Although it has now been declared a pandemic by the WHO, it is hard to know how serious the coronavirus pandemic will become. Whatever the outcome, it is likely that the economic consequences will be more serious than the health effects.

It seems that the best way to prevent the disease from spreading so fast that it overwhelms hospital systems is to quarantine people from infected areas. The speed of the spread can be slowed by creating social distance and reducing human contact by action such as limiting travel and preventing attendance at large sports and entertainment events. Unfortunately, government actions to slow the spread of the disease have a significant economic cost. Spreading the advance of the disease out over several months means that the changes introduced by the government will have to stay in place for much longer. And the more serious the disease, the longer that it will take for people to revert back to their normal behaviour.

Governments have had to choose between health outcomes and economic outcomes. Most have put people's health ahead of the economy.

Even before the coronavirus struck, the world economy seemed to be turning down, although the consequences were not entirely clear. Therefore, although the coronavirus was a catalyst for the recession that had already begun, the outcome will be determined by the other factors that were already in play.

The outcome is uncertain, but so many negatives are at play that the consequences are likely to be worse than governments expect.

Financial Markets

All over the world, financial markets have tanked. The main US share price indexes have fallen by a third in the last week. The falls have been similar in other markets and other countries. This represents a massive loss of wealth for people who own shares and other financial instruments directly, or indirectly through their superannuation funds and insurance companies.

But there is another consequence, which is even more serious. Over the last few decades, the finance sector has grown massively, far outpacing the rest of the world economy. Banks and other businesses in the finance sector have worked together to create a huge infrastructure of debt that sits on the top of the real economy. Most of these debts have some form of collateral attached to them for the security of the lender. This collateral often consists of shares and other financial instruments.

The big fall in the financial markets significantly reduces the value of the collateral that has been posted for security. This leaves the borrower with two choices. They can either post more collateral as security (if they have it) or pay down some of their loan until it matches their collateral. Both these options can be difficult in uncertain times, but the alternative is to default on the debt, which would have a snowball effect, weakening other financial institutions that are connected to the one that fails.

A significant portion of the debt is denominated in US dollars, often using foreign exchange swaps (partly because US interest rates have been so low). The need to beef up collateral against debt may be one reason why the US dollar has strengthened so much against other currencies. It is not a sign that the US economy is strong, but that the financial system is weak.

The central banks will try to paper over the cracks in the system by creating money and making loans, but this will not resolve the underlying problems that make the modern financial system unstable in the first place.

March 2020