COVID-19 and the ECB: A Macroeconomic Critique

30 May, 2020

In the 21st century the world has witnessed five pandemics, including H1N1 in 2009, Severe Acute Respiratory Syndrome (SARS) in 2002, and most recently COVID-19. Evidence suggests that the likelihood of pandemics will only continue to increase due to globalization, urbanization, changes in land use, and greater exploitation of the natural environment. These events have fueled discussions around the nature and extent of the accompanying economic contagion and what policy mechanisms are available to mitigate the fallout. Included in this debate is whether central banks, such as the European Central Bank (ECB), should seek to stabilize the economic effects of a pandemic, like COVID-19. Employing detailed macroeconomic analysis, this article endeavors to answer this crucial question.

Understanding the COVID-19 Pandemic’s Economic Effects

Before delving into whether the ECB should seek to stabilize the economic effects of COVID-19, we must first determine what those effects have been and are likely to be moving forward. A pandemic can induce multiple economic shocks with potentially significant consequences. While the full scale of coronavirus’ economic impact remains to be seen, it is clear that the pandemic has caused a major exogenous supply-demand shock that is already having drastic ramifications worldwide.

Supply-Side Shock

Sick workers do not add to a country’s gross domestic product (GDP). This is an example of the medical shocks of a pandemic. As of May 19, 2020, there were over 4.88 million coronavirus cases globally, of which about 2.66 million were still active. The larger impact, however, has stemmed from disrupted global supply chains and economies coming to a standstill as governments enact the containment measures necessary to limit both viral transmission and pressure on healthcare systems. These countermeasures include curfews, lockdowns, quarantines, travel restrictions, and school and business closures. By reducing person-to-person contact and removing infected people from the population, these actions slow the rate of infection and, ultimately, result in a flatter epidemiological curve. Flattening this curve saves lives both directly as fewer people get ill and indirectly as bottlenecks in the healthcare system which typically lead to suboptimal treatment are avoided. These preventative steps also aim to buy time to develop potential treatments and vaccines.

As the COVID-19 pandemic demonstrates, such measures can reduce productive capacity worldwide and lead to contractions in the level of economic output,  household spending, investment, and international trade. School closures, for instance, can temporary amplify the reduction in labor supply as individuals take off time from work to look after children. By one estimate, closing schools for an entire quarter could multiply the GDP impacts of an influenza pandemic in the United Kingdom by a factor of 6. This temporary employment reduction also occurs when people take off to tend to sick relatives.

And while the size of the output contraction resulting from COVID-19 may be attenuated due to digital technology and cloud-based collaborative software and databases, not all tasks can be performed remotely. In fact, the Organization for Economic Co-operation and Development (OECD) predicts that containment measures for the current crisis will cause an initial decline in the level of output of 20% to 25% in many economies. Eurostat revealed that the Eurozone economy contracted by 3.8% in the first quarter of 2020 compared to the final quarter of 2019—resulting in the lowest reading since records began in 1995. Moreover, the COVID-19 pandemic not only originated in the manufacturing heartland (East Asia, particularly China), but has severely hit other industrial giants (Germany, United States). As a consequence, direct supply disruptions have hindered production and led to secondary supply shocks in the manufacturing sectors of a number of less-affected nations.

Demand-Side Shock

Aggregate demand (AD) is comprised of consumer demand for goods and services, demand for investment goods, and government demand for goods and services. This is captured in the equation AD = C + I + G + (X-M), which we can use to further break down the coronavirus’ effects on demand. Since aggregate demand and GDP are calculated utilizing the same metrics, aggregate demand and GDP increase and decrease together.

Consumption (C): Much of our consumption is social in that it involves human interaction (e.g., restaurant, bars, sporting games, travel). COVID-19 has disrupted such economic activity as consumers have stayed home—either as necessitated by containment measures or out of fear of catching the virus. At the same time, even those willing to consume from home are thwarted through disruptions to delivery services and logistics. Some sectors (e.g., retail, manufacturing, accommodation and food services) have been hit particularly hard. Part of this loss can be permanent. For example, you may slightly increase the number of movies you see, meals you eat out at restaurants, and/or haircuts you get once public and private containment measures come to an end to make-up for what you missed while staying home. But overall, your net consumption in these activities will decrease over the year. In addition, as disposable income decreases so does consumption. As individuals become ill, self-isolate, lose jobs, and hesitate to make major purchases, we will, therefore, only continue to see substantial drops in consumption and, ultimately, aggregate demand—unless I + G + (X-M) increase sufficiently to make up for these drops.

Investments (I): Investments are down due to fear and uncertainty. No one knows how long the COVID-19 pandemic will last, or how severe it or the mitigation policies will be. Investors, consequently, have sought out safer assets by both pulling back on existing investments and avoiding making new investments.

