The coronavirus is both a public health and economic crisis. The fact that it is acting as a demand-side and supply-side shock, coupled with the medical solution being antithetical to economic recovery in the short-run, means that its severity is difficult to be underestimated. It also means that there are policy implications on how governments around the world ought to be dealing with it.
I think this is best illustrated by considering how the initial shocks in output will translate into longer-run second-order effects that slow recovery. From there, we can better understand which policies are more effective and which are less (hint: this isn’t your run-of-the-mill dip in the business cycle).
The coronavirus pandemic has first-order implications on demand and supply. On the supply side, workers being stuck at home from self-quarantine and being unable to commute to work due to transport shutdowns represents a huge reduction in the productive capacity of the economy.
On the demand side, as ordinary citizens start staying at home, there will be fewer customers for various businesses, most notably for shops, restaurants, airlines and various tourism-related businesses - this can be seen in the following:
In the last week of February, Walmart saw a 16.5% decrease in foot traffic compared to the week before. The price of oil has fallen to levels unseen since March 2002. Qantas has cancelled all international flights and furloughed 20,000 staff members. The big three automakers of Ford, GM and Chrysler have shut down production in the USA - that’s over 100,000 people who were employed who may no longer be, or at best be furloughed with less pay. That’s not to mention the 1 million other people employed in auto-manufacturing in the USA and 1.3 million in auto dealerships, all of whom will see the same risks to their employment status.
What this means is that all of these people are going to be saving more and spending less as their incomes fall, cutting into consumer demand. Combined together, this represents an economic contraction of staggering proportions. Analysts at Goldman Sachs are predicting a 24% contraction in US GDP in Q2 (April to June 2020), while others are expecting up to 1 million a month to become unemployed till at least June.
To put that into context, GDP fell by 4.2% in the Great Recession and 750,000 people lost their jobs every month. This would suggest an economic collapse beyond anything that anyone alive will remember. And worryingly, that is just the tip of the iceberg.
The direct supply and demand-side impacts don’t come close to taking into account ways this could get much worse - via government policy exacerbating the slump and via second order impacts that are likely to persist.
The former is simply an observation that governments will and are already mandating lockdowns (see: over 20% of the US population is under lockdown) and border controls (see: US-Canada, US- Mexico, Denmark etc). These will only serve to aggravate the existing collapse by further reducing consumer spending, and are likely to only become stricter as the coronavirus hits its peak in the western world.
The latter are second order effects that could prolong the crisis - it’s not the case that firms can just shut down and restart production once the coronavirus disappears. That’s because most firms, especially SMEs that drive the bulk of the economy, have little in cash reserves. The same goes for a significant proportion of the population, who live paycheck to paycheck and have little in savings.
An economic shutdown, even a temporary one for a few months, wouldn’t just be a matter of people and companies not earning money for a while - it would mean that millions go into debt and lots of companies into bankruptcy as their cash reserves dry up.
Even larger firms such as Volvo Motors are anticipating little more than half a year worth of cash reserves. This is problematic given that many companies, with the cheap lending conditions of the past decade, have become accustomed to refinancing debts. While this might have worked when lending was cheap, the coronavirus crisis has exposed the imbalanced financial system propped up and distorted by over a decade’s worth of ultra-low interest rates and quantitative easing.
This debt bubble (with more than $2 trillion in corporate debt due this year) could burst as lending dries up, causing a surge in corporate bankruptcies among firms that have taken excessive risk. One example would be Virgin Airlines, which has over $5 billion in debt to pay off while its market value has halved to a mere $500 million since the coronavirus crisis. It seems doubtful that many would lend to such an over-leveraged firm, making rolling over this debt nigh on impossible.
This could cripple the recovery as firms spend a long time deleveraging, and alongside this there would be firesales that devalue safe assets (hurting even responsible investors like pension funds and mutual funds), bankruptcies that hurt creditors and closures that lead to job losses. These mechanisms will contribute to a debt-deflation recession (where economic growth remains stagnant due to the need to pay off debts), one that is even riskier this time around, because corporate debt is 2 times as large as it was in 2008.
S&P are predicting defaults on non-financial corporations in the US to reach double digits and European firms to come close in the next year, especially since nearly 80% of corporate debt in the automobile industry is rated as speculative and 30% in the oil industry is rated as junk.
Worryingly, this is not isolated to certain industry, with around 50% of corporate debt in the US being rated BBB, which is just above junk bond status. That not only creates a risk of them being downgraded, making refinancing difficult, it also means more conservative investment portfolios in mutual funds may be forced to sell them off, triggering a further fall in value.
This financial risk is an international one - when there is panic, money usually flows into more stable countries, fleeing developing ones. In the first 8 weeks of the coronavirus panic, more than $55 billion has flowed out of emerging economies, double the leakage that was seen in 2008. This seriously compromises the ability for developing countries, with small tax bases and weak public finances that depend on foreign capital, from engaging in extensive government and private spending
Where We Stand
Perhaps the clearest sign of the economy being structurally compromised is by looking at leaders and markets. Deficit hawks across the globe are willing to throw their beliefs aside, with German leaders acquiescing to a €356 billion borrowing program, because they recognise the potential for catastrophe.
Markets are sending a similar signal - one of panic. Under normal conditions, US Treasury bonds in- crease in value when other asset prices fall, because they are seen as the safest possible assets one flees to. The fact that US sovereign debt fell in value, even if temporarily, suggests that people are sufficiently doubtful they’re turning to cash, a worrying sign of confidence in the state of the global economy.
However, it is not all doom and gloom. For one, many of the predictions of analysts are unreliable. They depend upon assumptions regarding the economic impact of a pandemic, epidemiological estimates of when and where the virus peaks and political guesswork about the responses of various governments.
