The Post-Pandemic Great Reset

Forthcoming at 2021 Atlantic Currents, Policy Center for the New South

The Covid-19 pandemic plunged the world into a health, social and economic crisis of exceptional magnitude. In economic terms, the restrictions established to contain the spread of the virus resulted in a sudden stop to entire sectors of activity and major disruptions to supply chains. Consequently, the global economy experienced its worst recession since World War II in 2020, with a 3.3% contraction in real GDP, a sharp decline in trade and direct investment flows, in addition to massive job losses. As a result, the downward trend in poverty that began in the 1980s has been reversed and more than 100 million additional people have fallen back into extreme poverty.

Recovery has been uneven, unequal, and incomplete, within and among countries. Additionally, we wonder about to what extent the pandemic has accelerated history by reinforcing some previous trends, leading the world to a “great reset”.

Among the enduring consequences of the pandemic, four of them are here highlighted: digital transformation has been speeded up; globalization will be reshaped; higher public debt will be a legacy from the crisis; and some economic scarring from the pandemic in labor markets may be expected.

Digital Transformation Accelerated

The pandemic accelerated the previous trend towards digitization of processes in the private production of goods and services and the provision of public services. Many firms and other organizations have in fact started processes of digital transformation, i.e., adopting cross-cutting organizational changes to implement a deeper use of digital technologies. Beyond digitizing information and digitalizing processes and functions that make up an organization's operations, the organization and its strategy have been digitally transformed.

The sudden and faster intensive digitalization and, in many cases, digital transformation of all time occurred in the wake of the pandemic crisis. In just a few months, the pandemic has brought years of change in the way many private and public companies and organizations across all sectors and regions operate, serving as a catalyst for change. In many cases, digital transformation was not a strategic priority before the pandemic, but it has become one ever since.

Digitization and digital transformation will require proper regulation and transparency in data use. Clive Humby, the British mathematician, coined in 2016 the phrase “data is the new oil”. In fact, as technology scholar James Bridle put it in a book in 2018, it can also be said that "data is the new nuclear energy." Data is a valuable and powerful commodity, but it also has an enormous capacity to do harm, as in its manipulation during recent processes of public decisions by popular vote (the 2016 US elections, the UK Brexit process, and several other electoral processes).

Furthermore, cybersecurity risks must be addressed. This year we have already witnessed attacks – politically motivated or aimed at ransom – on companies, at key points in supply chains and on critical infrastructure, and at public bodies. Cyber ​​security and curbing data misuse have become more necessary than ever, something only achievable with proper regulation and oversight.

Digitization of Finance

The financial sector is a special case of rapid technological change, a trend reinforced by the pandemic. Traditional banks have had to adapt to a competition environment in which online financial intermediaries operate without physical branches. Payments and credit are increasingly done with the use of digital platforms. The increased demand for digital services triggered by the pandemic has accelerated this transformation. The confluence we are witnessing is driving innovation in fintech and raising important questions.

As well approached by Arnoud Boot, Peter Hoffmann, Luc Laeven, and Lev Ratnovskiin in an IMF blog post last 17 December 2020 (“What's really new in fintech”), the recent digital financial transformation has been changing the ways in which information, communication, and prudential regulation are worked with.

On information: collection and analysis of data about customers now can benefit from using their digital footprint to improve solvency analysis. The authors call attention to artificial intelligence and machine learning as boosters of quality of assessment as compared to conventional techniques based simply on income, working time, assets, and debts.

Furthermore, they can promote financial inclusion, for example, by allowing more credit for informal workers and families and businesses in rural areas. Geographic competition between service providers tends to be reinforced by the possibility of serving more distant customers.

Communication has also changed with respect to customer relationships and the distribution of financial products. Not by chance, large platforms have started to include financial services into their ecosystems, which has led to the emergence of new specialized providers disputing payments, asset management and financial information provision with banks.

Prudential regulation will also be obliged to adapt, as operational risks of new lending technologies and business models must be assessed. Cybersecurity risks and regulatory arbitrage need to be tackled. And regulators must keep up in their capacity to not be left behind by market inventiveness.

Competition policies also need to deal with the strong forces favoring large digital platforms because of network effects. Furthermore, as in the broader digital transformation process, the bar is now higher for data policies to guarantee consumer privacy, as well as safe data collection, processing, and exchange.

