ADB, By Arief Ramayandi, Matteo Lanzafame, Irfan A. Qureshi

The pandemic represents a severe challenge for policymakers in Asia. They need a response that will help economies achieve a more efficient and fairer allocation of resources in the economy, enhancing productivity, economic growth and employment.

The COVID-19 pandemic may potentially leave permanent scars on advanced and emerging economies alike, including those in Asia. However, the crisis also raises an opportunity to foster stronger economic fundamentals for future growth and development.

Economic prospects appear gloomy as the pandemic may carry medium- or even long-term consequences. Prolonged periods of depressed demand, such as the current one, can inflict significant damage to an economy’s productive capacity—a feature of business cycles often succinctly dubbed as “hysteresis”.

One reason for this is that investment in the main drivers of long-run GDP growth—for instance, in physical and human capital—typically slows during output contractions. Moreover, physical capital and workers’ skills tend to depreciate more quickly when idle.

Both mechanisms can reduce the economy’s potential for growth. The risk of such a development, typified by the still fresh example provided by the persistent economic damage from the global financial crisis of the late 2000s, has been extensively highlighted since COVID-19 turned into a worldwide crisis.

Nevertheless, recessions may also bring about an opportunity to improve long-term economic performance if they unleash what the economist Joseph Schumpeter called the “gale of creative destruction”. This concept here refers exclusively to creative economic transformation—the incessant process of restructuring and reorganization of businesses that revolutionizes the economy from within, through entries and exits of firms due to innovation.

Spurred by competition and changing conditions, continuous product and process innovation procedures lead to new and more efficient production units replacing outdated ones, resulting in increased average productivity in the whole economy.

Under the right conditions, there are various channels through which periods of depressed economic activity can boost creative destruction forces that promote productivity-enhancing changes. For instance, lower returns during an economic contraction can lead entrepreneurs and banks to put more effort into selecting investment projects—thus improving the allocation of talent, financial capital and other productive resources in the economy. Similarly, since a high labor force turnover is often costly, firms tend to hoard some of their workers during downturns and engage more staff in R&D tasks and training activities when business is sluggish.

Furthermore, recessions can also have a selection effect on the economy as less efficient businesses—often referred to as “zombie firms”—are more likely than others to go bankrupt during a crisis, providing room for more innovative ones to flourish. Similarly, when times are hard, creditors and lenders typically exert more pressure on business managers to use funds efficiently and effectively. These mechanisms have the potential to boost the economy’s aggregate productivity in the medium- to long-term.

The key is for policy measures to be aimed at promoting, rather than dampening, creative destruction in the economy.

While the reallocation of productive resources implied by creative destruction is best left to market forces, policymakers can help the process by providing appropriate incentives while minimizing the costs at the same time. The key is for policy measures to be aimed at promoting, rather than dampening, creative destruction in the economy.

For instance, subsidies to furloughed or unemployed workers could be partly linked to attendance in training programs, re-skilling and job-search activities—thus boosting the accumulation of knowledge and human capital in the economy. For firms, public liquidity support should be subject to clear time limits and measured against achievement of adequate productivity targets to weed out zombie firms while supporting viable entrepreneurial activity.

Most of all, policy should pay special attention to exploiting the opportunities provided by the COVID-19 crisis to encourage innovation—so that developing economies such as many of those in Asia and the Pacific can further reduce the technological gap with high-income countries. To this end, tax breaks or other incentives could be used to induce firms to reallocate staff to R&D activities during the downturn or undergo restructuring­ to adopt more efficient production processes and/or deliver new products and services.

Encouraging investment in new technology, such as advancements in digitalization, would favor the more innovative firms—as would incentives for training programs or hiring higher-skilled workers.

These measures should be accompanied by targeted social safety nets, aimed at protecting workers rather than jobs, and active labor policies to help workers adapt to an evolving job environment. To safeguard standards of living for vulnerable groups, governments should also aim at replacing distortionary and often costly food and fuel subsidies with targeted liquidity provisions and cash transfers for deserving households.

Depending on the country circumstances and context, such a policy strategy may require reforms at the institutional level to improve the conduct of public-sector intervention, bolster financial-sector development and implement regulatory changes to promote competition in goods and labor markets.

The COVID-19 pandemic represents a severe challenge for policymakers in Asia—turning it into an opportunity for “creative destruction” will help economies achieve a more efficient and fairer allocation of resources in the economy, enhancing productivity, economic growth and employment in the medium- to long-term. This requires policy commitments to support the phasing out of long-standing practices, to make way for a Schumpeterian transformation led by innovation and entrepreneurship.