Last Updated on Friday, 23 April, 2021 at 9:53 am by Andre Camilleri
Dr Brian Micallef, PhD, works in the Research Department of the Central Bank of Malta.
The Covid-19 pandemic has led to a severe contraction in output.
In Malta, real GDP fell by 7% in 2020, reflecting its large services sector and its reliance on the tourism industry, which were among the most heavily affected. However, while short-term declines in GDP tend to attract most attention in the press, a key question facing policymakers is the extent of persistent damage in output resulting from the crisis.
In addition to GDP, as a measure of output, economists and policymakers are also interested in the concept of potential GDP, which is a theoretical construct intended to measure the economy’s supply capacity. Unlike GDP, this measure of supply-side capacity is not directly observed and thus has to be estimated using various methods, which range from statistical filters to state-of-the-art structural modelling techniques.
One of these methods is known as the production function approach, which provides a convenient framework to think about long-term potential growth in an economy. In this framework, potential GDP depends on the stock of capital available (for instance, building, machinery and equipment), the labour force and measures of productive efficiency. The trend labour force can be further decomposed into various categories, such as the share of individuals of working age, the participation rate and the hours worked, while excluding the structural unemployment rate.
With this framework in mind, permanent damage to the economy’s supply side potential following a recession can occur through various channels. For instance, unemployment may remain high after a recession as some sectors downsize or through the deterioration of job skills that make workers less employable after the recession has ended. Others could become discouraged and exit the labour market, leading to a smaller workforce. Heightened uncertainty or cash flow difficulties can lead to a drop in business investment, both in physical capital and in research and development, which translates into a slower pace of capital accumulation. In turn, this can adversely affect productivity through a slower pace of technological adoption. Productivity can also be permanently affected by viable firms that go out of business and through resource misallocation across industries. Furthermore, the longer the crisis persists, the more likely that the shock will propagate and spill over to other less-affected sectors of the economy.
Recent analysis by the International Monetary Fund confirm that most recessions leave persistent scars, mostly due to sluggish productivity growth and, in the case of financial crises and pandemic recessions, by a slower accumulation of capital. According to the latest projections by the IMF, medium-term output estimates for the global economy stand around 3% lower relative to the pre-pandemic projections. By comparison, the projected output losses for the global economy following the 2009 financial crisis stand at around 10% as financial crises tend to be associated with more permanent scars.
During the current recession, short-term output losses were mitigated by the swift and unprecedented policy response from fiscal and monetary authorities. This policy mix helped to cushion households’ income and businesses’ cash flow, prevent unnecessary increases in unemployment and firm bankruptcies and avoid the amplification of the economic shock through the financial sector, for instance, by an increase in non-performing loans. In other words, the response was intended to limit economic scarring, thus avoiding a temporary, though prolonged, shock from having more pronounced and permanent long-run effects. The strong fiscal response reminds us of the importance of creating room for maneuver in good times so that it can be used to stimulate economic activity during recessionary periods without endangering the sustainability of public finances.
Going forward, the recovery path remains clouded by a high degree of uncertainty. Some of this uncertainty is related to the nature of the pandemic and the virus itself, such as the efficacy of vaccines against the emergence of new variants and the scale of disruptions before the vaccination programme starts to deliver widespread protection to society. Other factors that contribute to higher uncertainty include the prospects of a weaker than anticipated global recovery or the possibility of shock amplification through macro-financial linkages. On the upside, pent-up demand by households from the savings accumulated during the pandemic is expected to boost growth once the restrictions are lifted. Despite this uncertainty, it is encouraging that according to the IMF’s latest estimates, medium-term projections for output growth in Malta are expected to average around 4.5% for the period 2024-2026. Hence, given the current policies, these projections suggest that the medium-term damage is expected to be less severe than the sharp contraction in 2020 might suggest. This is the highest growth rate among the euro area countries and bodes well for the country’s resumed income convergence with the euro area.
This article is based on some of the author’s studies that were submitted as part of his doctoral degree from the University of Portsmouth. The views expressed in this article are those of the author and should not be interpreted to reflect those of the Central Bank of Malta. Financial support from Malta’s Tertiary Education Scholarship Scheme (TESS) for the completion of this doctoral research is gratefully acknowledged.