A sudden stop? Covid-19, containment and the economy

Assessing the economic impact of Covid-19 requires a new approach to a problem economists have not encountered in modern times, writes Dr Kirdan Lees

Covid-19 has presented quite a problem for economists. Containment policies that seek to flatten the Covid-19 curve or eliminate the virus, restrict economic activity.

All governments are confronting this issue. The interactions between these choices – not just locally but globally – will drive outcomes in New Zealand. Within New Zealand, we can only “control the controllable”. Global decisions will determine long-run outcomes but what we do locally matters for immediate impacts.

Expect a sizeable hit to the economy but in such uncertain times, policymakers should assess four key scenarios rather than rely on a single set of numbers.

Right now, traditional stimulus policies are ineffective since containment policies stop people getting out and spending in the shops and online retail deliveries are still limited. Instead, we need government “shield policies”, a suite of initiatives that try to preserve firms, help vulnerable workers and keep in place supply networks until we resolve the health crisis. Figure 1 shows the trade-offs, adapting work by Shaun Hendy on controlling the virus, and Richard Baldwin on the intent of economic policies.

Effectiveness of containment policies and shield policies determine outcomes

Economic outcomes depend on the effectiveness of both virus containment policies and economic shield packages. In the absence of effective packages to flatten the curve (moving from the dark red line to the dashed red line in Figure 1), intensive care units will be over-run and many lives will be lost. Effective containment through the lockdown and social distancing will save lives but sharply curtail economic activity.

Robust shield policies preserve jobs and firms, reducing the economic hit (moving from the dashed green line to the dotted green line). Effective shield policies loan firms the working capital to ride out the sudden stop in demand caused by border closures and the lockdown of Alert Level 4 restrictions. We frame outcomes as contingent on both sets of policies in Figure 2.

Assessing economic impacts requires a flexible analytical framework

Macroeconomic models (such as the otherwise sound models within the Reserve Bank and Treasury) struggle to deal with large shocks and quantity constraints (for example lockdown policies) that do not allow demand to adjust to prices, including interest rates.

Instead, for each scenario we estimate activity under by making assumptions on:

  1. Investment and spending at each Alert Level, by each consumption good;
  2. The length of period Alert Level 4 and border controls apply for each scenario
  3. Combining (i) and (ii) to get a path for consumption, investment and net exports
  4. A cross-check of our estimates from the supply-side based on the number of workers at home on a sector-by-sector basis.

This analysis shows to expect a large hit to the economy in the second quarter of the year. Combined with containment policies, expect substantive rises unemployment.

The outlook is uncertain, changing rapidly and is contingent on health and economic policies. Rather than rely on a single set of numbers, we will present views on outcomes over time as new information on health and economy comes to light.

This means monitoring real-time data, including the change in the number of Covid-19 cases and key high-frequency economic data, to update the chance of each scenario occurring. Right now, we place relatively more weight on effective containment policies. The size of fiscal support to date favours the top half of the matrix. At least for now, scenario 1 appears most likely but the situation is highly fluid.

Regional and sectoral differences will be pervasive. There will be winners and losers. But tracing the likelihood of key scenarios can help policymakers understand the rapidly evolving impacts over time.

Dr Kirdan Lees is a Partner at Sense Partners.

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