COVID-19’s impact on global supply chains will cause a recession like we’ve never seen before

For nearly three decades, global supply chains were the quiet engines of economic globalization. From 1990 to 2008, they drove the rapid expansion of trade, accounting for 60-70% of its growth. More than a decade later, however, they have stalled – and may in some areas be going into reverse.

The strain on global supply chains partly reflects the turn by many governments toward protectionist policies since the openness of the world economy peaked in 2011. And now, the COVID-19 pandemic has caused a supply-shock recession. The related uncertainty may slow the expansion of global value chains by at least 35%. Indeed, world trade is no longer expanding faster than world GDP. If this continues, companies will reshore manufacturing from Asia and elsewhere.

It’s clear that shrinking production at firms worldwide will create a recession – and a recovery – unlike any we have seen. In outlooks for next year, the International Monetary Fund, the OECD, and other international organizations assumed a V-shaped recovery. But this narrative was likely influenced by the rapid recovery of global value chains after the 2008-10 Great Recession, a downturn that originated in the financial system, not the real economy worldwide. Given the importance of broken supply relationships in the current downturn, this recession is likely to be unique.

Firms are vulnerable in other ways. For example, suppliers affected by a lockdown impose substantial output losses on their customers when the input they produce is specific to the customer and embodies a high level of research and development and intellectual property. In such cases, switching to another supplier is costly and slow.

It’s not surprising that pandemic-related disruptions are unique. After researching three decades of major natural disasters in the United States, Jean-Noël Barrot and Julien Sauvagnat of MIT found that suppliers hit by a flood, earthquake, or similar event impose large output losses on customers. Indeed, when a disaster hit one supplier, firms’ sales growth suffered an average drop of 2-3 percentage points. The impact spilled over to other suppliers, magnifying the original shock.

It is also likely that this recession will generate lower trend GDP growth. After all, global supply chains were a major driver of productivity growth in many countries in the 1990s and for most the aughts.

The integration of Eastern Europe into the global economy after the fall of the Berlin Wall contributed not only to Germany’s recovery from being the “sick man of Europe,” but also to rapid growth in the Czech Republic, Hungary, Poland, Slovakia, and other countries in the region. If the slowdown in the growth of global value chains since 2011 was already contributing to anemic productivity growth in developed countries, an accelerated slowdown, or even contraction, owing to pandemic-related disruptions, does not bode well.

In these circumstances, the only option for policymakers is to spur growth in specific sectors, which is exactly what stimulus programs are designed to do. In Germany, Volkswagen and other companies have pushed for a “cash for clunkers” stimulus package similar to the one that was enacted in 2009, but Chancellor Angela Merkel’s government has decided not to pursue such a policy.

It’s worth rethinking that decision. New macro models of the pandemic suggest that sector-specific stimulus may generate the largest fiscal stimulus per dollar spent. An economy in which 50% of the economy is fully shut down, as in a pandemic, is not the same as one in which all economic activity collapses by 50%, as in a depression. In a pandemic, a sector’s relationship to the rest of the economy determines the outcome.

That means the best way to maximize the impact of fiscal stimulus is to identify sectors that are not substitutive. In Germany, like elsewhere, autos have a complementary relationship to the rest of the economy. The more cars are consumed, the larger the demand for auto inputs. The industry imports only 29% of its inputs, compared to 76% in textiles. This is why schemes to stimulate the purchase of autos are better than, say, restaurant vouchers. In fact, dining out reduces supermarket shopping, generating less aggregate demand.

The pandemic poses a huge challenge to economic policymakers. Like it or not, engineering any recovery, much less a V-shaped one, will require governments to set aside issues that would be of utmost importance in ordinary times. Their credo should be Hippocratic: First, do no further harm.