As well said by Boot et al (2020) in the IMF blog:

“Overall, while much of the technological progress in finance is evolutionary, its pace is accelerating rapidly. Fintech's potential to reach more than a billion people outside of banks around the world and the changes in the structure of the financial system that this can bring could be revolutionary.”

Globalization Reshaped

The acceleration of history by the pandemic also includes speeding up some recent trends regarding globalization. The pandemic will not reverse it but reshape it.

World trade took a deep dive during the first months of the global pandemic. After all, mandatory or recommended lockdowns and travel restrictions disrupted economic activities, before being scaled back since the second half of 2020.

According to the World Trade Organization (WTO), the global merchandise trade volume is expected to have risen by 10.8% in 2021, while growing 4.7% in 2022. Such a moderation is bound to happen as merchandise trade goes back to its pre-pandemic long-run trend.

Supply chain disruptions – such as semiconductor scarcity and port backlogs – have curbed trade in many sectors. The biggest downside risks are still coming from new rounds of the pandemic itself. It is important to highlight the remarkable divergence across countries, despite the return to trade expansion: some developing countries are falling behind when it comes to trade recovery.

The trade downfall of 2020 was unlike previous global recessions when merchandise trade bore the brunt of the negative impact. Indeed, this crisis is different. The unusually large drop in commercial services trade is likely related to social distancing measures and travel restrictions, which curb the delivery of services that involve physical proximity to users. Less spending on services, particularly in travel-related sectors, may have also left consumers with unspent income that could be redirected toward the purchase of goods. This may partly explain the relatively small decline in merchandise trade in the first half of 2020 as well as the subsequent logistics bottlenecks.

Countries in all regions have been impacted by the trade slump but to different degrees. Besides China as a first-in-first-out case, trade reduction in Asia was smaller than elsewhere. Countercyclical fiscal and monetary policies in other regions have helped them sustain relatively high levels of consumption of merchandises during the crisis, with Asian countries being major producers and exporters of goods for which demand has remained strong during the pandemic, including electronics and medical supplies.

The pandemic brought a “perfect storm” to developing economies. Besides the COVID-19 shock, they faced other shocks from abroad (finance, remittances, tourism, and commodities). The March 2020 financial shock was partially offset because of policies adopted by central banks in advanced and emerging market economies. Remittances resisted but tourism dropped substantially.

In the case of primary commodities, there was a mixed picture, with prices—other than metals—falling by different degrees in the second quarter of 2020. The price of fuels declined most, around 50% year-on-year, but recovered strongly since then.

How has the pandemic affected the future global trade landscape?

Previous trends in global trade

What did the trade shock look like compared to the trends prior to the pandemic? In fact, world trade volumes have lagged GDP growth since the 2000s, a trend reinforced after the onset of the global financial crisis.

Some transitional—and therefore potentially reversible—factors behind this can be highlighted. The weak recovery of fixed investments in advanced economies after the global financial crisis (GFC) suppressed a major source of trade volume, given the higher-than-average cross-border exchanges that characterize fixed investment goods. However, some structural trends have also been at play.

The golden era of globalization 2.0, associated with the rise of global value chains, clearly peaked by 2008. Global trade stagnated as a share of GDP and foreign direct investment fell in the 2010s.

The golden era reflected the combination of two major events. First, trade opening measures integrated areas with cheap labor into global markets—China and others in Asia, but also Eastern Europe and Mexico. Second, technological breakthroughs in terms of transportation (containers, for instance), and information and communication technologies allowed a fragmentation of production processes and their geographical dispersion. Cost minimization could be achieved by spreading value chains globally and trading intermediate goods across borders.

After steadily increasing between the mid-1980s and the mid-2000s, trade elasticity to GDP eased off. The world’s exports-to-GDP ratio seems to have approached a plateau (or a ‘peak trade’). Since 2008, world trade rose slower than GDP at a ratio of around 0.8:1, leading to a slight fall in the share of exports in global GDP. Even if transitional post-GFC factors were partially reversed, the presence of a long-term trajectory of trade elasticity displaying a slowdown already prior to the recent pattern, would suggest no automatic return to the heyday.

Some structural trends can be pointed out. First, as manufacturing started to become more automated, advantages from locating production to where workers were cheapest started to shrink in some of the previously dispersed GVCs. This is neither a sectoral uniform nor immediate process, but overall, recent technological trends have pointed in that direction. Digitization has been sped up by the pandemic, as we have already approached, and tends to provide an additional push.

