The coronavirus, a pre-industrial crisis?

The paralysis of the world economy as a consequence of the confinement tells us that this crisis will not be like the one in 2008 but like the ones before the Industrial Revolution, confronting our society with an unexpected challenge. In this article we analyze its characteristics and immediate precedents.

The coronavirus, a pre-industrial crisis?

The spread of the coronavirus and the consequent containment measures applied around the world have led to a sharp drop in global gross domestic product (GDP), with an impact that is still difficult to quantify on unemployment figures.

In this context, there are many analysts who compare the current economic crisis with the one suffered in 2008, trying to see similar parameters that can help us find solutions. This point of view seems to be shared even by Christine Lagarde (current president of the European Central Bank), when she referred to this context as "a scenario that will remind many of us of the great financial crisis of 2008" (EU summit of 11 / 03/2020).

Looking for precedents

However, there are multiple reasons that allow us to affirm that the nature of this crisis is radically different from that of our most immediate referents, such as the Great Recession of 2008 or the Crack of 1929.

The main reason is that these crises were born in previous processes of distortion of the markets that generated bubbles and therefore deep mismatches between supply and demand. The problems of the current economy, on the contrary, derive from an external supply shock due to factors completely unrelated to the economy, such as the prohibition of companies from operating normally.

In this way, the direct cause of the collapse of production is the fact of confining workers to their homes, not previous dysfunctional behaviors in the markets that would have ended up exploding as has happened with the bubbles.

We can say, therefore, that we are facing a supply crisis, although this shock may have collateral effects on demand through Say’s law, as we will explain later.

As we have already commented, it is difficult to draw parallels with previous crises since they are not about stock market bubbles (1929, 1987, 2000, 2008), growth models of excessive energy intensity (1973) or episodes of banking panic (1873) .

If we want to seek similar precedents, we must therefore go back even further in time, to pre-industrial economies where supply shocks due to external factors (mainly bad weather or diseases in crops) were relatively frequent. Without a doubt, the closest and best documented example in Europe of a crisis of this type is the Great Irish Famine , from which we can draw three valuable lessons to understand our current situation.

Lessons from the Great Irish Famine

The Irish crisis demonstrates the futility of trying to boost elastic aggregate demand over rigid supply.

In the first place, with regard to the direct causes of this type of external shocks , it is clear that, unfortunately, it is impossible to prevent them from taking place, at least from the economic sphere. In the same way that no one could foresee or prevent the arrival of the Phytophthora infestans that devastated Irish potato crops, no economist could have done anything to prevent the emergence of COVID-19.

In this sense, the truth is that no matter how many prevention measures that can be taken, it is impossible to be completely protected against external agents that burst into our lives by surprise and condition our individual actions, which inevitably ends up affecting society as a whole. . The conclusion, therefore, is that no economy, however prosperous and balanced it may be, is capable of withstanding a shock of these characteristics without suffering repercussions on the levels of employment and GDP.

This premise leads us to the second conclusion. If preventing the appearance of these crises is impossible, the solution must necessarily go through the reaction capacity of economies to adapt to new conditions. The example of Ireland is very clear in this regard, since the multiple restrictions that weighed on the island’s economy had generated an excessive dependence on certain products and prevented the agricultural sector from being reconverted. This rigidity of supply was precisely what ended up turning a series of bad harvests into a first-rate humanitarian crisis.

In the current context, perhaps the idea of ​​some peasants condemned to insist again and again on the planting of potatoes even knowing that the harvest would possibly be a failure, for the simple reason that they could not do otherwise, might seem too far away. . Today we do not have problems in agriculture, but we do have thousands of bars, restaurants and hotels around the world that governments encourage to reopen and that can only be limited to see how the days continue to pass, waiting for customers who may not return .

Are these two realities so different? In essence, their problem is the same: economies highly dependent on a sector and without the ability to adapt to unexpected changes, so the impact translates entirely into job and wealth destruction.

The conclusion that the problem is essentially a supply crisis leads us to the third premise, the futility of demand-side stimulus plans . In this sense, the Irish experience has shown that attempts to reactivate the economy with increases in public spending are not a solution, since they are based on artificial injections of money to stimulate consumption. The problem is that boosting an elastic demand over a rigid and contracting supply only deepens the imbalance between both variables, does not generate long-term employment and sometimes also triggers inflation.

In a global context in which the standard of living of so many people is being threatened, it is important to highlight this point, since social assistance policies must be distinguished from those of economic reactivation. For this reason, it is legitimate for certain governments to be able to propose certain temporary measures aimed at alleviating the material needs of people in a particularly vulnerable situation (such as minimum income), but provided that they are approached as decisions of a humanitarian nature and never with the intention of turning them into the key to reactivating the economy.

The actions of the public power on aggregate demand, therefore, should be reduced to the minimum necessary to alleviate the consequences and should not replace those directed at the cause of the problem, that is, the collapse of supply.

These three lessons from the Irish crisis lead us to wonder why so many governments around the world seem to mistake the supply shock that COVID-19 has produced for a demand crisis , at least if we read the news about stimulus plans from Keynesian inspiration expected as soon as the health situation normalizes. Say’s law, while not accepted by all economists, could perhaps help us find an explanation.

The coronavirus crisis and Say’s law

Any solution that seeks to attack the root of the problem must necessarily go through making production conditions as flexible as possible.

As we know, the formulation of Say’s law establishes that every supply generates an equivalent demand . Of course, this does not mean that producing a good will simultaneously create a demand for it, but it does mean that the duration of the production cycle will require payments to the factors of production. In turn, these income transfers will be converted into consumption and investment for other markets, according to the preferences of the agents participating in the process and the time preference rates (or interest rate).

In the current context, a company that sees its activity paralyzed and has to make layoffs will stop transferring income to its production factors (raw materials, employee salaries, etc.). Naturally, both providers and unemployed workers will stop receiving resources and will have to adjust their consumption and savings levels, spreading the crisis to other sectors via reduced demand.

We could then say that although the crisis has hit aggregate demand in our economies hard, it has done so only collaterally and as a consequence of a prior contraction in supply. Therefore, it is clear that any solution that seeks to attack the root of the problem must necessarily go through facilitating the use of our productive capacities in the new economic scenario that has configured the COVID-19 pandemic.

In other words, it is about making production conditions as flexible as possible so that companies and workers can adapt to changes in consumption habits and thus minimize the impact on growth and employment. In Ireland, the effects of the crisis subsided precisely when the abolition of protectionist laws allowed a gradual reconversion of the agricultural and livestock sector and the transfer of labor to industry, although the late application of these reforms allowed the tragedy to continue.

In summary, for all this to be possible it is essential that economies have certain conditions that facilitate transactions by making their conditions more flexible.

While it is true that these solutions may seem remote in countries where health and safety needs have triggered public spending, we must not ignore the destruction of the productive fabric that we can already see in our economies whose salvation requires urgent measures.

For this reason, perhaps it would be useful that when the health situation returns to normal and large stimulus plans are proposed, our economic authorities pay attention to the lessons that history offers us.