To add to that, there are undoubtedly ways to mitigate the economic dangers, and we have more resources to deal with this economic crisis than we did in 1929, making a Great Depression-type event unlikely.
The Monetary Response and its Limits
On the monetary side, central banks are doing their utmost to cushion the collapse and prevent the financial system from becoming a problem in its own right. The Federal Reserve and the Bank of England both slashed interest rates to near 0, with the BoE hitting the lowest base rate in its 325 year history. This has been further bolstered in the UK by the BoE lowering capital requirements among banks, allowing them to lend out even more money.
They have also begun engaging in bond purchases and increased access to short-term loans, with the BoE offering £100 billion worth of cheap loans to companies and the Fed providing significant backing to repo markets and commercial paper markets. The former is where Treasury bonds are bought and where banks derive their day-to-day funding, while the latter includes money market mutual funds that provide 3 month loans to businesses. These are two key aspects of the financial system that keep banks and businesses well-funded.
Meanwhile, the European Central Bank’s President, Christine Lagarde, declared that “there are no limits to our commitment to the Euro”, a declaration reminiscent of Draghi’s “whatever it takes” statement in 2013 and one that restored some confidence among investors.
Insofar as the dollar remains the global currency, the Federal Reserve is crucial in ensuring dollar- liquidity across the globe, and as it did in 2007, it has opened up swap lines with other major central banks. By extending the length of time of the swaps and lowering the interest margin it charges on those swaps, it has been able to provide more dollar-liquidity in financial hubs globally.
Combined together, these steps are crucial in preventing a financial panic and ensuring that credit is readily available - however, central banks are somewhat limited in their effectiveness. Most obviously this is due to interest rates being already low, meaning that markets are likely to believe central banks to have limited ammunition - the stock market rally following the Fed’s 0.5% rate cut lasted a mere 15 minutes, and the ECB will face bigger problems with its base rate being already at 0. Functionally, the Fed deployed nearly all of its playbook in a single weekend (compared to across a year and a half during the Great Recession), and other central banks aren’t far behind in exhausting their resources.
Furthermore, the Dodd-Frank Act means that the Federal Reserve is no longer able to bail out individual companies outside the banking sector as it did in 2008 with AIG. Instead, it would need the Treasury’s approval for these loans, making it likely that fiscal policy will take the forefront if it comes to supporting insolvent airline companies. Although all of this liquidity provision will help cash-strapped businesses survive the next few months, its constraints mean that fiscal injections of capital will indubitably be needed to provide the thrust of the support and give them time to get back on their feet to reignite the economy.
The Fiscal Response and its Limits
In the UK, Chancellor Sunak announced that the UK government is going to pay 80% of wages for those who have been furloughed due to the coronavirus for up to £2,500 a month for at least three months. This has since been extended to self-employed individuals. That is equivalent to paying up to the median wage, representing a significant injection. Alongside this he has offered a £330 billion package of government loans to firms hurt by the coronavirus and cash grants of varying sizes to 700,000 small businesses.
Perhaps most importantly, he has been clear in his determination, saying that he has the legal authority to “offer whatever further financial support necessary”. That represents a huge commitment towards defending the economy that undoubtedly renewed confidence among business owners.
Meanwhile, the USA has delayed tax day by a quarter, bringing it to July 15. The $2 trillion stimulus package provides handouts of up to $1,200 per person, suspends student loan payments for 6 months and expanded unemployment insurance by $600 a week for four months. This is on top of the $200 to $500 a week provided by states, and alongside this is the creation of an unemployment assistance program to include the self-employed, independent contractors and gig economy workers.
The Treasury has also provided $500 billion in loans, with 10% earmarked for air carriers and national security. The loans are conditional upon businesses not being able to issue dividends till at least a year after the loan has been repayed and them retaining 90% of employees for 6 months, with a delayed repayment schedule for SMEs and non-profits. $1 billion has also been provided for the Defense Production Act, with Trump compelling GM to make ventilators via this legislation.
The package further includes $32 billion in grants and $29 billion in loans for the airline industry, conditional upon them not making furloughs, paycuts, stock buybacks and issuing dividends for the next 6 months. Hospitals and healthcare also received $117 billion to support the provision of care.
These sorts of fiscal policies are by and large enormous commitments that will help businesses stay alive and not have to fire their workers immediately, allowing economic spending to continue.
However, this sort of conventional fiscal firepower is unlikely to be sufficient, primarily because of the unique nature of the coronavirus crisis being one where the fear of contagion rather than credit is the limiting factor on demand.
The supply-side nature of the crisis is similarly difficult to deal with, since even if firms have the money to pay workers, quarantines mean that they may be at best less productive due to working from home, and at worst unable to go to work in sectors that cannot rely upon working online.
In this vein, fiscal responses will need to be targeted towards keeping families afloat while a quarantine is in place - with over 25% of the workforce not covered by sick pay, the ability for many workers to return to work and thus spend their income depends on dealing with the medical threat alongside financial support. That means further fiscal plans to build up a comprehensive short-term safety net and increase healthcare provision.
The Outlook Going Forwards
The best case scenario is one where the market is forced to deleverage, and where the crisis proves to be a useful correction for a bloated economy. However, this requires an incredible amount of collective action - not only to ensure that a credit crunch doesn’t occur, but also to protect ordinary citizens from the potential downsides of this adjustment as they stay at home. It is incredibly unclear if central banks have the capacity of doing the former and if governments have the political will to do the latter. The worst case scenario looks like an economic calamity beyond the scale of even 2008, and one that lasts a long time because it is coupled with a medical crisis stemming from insufficient access to coronavirus test kits, respirators and hospital beds. Regardless of which occurs, one thing is certain - the cracks and complacency in our medical and financial systems are becoming incredibly apparent, and life post-coronavirus will not look the same as beforehand.