In any case, the first major wave of vertical and spatial fragmentation of industrial production has completed, while services have not stepped up with the same intensity.

Furthermore, the major wave of trade-cum-structural-transformation has been followed by China’s rebalancing: climbing up the ladder in GVCs, while gradually lifting domestic consumption as a share of GDP and moving toward higher GDP shares for services. As China’s middle class has grown, it has consumed domestically more of what it produces. China’s share of world exports stopped rising in 2015 while its share of world imports has continued to grow.

Advanced countries are also becoming services economies. While the rise of GVCs and growth-cum-structural-transformation—especially in China—were taking place, with corresponding impacts on the landscape of foreign trade, advanced economies maintained a steady evolution towards becoming services economies, a trend that has been maintained since the GFC.

The state of current technological trajectories, and rising shares of services throughout, would imply an anti-trade bias, given the still lower trade-propensity of services—with a few exceptions, such as tourism.

Additionally, rising trade-restrictive tax-cum-subsidy policy measures adopted in some key sectors by some countries may also have become more significant. In the 2010s, no major and deeper multilateral trade deals were implemented, the United Kingdom voted to leave the European Union, and the United States renegotiated existing trade treaties and relationships.

New factors brought by the pandemic

The pandemic crisis has brought an additional series of—temporary or not—trade restrictions. Many countries reacted in the early phase of the pandemic by tightening trade restrictions on exports of some medical and food products. By mid-April 2020, more than 80 countries had imposed export bans on medical devices and personal protective equipment used to curb the spread of COVID-19.

It is true that some progress has been made in trade-facilitating measures easing restraints on international trade, as governments perceive the advantages of relying on foreign supply and demand as a complement, rather than counting on self-reliance. There was also the trade pact agreed in November of 2020 between members of the Regional Comprehensive Economic Partnership (RCEP)—China, Japan, Korea, Australia, the ASEAN countries, and New Zealand. RCEP reduces tariffs on goods, expands market access for some services, and unifies rules of origin within the bloc. However, some of the distortionary barriers to trade introduced around the world over the past two years are still in place.

So, how might disruptions and shortages for some essential products affect the views of GVC managers and governments? There has been a revival of discussions about unforeseen, or underestimated, potential costs and risks of the international fragmentation of production. On the one hand, there are claims that trade dependency should be diminished, including by repatriating production, as a potential way of reducing risk. On the other, such retrenchment of trade would also create substantial efficiency costs, if it goes beyond what we described as structural factors underlying the evolution of global trade prior to the pandemic.

Supply chain tradeoffs: the GVC perspective

As happened in the tsunami-related events earlier in the 2010s, severe supply disruptions during the pandemic for everything from auto parts and consumer electronics to protective equipment have highlighted the existence of risks from concentrating too much production and sourcing in a small number of distant low-cost locations, and from overreliance on just-in-time inventory management. Rising tariffs, restrictions on market access, and other manifestations of geopolitical frictions may also lead some companies to revisit their supply chains.

In some cases, it might be decided that it pays to adopt more regional, ‘multilocal’ sourcing and manufacturing footprints, while keeping larger ‘safety stocks’ in inventory—even if these options entail somewhat higher costs.

The types of change will vary by industrial sector, as firms will have to consider tradeoffs between resilience and efficiency/costs. There is the previous trend that we alluded to in some segments toward locating production closer to customers, especially when the adoption of advanced Industry 4.0 manufacturing systems offsets higher labor costs. Medical equipment, biopharmaceutical products, semiconductors, and consumer electronics, for instance, are likely candidates to also be subject to geopolitical and government pressures. Ultimately the consequence of the pandemic will be a greater weight given to those considerations.

Government policies and geopolitical frictions

Governments are also likely to put greater emphasis on domestic production, particularly of medical supplies and equipment, as well as of key inputs (e.g., semiconductors) to reduce the risk of future supply shocks. Germany has expressed interest in localizing more supply chains, for example, and South Korea is exploring measures to encourage reshoring of manufacturing. This will not necessarily translate into full neglect of the broader gains from globalization, but it will selectively reinforce a search for greater self-reliance. The pandemic is prompting some governments to place further controls on trade in medical and agricultural goods.

Given the revealed costs—failures—of unilateral trade policies in the style followed by President Trump in the U.S. But there may be plurilateral efforts to broaden the agenda of trade restrictions as a quid-pro-quo in negotiations about rules and standards.

