The expansion of the coronavirus in several countries is increasing. The combination of restrictive measures, production stoppage and spontaneous consumer panic is paralyzing economic activity. The effects on the world economy could be massive.
Several industries in the north of Italy are closing. This will cause an interruption of production in several plants of the production chain of these companies. The first negative impact to the economy comes from a negative supply shock, resulting from a reduction in the supply of work: people do not go to work anymore and the supply chain slows down. But in a vertically integrated international economy the repercussions between countries and sectors could be strong.
Given its production structure, the Italian economy is particularly fragile in this scenario. In driving sectors such as mechanical manufacturing, tourism or catering, it is impossible to compensate for the reduction in the supply of work and the lower production through smart working.
Even in the high-tech sectors, on the other hand, smart working cannot be a perfect substitute for work based on physical proximity. Here the physical proximity of people is a crucial driving force for innovation and the production of ideas. Over time, the limitation of the moments of aggregation will have a negative effect on productivity, on the efficiency with which capital and labor are combined, amplifying the negative shock on the supply side.
The peculiarity of the coronavirus, however, is in combining a shock on the supply side with an increase in uncertainty. And it is that particular type of uncertainty associated with limited knowledge, such that it is impossible to describe the existing state or future outcomes. The uncertainty paralyzes demand, pushes to postpone consumption and reinforces precautionary savings.
There is much discussion about what responses monetary policy can do to avoid a recession. The scenario, is particularly delicate for central banks, which are almost everywhere close to the zero lower bound.
To understand what constraints the central bank is facing, it is crucial to quantify the supply component compared to the demand component of the shock. A supply shock reduces production and investment, but tends to exert an upward effect on prices. A rise in inflation, paradoxically, makes the zero rate constraint less stringent; because it pushes down real interest rates, let starting an expansionary monetary policy without the central bank having to move nominal rates down.
When nominal rates are stuck at zero, or they are even below zero, demand shocks are problematic, because they move economic activity and inflation in the same direction, downwards. Falling inflation, with nominal rates at zero, raises real rates, making the monetary policy response involuntarily restrictive.
If coronavirus destroys international value chains, there is little monetary policy can do. But at least, in the shock supply scenario, the monetary policy of zero interest rates does not automatically tend to aggravate the situation.
The real dilemma for monetary policy derives from the contraction of demand induced by uncertainty, which is unlikely to be solved with the lowering of interest rates. There could be a paralysis of the economy caused by the freezing of the credit market and by the fall of liquidity: companies that are struggling to repay loans because they have had to suspend production and are unable to meet orders already listed represent the offer side. Or they quickly see orders and reservations drop. This is the deman side. In turn, this domino tends to reflect on the credit system, in a financial crisis scenario.
If the economic system, tightened in the grip of supply and demand that tends, tends to paralysis, it is crucial that monetary policy thinks about instruments that guarantee its functioning. The level of interest rates cannot make the difference this time. It is necessary to ensure greater liquidity for banks, but to constrain it to the supply of credit to those efficient companies which, however, risk freezing for reasons independent of their productivity.
For the moment, the most important thing is to finish the pandemia and to start living the normal life. But what will remain after in the economy, could be even worst.