Government Spending (G): As we have seen with COVID-19, government spending often increases in a pandemic as governments implement a number of measures to counteract the crisis’ economic, financial, and social impacts. As of April 29, 2020, G20 countries had provided $6.3 trillion in fiscal support, the largest component of which is being directed to finance businesses. Thus far, direct government spending is at higher levels than during the 2008-2009 global financial crisis. While the current support is mostly focused on keeping companies and individuals afloat, there are already discussions of governments implementing infrastructure projects once health restrictions ease to create jobs and stimulate the economy (i.e., through new demand and investments). There is also an increase in government-supported healthcare costs.

Net Imports (X-M): Net imports have, on average, decreased due to the fact that overall economy activity is down. For instance, the European Commission recently published a report detailing the coronavirus’ impact on global and EU trade, which predicted that the COVID-19 crisis will result in a decline of 9.2% in EU exports and 8.8% in EU imports from third countries in 2020.

Ultimately, a negative demand shock shifts the AD curve to the left, depressing output and employment in the short run. Each of these adverse first-round demand shocks are likely to be amplified by worsening financial market conditions. It is also important to note that the demand-side shock caused by a pandemic is both practical and psychological.

Psychological Components

Individual behavior is based upon beliefs, which are subject to cognitive biases. If people feel good about the economy, they tend to spend. The converse is also true. Concerns or uncertainty about the economy tend to result in wait-and-see purchase delays by consumers and investment delays by businesses. Consequently, people can act in such a way that they amplify economic disruptions—particularly if they are ill-informed. People are often acting off of imperfect information. When there is an imbalance of information across participants in a transaction, information asymmetry occurs. As the 2008-2009 financial crisis demonstrated, information asymmetry can lead to the psychological impacts of a shock extending beyond those directly implicated.

In that specific case, while there were a certain number of subprime mortgages, individuals did not know how large the problem was or how many people would default. The fear and uncertainty around this led many people to move to safer assets and reduce their economy activity. The resulting decrease in economy activity, in turn, led to higher unemployment and more defaults, which fed the fear. It became a vicious, downward cycle. A similar pattern can emerge as a reaction to a pandemic. In fact, during the SARS outbreak in 2003, a lack of information did cause a large number of individuals to panic and overact, which the World Bank claims led to the economic costs of the pandemic being needlessly high.

Second-Order Effects

While a pandemic could result in a relatively mild and short-lived recession followed by a V-shaped recovery (as seen during the 2003 SARS pandemic), that does not appear likely in the current crisis. Rather, the consensus is that COVID-19’s economic impact will be multifaceted and have cascading effects, including liquidity and solvency issues. These second-order effects could transform the situation from an acute economic crisis to a prolonged economic downturn. For example, the International Monetary Fund (IMF) anticipates that the COVID-19 pandemic will lead to the worst economic fallout since the Great Depression with the Euro area’s GDP dropping by 7.5% this year.

Faced with this sudden collapse of economic activity, many countries may experience large increases in their nominal sovereign debt burdens. Italy—one of the Member States hit hardest by the coronavirus—has the second highest government debt-to-GDP ratio of any EU country, which at the end of the fourth quarter of 2019 was recorded at 134.8%. The country was also experiencing high unemployment prior to the crisis (about 10% in October 2019), making it further vulnerable to the pandemic’s economic fallout. IMF projections indicate that Italy’s GDP will contract by 9.1% in 2020. The country, however, has increased its coronavirus stimulus spending to €750 billion, or nearly half of its GDP. And while Italy has advocated to share the burden of sovereign debt incurred due to COVID-19 via a mechanism known as “coronabonds,” other Member States have been hesitant.

Longer-Term Outlook & Supply-Demand Doom Loop

Assuming that the supply shock caused by COVID-19 is persistent and severe, we can begin to theorize some other longer-term consequences. According to New-Keynesian thought, employment and output are determined by aggregate demand, which depends on productivity growth. The reason for this is that faster productivity growth boosts expectations of future income and induces individuals to spend more in the present. If the economy is initially at full employment and a pandemic, like COVID-19, causes a persistent drop in productivity growth, lower demand and involuntary unemployment occurs as businesses lose money and start letting people go. As Guido Lorenzoni notes, these developments can negatively impact individuals’ expectations of future productivity and generate a demand-driven recession (see again the psychological effects of a shock).

Productivity growth is driven in part by firms’ investment, which in turn depends on aggregate demand. Weak aggregate demand, as in the case of a pandemic, reduces a firm’s incentive to invest. As mentioned, we have witnessed this in past crises (e.g., 2008-2009 financial crisis) as consumers and firms faced with great uncertainty postponed purchases and delayed investments. As a result of this effect, the relationship between productivity growth and aggregate demand is positive. If a pandemic generates a severe and persistent supply disruption, this could not only result in a major slump driven by weak aggregate demand, but a supply-demand doom loop as lower demand induces firms to cut back on their investments and, ultimately, generates an endogenous drop in productivity growth. This sparks a vicious, downward spiral (i.e., supply-demand doom loop) that can amplify the impact of the initial supply shock on employment and productivity growth.

