As we are passing through some unprecedented times set in by the viral outbreak, several studies are emerging that are trying to understand, estimate and project the economic impact of Covid-19. Undoubtedly the atmosphere of fear and uncertainty coupled with official lockdowns has slowed down major economic activities locally, as well as globally, with immediate and far-reaching consequences.

In our national context, it might be interesting to think through few “what if” scenarios to figure out some reasonable estimate of the impact considering a rather constrained policy landscape. Besides, within the limitations set largely by the available fiscal space, an analysis of potential policy interventions to deal with the high likelihood of increasing unemployment rates shall help in determining the future growth trajectory.

Before an actual review of broad potential issues is done it is important to point out that on the revenue side the state is going to suffer imminently on account of lower sales tax collection from the services sector. So, for a country which is already struggling hard to meet the tax collection targets, one important item for future policy discussion is about the changes in tax revenue portfolio but this also means limited fiscal space for any kind of a support or stimulus package.

One lesson learnt from 2008 is that a tax cut-based stimulus might not work for the industry but may keep household spending stronger for a while

Let’s begin by trying to figure out the dimensions of ensuing economic impact which is driven by a mix of lowering market demand and dropping supplies. The factors affecting the demand can be easily traced to consumers’ behaviour based on risk aversion, fear-based avoidance or panic buying.

Media reports indicate a drop in demand for output from both domestic and foreign customers. Still, there are certain sectors where a demand surge is witnessed such as health care, medical supplies, delivery services etc.

On the supply side, a major disruption is related to the labour market — reasons for lower labour force participation may range from any form of a medical disability, inability to get to work or preoccupation at home for caregiving.

This, along with voluntary or mandatory business closures or interruption of critical inputs in the supply chain from domestic and foreign sources, can contribute to a drop in supplies. Now the final outcome scenario on the economic front would depend upon the severity and duration of the virus outbreak which could be mild and contained, moderate and slow and pandemic and exponential depending how its contagiousness is managed.

To determine the Covid-19 impact on overall economic growth the focus is placed on the key variable of policy concern that is unemployment and its possible ripple effects. Layoffs segregated according to industry and occupation, consequent on moving from mild restriction to complete lockdowns, have been estimated by a recent Pakistan Institute of Development Economic document and are quite substantial.

More plausible numbers on these along with effects on spending patterns can be subsequently obtained by reaching out to local businesses through chambers and associations coupled with consumer expenditure surveys. It can be reasonably assumed that few sectors such as hospitals, masks and sanitiser manufacturers, grocery stores might be hiring more people while many others such as tourism and hospitality will be laying off.

We might observe similar patterns within sectors as emergency medical personnel shall be in greater demand compared to ones performing cosmetic treatments. At this point, it is difficult to quantify the impact on the informal sector but most small business, daily wage workers etc are expected to be the worst hit. Since these constitute the major employment avenues the overall effect shall not be insignificant. The rising unemployment will lead to more reductions in demand — a phenomenon referred to as “ripple effect” and this raises fear of economic stagnation.

A concern for economists since the Great Depression is the causality between insufficient aggregate demand and economic stagnation, i.e. a protracted period of high unemployment and low growth.

Historically, a dominant symptom of all slump episodes has been the prevalence of high unemployment rates. Typically, slump periods have also been marked by slowdowns in investment, low productivity growth and in large dips in output. So does economic theory predicts an economic slump characterised by high unemployment and low growth?

The connection between depressed demand, high unemployment and weak growth can be the result of circular causation. A positive feedback mechanism sets in when unemployment and weak aggregate demand hurts firms’ investment in innovation which results in an output dip and the low growth dampens aggregate demand.

Studies show that the interaction between these two forces can give rise to prolonged periods of high unemployment and low growth — aka stagnation traps.

There is also obviously (but importantly) going to be a large distributional impact from all of this that must be addressed. It seems that the sectors (and people) who are being the hardest hit are at the lower end of the income distribution and more vulnerable to start with.

It is therefore important to find out an optimal package that caters to the short- and long-run needs of the economy. Immediately giving subsistence support to the people affected by job loss, especially those in lower-income households where the money will be spent on necessities (groceries and rents), makes the most sense besides alleviating the pain of the situation.

One lesson learnt from 2008 is that a tax-cut-based stimulus might not work for the industry, but such rebates do delay the drop in the economic activity by keeping household spending stronger for a while. It seems that the pandemic is switching people from one economic pool to another in the short term so the purchasing patterns will change shifting the demand for products from more durable to short-term consumption.

To avoid a potential stagnation trap, it is important to analyse policies aiming at sustaining the economic growth by subsidising investment in productivity-enhancing activities. While these policies have been studied extensively in the context of endogenous growth literature, studies show that they operate not only through the supply side of the economy but also by stimulating aggregate demand.

In fact, the literature points out that an appropriately designed subsidy for innovation can push the economy out of a stagnation trap and restore full employment. However, to be effective, the policy intervention has to be optimally designed and appropriately targeted, to cause a regime shift in agents’ expectations about future growth.

The writer is a professor at the Department of Economics in Lums

Published in Dawn, The Business and Finance Weekly, March 30th, 2020