The global economy is in a recession. According to the IMF, this recession triggered by the “Great Lockdown” will be more intense and more extensive than the “Great Recession” in the wake of the global financial crisis (GFC). But that is not the only factor that separates the corona financial crisis (CFC) from the GFC. There are other critical differences between the two crises, and it is important to recognise them for they have implications for the nature and effectiveness of the solutions. I will, in particular, refer to four differences.
The first difference stems from the origin and transmission of the crisis. The GFC originated in the financial sector as banks and financial intermediaries got carried away by irrational exuberance and recklessly piled on risk. Remember CDS, CDO, MBS, ABS and various other acronyms that were the villains in the GFC drama as it unfolded in the rich countries. As people lost their wealth and savings in the financial meltdown, demand collapsed and growth slumped. The contagion, which originated in the financial sector, spread to the real economy.
In contrast, the CFC came from outside the economic system. As the pandemic spread, the first impact came by way of a supply shock as China-centred supply chains broke down. And then as countries ordered lockdowns and economies shut down, demand slumped. The ensuing distress in the real economy led to distress in the financial system.
This route of transmission — financial to the real economy or vice versa — has implications for crisis resolution. The central challenge in the resolution of the GFC was to restore faith in the financial system, which meant rescue and rehabilitation of banks and other financial institutions. Once that task in the financial sector was accomplished, repair of the real economy fell in place. Demand came back, supply resumed and growth picked up.
In contrast, the central challenge in the resolution of the CFC is to beat the pandemic, and that solution has to come from science. Only when there is public confidence that the incidence of the pandemic has been brought down to a low-level equilibrium, will there be a resolution in both the real and financial economies. We are, of course, seeing that even during this crisis, just like in 2008, governments are coming out with fiscal stimulus packages and central banks with monetary stimulus packages. But these are not solutions to the pandemic; they are just holding operations till the central problem is resolved.
The second difference between the two crises arises from the asymmetry of the solutions. The GFC originated in the subprime mortgage sector of the US and then, rapidly engulfed the world. The CFC originated in the Hubei province of China and rapidly engulfed the world.
But the similarity ends there. For the resolution of the GFC, restoring financial stability in the US was necessary, and for the most part, a sufficient condition for restoration of financial stability everywhere. In other words, no country was safe until the US was safe, and once the US financial system became safe, financial systems everywhere became safe as somewhat of a by-product. The situation with the CFC is different. Every country needs to control the pandemic within its borders. But that is not sufficient because the virus can hit back from across the border. In other words, rich countries are not safe until poor countries are safe too. And no country is safe until every country is safe.
How the policy interventions interact with one another makes for the third difference between the two crises. During the resolution of the GFC, solutions in the financial sector and in the real economy reinforced each other. For example, to mitigate the crisis, the RBI cut rates to stabilise the financial system and intervened in the forex market to stabilise the rupee. Meanwhile, the government extended special concessions for housing and real estate sectors to provide stimulus in the real economy. There was synergy in these actions.
In contrast, in managing the challenge of the CFC, what we are seeing is tension between the various sets of policy actions. The effort to contain the pandemic is exacerbating the challenges in both the real economy and the financial sector. The more stringent the lockdown to save lives, the more extensive the loss of livelihoods. Managing this tension is by far the biggest dilemma for governments battling the crisis.
The global financial crisis, although it was called “global” did not affect all countries equally and that accounts for the fourth difference between 2008 and now. China was less affected even as all rich countries were in a financial meltdown. In fact, one of the less acknowledged facts of the 2008 crisis is that it was the stimulus provided by China that kept the global economy afloat. In contrast, now all rich and big economies are weighed down by the virus, and there is not a single large economy to keep the rest of the world afloat. If pandemics are going to be more frequent, as is now suspected, it is all the more important that there is a more enforceable global protocol on early warning and information sharing.
For all their differences, the GFC and CFC are similar in one respect — they both teach us life-enhancing lessons. The GFC forcefully reminded us that greed and avarice will only bring tears in the end. The CFC is teaching us that the force of nature is bigger than the combined force of our science and technology. Hubris is wrong.
This article appeared in the print edition of May 16, 2020, under the title ‘Two crises, two lessons’. The writer is a former governor of the Reserve Bank of India