Should the ECB Intervene?

In order to optimize their efficiency, businesses operate with as little idle capital as possible, increasing their exposure to economic disruptions. When an economic shock occurs and these businesses experience a sudden drop in demand, they start drawing down their credit lines with banks. These credit lines, however, are not usually large enough to absorb the full supply-demand shock caused by a pandemic. Moreover, as previously discussed, the uncertainty surrounding a pandemic can tank investors’ confidence so much so that when companies in need of cash approach debt markets they struggle to find willing lenders. This leads to either companies agreeing to very high interest rates, or the complete breakdown of the credit market (which we have witnessed in the COVID-19 pandemic). This can impact a business’ ability to remain solvent. Without intervention a pandemic can, ultimately, lead to not only mass insolvencies and bankruptcies among households and firms, but involuntary unemployment.

Unemployment has already surged across the European Union amid the COVID-19 pandemic. The International Labor Organization (ILO) predicts that 12 million full-time jobs will be lost in Europe during 2020. Estimates from the consulting firm McKinsey, however, state that up to 59 million jobs are at risk from permanent cutbacks and reductions in pay and hours. In February 2020, the unemployment rate in the Eurozone was 7.3%, the lowest level it had been since March 2008. This rate has since increased as containment measures have been widely introduced. In a worst-case scenario produced by McKinsey, unemployment could peak in 2021 at 11.2% and not return to 2019 levels until 2024. This economic contagion will not only vary across industries and demographic groups, but have the potential to exacerbate existing social inequalities both within and between Member States.

Overall, these forecasts are concerning especially considering how in the aftermath of the 2008-2009 financial crisis, several countries witnessed high numbers of discouraged unemployed workers who left and never re-entered the labor market (a massive waste of resources). A number of companies—particularly within the travel and retail sectors—have also struggled to meet their debt obligations and have entered administration citing dramatic drops in demand linked to the COVID-19 pandemic. Some of these developments are irreversible, meaning that even if there is a rebound later this year, companies cannot suddenly return to their pre-pandemic capacity. Rather, they have to rehire workers, re-implement internal processes, put factories back online, etc.

As one of the two main agents involved in setting economic policy, governments have tried to prevent this from happening, including by subsidizing wages so that employers do not fire employees permanently and passing bills to make loans and/or grants available to struggling businesses. To help support such government action, the European Commission has proposed a temporary new instrument known as the Support to mitigate Unemployment Risks in an Emergency (SURE). Up to €100 billion are available to the wage-subsidy scheme, which offers assistance in the form of loans granted on favorable terms from the EU to affected Member States. These loans are meant to support Member States in addressing sudden increases in public expenditures for the purpose of preserving employment. The Commission is also working on proposal for a permanent European Unemployment Reinsurance scheme to further protect workers from economics shocks.

There are, however, limits to fiscal policy (e.g., bond vigilantes, fiscal rules) that constrain government action. In the EU, these limits include the Stability Growth Pact. And while the European Commission has activated the general escape clause of the Stability and Growth Pact—suspending the zone’s normal debt and deficit limits—in the wake of the current pandemic, that has not changed the fact that executive branch mechanisms are slow and inefficient. The SURE scheme, for example, is not expected to be operational until June 1, 2020. The Commission’s proposal for a permanent unemployment benefit scheme is anticipated to be presented even later this year. Furthermore, fiscal interventions are often not enough on their own. As the other main agent involved in economic policy, central banks can respond immediately when the economy is in free fall. In doing so, they can lower borrowing costs and restore not only some much-needed liquidity, but confidence in the market.

Failing to act can have devastating consequences. This was seen during the Great Depression, where the United States Federal Reserve failed to respond aggressively. It is commonly agreed upon that this lack of an effective and appropriate monetary policy amplified the crisis’ initial shocks and contributed to a downward spiral in economic activity. As a further consequence, a lot of economic output was permanently loss and it took longer for the economy to recover. The resulting depression and soaring unemployment also negatively impacted psychological wellbeing and prevented basic needs from being met. Learning from these mistakes is crucial as we experience the worst economic downturn since the Great Depression.


The COVID-19 pandemic and resulting economic contagion clearly represent a serious threat to not only price stability (the ECB’s primary objective), but financial stability more broadly. To mitigate these negative socio-economic consequences and aid recovery, a quick, sizable, and coordinated response involving both fiscal and monetary interventions is essential. Hence, the ECB should seek to stabilize COVID-19’s economic effects. That being said, they should not deploy unlimited means to protect the economy. Rather, the ECB needs to balance short-term pain with long-term consequences in their actions. We will consider this caveat further in the Part II of this series as we delve deeper into the various interventions available to the ECB and their macroeconomic implications.

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