On the technology front, a potential decoupling of the U.S. and Chinese sectors—which could make devices and IT systems in both markets no longer interoperable—might have further repercussions. China has signaled that it is searching for more self-reliance by talking about ‘dual circulation’ and ensuring greater diversity of sources of commodity imports. Again, the COVID-19 crisis did not create these frictions, but it has emphasized and reinforced them.

The climate change agenda

The future of trade is also being redefined in other ways. The pandemic has had a positive spillover effect on the climate change agenda. ‘Green recovery’ is the catchphrase. For example, as part of its European Green Deal strategy to slash greenhouse gas emissions, the European Commission is considering imposing a carbon tax on imports. This tax could redefine global competitiveness in a range of industries, particularly if the U.S. follows suit.

By intensifying geopolitical and economic forces already at work, the pandemic’s disruptive impact on international trade will leave a lasting mark. The pandemic is accelerating history, i.e., some recent trends are being sped up. The pandemic will not reverse globalization, but it will reshape it.

Job Market Scarring

All economies affected by the pandemic have something in common. The rate of vaccination of the population—quite different in different countries—has been the main factor determining the prospects for the resumption of economic activity, as it is a race against local waves of transmission of the virus.

Personal contact-intensive services have borne the economic brunt of the pandemic. To the extent that vaccination enabled them to restart, one may even be able to witness some temporary dynamism in the sector because of pent-up demand. However, international tourism will not be included at the outset since vaccination will have to reach an advanced level both at the origin and destination of travelers.

But let us not be deceived: the pandemic will leave scars and countries will not return to where they were. There will be a need for retraining and job reallocation for part of the populations of all countries.

The pandemic left a trail of unemployment, particularly affecting minorities, low-skilled workers and, in Emerging Market and Developing Economies, women, who predominantly occupy jobs in contact-intensive services.

Before the pandemic, as we have remarked, it was already known that ongoing technological changes—automation and digitalization—were posing challenges in terms of the need for training or retraining for part of the workforce. The response of companies and consumers to the pandemic has deepened these trends and is not expected to be reversed.

A February 2021 report by the McKinsey Global Institute (“The future of work after COVID-19”) estimated that in eight countries (China, France, Germany, India, Japan, Spain, the United Kingdom, and the United States), more than 100 million workers will have to find new, more qualified jobs by 2030. This is 25% more than they had previously projected for developed countries. Their estimates point to shifts in occupations by 2030, with a relative rise in healthcare and science, technology, engineering, and mathematics (STEM), while jobs in food service and customer sales and service roles decline. Less-skilled office support roles would also tend to shrink.

Why? Many of the practices adopted during the pandemic are likely to persist. Where done, consumer surveys indicate that sales via e-commerce, which have grown substantially during the crisis, are not expected to shrink too much. Also, remote work will not be fully reversed, with the hybrid organization of work processes becoming more common. The fact that employees in remote occupations have worked more hours and with greater productivity during the pandemic will encourage continued telework.

McKinsey suggests that changes in “work geography” will have consequences for urban centers and workers employed in services, including restaurants, hotels, shops, and building services—25% of jobs in the United States before the pandemic, according to David Autor and Elisabeth Reynolds (“The Nature of Work after the COVID Crisis: Too Few Low-Wage Jobs”; NBER, July 2020). Indeed, demand for local services in cities has dropped dramatically as remote work has increased, regardless of confinement.

Autor and Reynolds indicated four trends for the world of work after the pandemic. In addition to automation, they highlighted the increase in remote work, the reduction of density of workplaces in urban centers, and business consolidation. The latter is due to the growing dominance of large firms in many sectors, something exacerbated by the bankruptcies of smaller and more vulnerable companies.

All these trends have negative impacts on low-income earners and the distribution of income. They tend to increase the efficiency of processes in the long run, however, leading to harsh consequences in the short and medium terms for workers in personal services, who are generally not present among the highest paid. Workers at the top of the wage pyramid, including professionals in STEM, will see their opportunities grow.

Technological progress is one of the main causes of the increase in income inequality in advanced countries since the 1990s. The acceleration of inequality with the pandemic therefore tends to intensify the challenges. In a way, again, it can be said that the pandemic is accelerating history, rather than changing it.

