Having started the last external editing pass of my manuscript on recessions, I am now faced with a possibility that I feared: to make the text go beyond events. I divided my text into two parts, and the first part mainly covered post-Keynesian theory, which is resolutely focused on explanations of demand-side recessions. Meanwhile, the coronavirus gives us an example of a supply-driven recession …
To be fair to myself, I had a text that covered such possibilities, and I just added a text that noted that the pandemic was developing at the end of the writing. However, it is somewhat embarrassing that I have an upcoming book on the causes of recessions, and very little coverage of the causes of a recession that could possibly strike almost simultaneously with the publication of the book.
(Note: I am taking a detached view of the effects of the coronavirus spreading here. I have a natural pessimistic tendency, and therefore I could very easily run away with scary stories. There are already other people who panic, so I don’t add much value if I get on this train too.)
From a theoretical point of view, the slowdown in China (the extent of which is still unknown) seems somewhat similar to the story of a real economic cycle model (RBC): growth simply stops because of ‘a “random shock” that hits production (“the supply side of the economy”). And since most dynamic stochastic general equilibrium (DSGE) models have an RBC kernel, they behave in the same way. The reason why I haven’t written a lot about such a possibility is that I pushed the RBC models to the second volume, which is only partially written. To what extent the coronavirus causes a recession, the natural place to discuss it is in this context.
The problem with the history of RBC is simple: the mechanism of the model is a decrease in productivity. In other words, less production for the same number of hours worked. However, this is not what happened in China: production fell because an external factor imposed a strong constraint on the hours worked (the workers are in quarantine). There is absolutely no way to pretend that the decline in working hours is the result of optimizing workers’ decisions regarding their lifetime consumption plans: either they are not allowed to work, or they wish to skip work for fear of being infected.
The effects outside of China depend very much on the rate of growth of infections – a subject on which I have no expertise. However, although we are optimistic about the spread of the virus, there is the possibility of production disruption due to the lack of necessary inputs, given China’s central importance in global supply chains. This mechanism could be considered as a decrease in productivity. Nevertheless, we are faced with the reality all the aggregated macro model offers almost no useful tool for analyzing this scenario, nor any useful forecasting capacity. (Update: the previous sentence caused some dismay online. I have adjusted it to be clearer, although it is still equivalent to my original wording. There is a big step between discussing RBC models and the rejection of all aggregated models, and it was not covered here As I just wrote a 58,000 word manuscript where variations of this text appeared several times, it seemed obvious to me when I wrote it.)
The other thing to keep in mind is that the raw effects of the virus only provide the initial boost for reduced production. Unless the death toll is catastrophic, production is expected to rebound. The problem is that any slowdown would cause new problems. For example, a reduction in risk taking could cause weak borrowers to fail, leading to spillover effects. At this point, we return to the demand side narrative of the recession.
(c) Brian Romanchuk 2020
