European policymakers are responding flexibly and proactively to the risk of a severe economic downturn. But more is needed to avoid a chain-reaction of bankruptcy and unemployment rippling through the economy.

Until recently, the coronavirus—as seen from a European perspective—was all about weaker Chinese demand growth and global supply-chain disruption. Now, with several countries just a small step from total economic lockdown and others closing their borders, the threat of a deep economic contraction looms large. Moreover, with financial stress escalating, the risk of a full-fledged credit crunch is rising.

Moving into Lockdown

The list of European countries placing restrictions on economic activity is rising fast. Italy has been at the forefront of the European battle to control the virus, banning all non-essential travel and ordering all retailers except for food stores and pharmacies to close. But Spain has now adopted similar measures, France is not far behind and Germany has announced a border shutdown. No country has yet ordered factories to close, but this could change at any moment and companies are starting to do this anyway.

Assessing the Impact

In these circumstances, the normal rules of economic forecasting don’t apply. Put simply, there are no precedents. From a purely mathematical perspective, were governments to call a complete halt to all economic activity for a two-week period—as has been mooted in Italy—the hit to annual economic output would be roughly 4%. That’s similar to the contraction experienced by most countries during the global financial crisis (GFC).

Another insight into the potential scale of economic disruption can be found in the national accounts. Over the last 10 years, normal seasonal factors have reduced euro-area output by an average 4% during the first quarter of the year. And this is a pattern that people are used to dealing with, and therefore a starting point for thinking about the potential impact of the coronavirus.

Neither of these statistics is directly applicable to the current situation. But what they do suggest is that the hit to euro-area GDP is likely to be large and lie well outside of normal forecasting ranges. With more and more countries moving into economic lockdown, a 5-10% contraction in euro-area output during the first half of the year would not be surprising.