The role of public policies will be central in the post-COVID-19 world, both in strengthening social protection—including through unemployment insurance and income transfer programs—and in the requalification of workers. Instead of denying technological advancement, it is better that public authorities help people to adapt, minimizing the resulting scarring.

Debt Increased

One feature of the global economy in the post-pandemic “new normal” is the worldwide rise in public and private debt levels. As a result of the public sector's role as the ultimate insurer against catastrophes, policies to smooth pandemic curves and the pandemic recession have left a legacy of larger public sector debt worldwide. Lower tax revenues and higher social and health expenditures have reflected the option of trying to avoid widespread destruction of people's productive and livelihood capacity during the pandemic. On the private sector side, indebtedness was the way for many firms to survive the sudden stop, when the result was not bankruptcy or closure.

According to the IMF’s Global Debt Database, the largest one-year global debt surge since World War II happened in 2020. The health crisis and recession led to global debt rising to $226 trillion, or 256 percent of GDP.

Debt was already high prior to the pandemic, but now governments are in a scenario of record-high public and private debt levels, and higher inflation. Slightly more than half of the debt increase was incurred by governments, with the global public debt ratio climbing to 99 percent of GDP. But private debt from non-financial corporations and households also went significantly up.

The burden of meeting higher levels of public debt will depend on where basic interest rates go as a response to ongoing inflation hikes. However, even governments with a better credit risk rating will face debt accumulation. And sovereign debt stress is likely to increase in many other cases, particularly in over indebted developing countries.

Spending cuts to contain fiscal deficits will be very costly in terms of political capital, especially after a crisis that will leave behind higher degrees of income inequality and which is occurring after a recent spending restraint in many countries. Among advanced economies, the trend in recent decades has been to reduce corporate and personal income taxes, and reversing such decreases increasing it is an obvious option to fill the fiscal gap caused by the coronavirus.

Ongoing demographic trends already pointed to the need to find new ways to cover growing public spending and the pandemic crisis will accelerate this search. However, to avoid undermining that movement through fiscal wars between countries, pluri-national consistency through tacit or explicit cooperation will be a necessary condition. The recent plurilateral G-7 and G-20 negotiations on a global corporate tax have been a good omen.

Take, for example, fiscal challenges in the eurozone compounded by the pandemic crisis. Highly impacted countries - such as Italy and Spain - were already showing fiscal vulnerability before the virus outbreak, despite years of fiscal restrictions. The opposition between requests for mutualization of debt at the eurozone level, as an integrated set of countries, and the country-specific tax structures required by others - Germany - will require resolution. The announcement by the European Central Bank that it would buy another 600 billion euros in bonds, together with the plan announced by the European Union to create a new recovery fund of 750 billion euros to help the countries most affected by the pandemic pushed the problem forward.

Greater intensity and frequency of stresses in the public and foreign debts of the poorest countries will also be present. The poor countries' external debt had increased substantially since the 2008-09 global financial crisis. The G20's postponement of the payment of its official bilateral debt eased the service burden in the short term, but the debt will continue to accumulate and the underlying debt trajectories to be dealt with after the pandemic remain on course. A key component in this regard will be China's role as a creditor, as its financial exposure to developing countries through credit lines and loan agreements - often linked to commercial projects at market rates and backed by guarantees - has increased in recent history.

The great reset by the pandemic has also left a “moving contradiction”

Higher debt, accelerated digitalization, labor market scars, and reshaped globalization will be legacies of the pandemic, as trends already present in history in previous years that have been speeded up. However, it shall also accentuate the “moving contradiction” between, on the one hand, a reinforcement of domestic reorientation of countries and, on the other, the need for policy coordination between countries in many areas. Dealing with future pandemics, climate change, cyber security, terrorism, migration trends etc. will require more multi- or pluri-nationalism and less nationalism, in the opposite direction to what was underway, and which was accentuated by the coronavirus.

Otaviano Canuto, based in Washington, D.C, is a senior fellow at the Policy Center for the New South, a professor affiliate at UM6P, a nonresident senior fellow at Brookings Institution, a professorial lecturer of international affairs at the Elliott School of International Affairs - George Washington University, and principal at Center for Macroeconomics and Development. He is a former vice-president and a former executive director at the World Bank, a former executive director at the International Monetary Fund and a former vice-president at the Inter-American Development Bank. He is also a former deputy minister for international affairs at Brazil’s Ministry of Finance and a former professor of economics at University of São Paulo and University of Campinas, Brazil.