into account when choosing topics for our publications, but a thorough analysis of economic and financial developments requires discussing a wider variety of topics. This publication cannot be considered as ‘investment research’ as described in the law and regulations concerning the markets for financial instruments. Any transfer, distribution or reproduction in any form or means of information is prohibited without the express prior written consent of KBC Group NV. KBC cannot be held responsible for the accuracy or completeness of this information.

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