It has been another week of interesting panel discussions over the web. Many new perspectives and ideas have been brought up yet again allowing us to have a better picture of what the coming months are expected to look like. If you’ve read my last article, you’ll notice that there are ideas that are the contrary of one another. So, whose ideas do I listen to and consider? I would recommend you do both. People will have differing perspectives no matter how educated or how experienced they are. This is what makes any topic so exciting and constantly changing. It is important to understand the thinking behind each idea that you are being told about and consume these thoughts. When you are able to do this, you’ll naturally form your own ideas and perspectives and decide on what you agree with and what you decide to follow. That way you are likely to have a more rounded understanding whatever the topic may be. Now, over to this week’s speakers who discussed the economic outlook during a pandemic.
Navigating a Recession, Finimize
Sylvain Broyer, Chief economist EMEA at S&P global ratings
There’s been a significant amount of government spending in both the US and Europe. Looking at the CPI predictions for 2021 inflation doesn’t seem to go too high for the economies. Do you expect inflation to become a problem later on, after 2021?
People won’t be spending in the short term as they are under lockdown and can’t freely move. We’ll see deglobalisation of supply chains as these times show a better picture of how important it is for a country to be able to stand on its own two feet when it gets to producing goods in a tight environment. Level of consumer prices won’t increase more before it decreases first. In a few weeks, the question will be about how recovery could increase potential growth in the EU if sustainable growth is achieved. Depends on the policy response and recovery fund if they will allow the creative and destructive processes to play in full or not.
Potential debt crisis in southern Europe?
The level of systemic stress is much less important than during the GFC or the EU crisis. We’re not at the same stage as we were then, we won’t see a repeat of the 2012 debt crisis. Look at what IMF said in terms of public deficit: It is expected to widen 7% of GDP. Theoretically, interest rates can remain at the current level, but interest rates are much lower now than they were 7 years ago. Italy has yields of 100 to 150 bps below what it was 2 years ago. Where’s the stress? The more important question to ask is what the ECB could do about a second wave. It’ll depend on governments and willingness of the population to accept more lockdown. ECB monetary space is not exhaustive , they will have more space to do more. However, the ECB won’t be allowed by the treaty to buy public debt on the primary market and so therefore, won’t be able to buy as much debt as for example the bank of japan. Japan has a balance sheet of more than 100% of GDP because of this. The ECB however, has to cope with the EU treaty ban on direct financing of governance. The direct financing of states makes some people believe that the ECB won’t be allowed to buy more than 50% of public debt outstanding. After 5 years of QE they now have about a quarter of debt outstanding. After the program, they’ll probably have about 36%. After all this, they will still have 2tr of public space to buy debt. It will be a more drawn out recovery in Europe compared to the US. The EU is better prepared to cushion the recession, but not better prepared for the recovery. Policy response is very different between the two economies. The economic losses will be taken by the government in the US. The housing and corporates will be at the losses.
European governments have implemented short term pay. It is a very strong move as in Germany it avoided 3-4% in the unemployment rate in 2009. The cost for the states for short-time worker is less important than the long-term unemployment benefit. But it isn’t out of altruism but rather an incentive as it’ll help smooth the unemployment rate. Don’t expect the unemployment rate to increase by more than 1% this year. Longer-term: the US will find a quicker path to recovery than the EU. Quicker process of creative destruction in the US than Europe.
Gold what direction will it go? And other safe havens, and bitcoin
Data shows the bitcoin is not a safe haven as some people might believe. Gold is in physical and it could be traded 200 years ago, it could be used as a medium of exchange. That’s why its historical value has a safe haven. But now you don’t hold gold for the same reasons, you can’t buy bread and necessities with it. Buying gold is now for speculating. Precious metals are bought in sharp downturns but then they don’t survive the recovery. Especially if there’s a ban on dividend payments in the stock market, it’ll make yielding assets scarcer when the recovery sets in as soon as the 3rd quarter, positive yielding assets will be very high in demand and gold won’t belong to that group.
Relative value of currencies
Foreign exchange swap lines will protect the currency, where it is right now. This helps avoiding too much FX volatility. Don’t expect too much change in the currency money.
London Business School, The economics of a pandemic
Paolo Surico, Professor of Economics LBS
The important area to look at is the cash flows. As uncertainty increases households reduce consumption. Less consumption will mean that the firms receive less income and will make less profit. In some cases, this will lead to the firms having to close down. Increasing uncertainty reduces investment. If you stop the cashflow of earnings, it will reduce the cash flow for consumption which causes the cycle.
Many small businesses rely on cash flows. Firms with cash flows to asset ratios of above 0.5 account for about 10% of employment among private businesses. All private businesses account for more than 60% of total employment. So (small) firms with cash flows to assets > 0.5 account for some 6% of total employment in the economy. Looking at the balance sheet of private firms, the larger the firm the more assets the less cash flow to asset ratio. Smaller firms stop selling because they can’t survive instantly. Asset values also go down significantly due to value loss.
A survey of US businesses with fewer than 500 employees impacted by the coronavirus finds that 43% are temporarily closed due to Covid-19, citing lack of demand or employee health. On average, workforces have been reduced by 40% since January. Three quarters report only having enough cash on hand to cover expenses for the next two months or less. 70% are interested in a government-subsidized aid program but worry about bureaucratic hassles or challenges proving eligibility.
Many new businesses will not start up. Start-ups account for the majority of job creation in the economy. Experimental new data indicates a sharp decline in applications for new businesses in the last two weeks of March, among both firms planning to hire workers (red) and self-employed (blue). These businesses applications have shown a high likelihood of becoming an employer business within four quarters, indicating both near-term and longer-term consequences.
One third of the British population self-report their financial situation as “finding it difficult” or “just about getting by”. 48% of renters, 32% of mortgagors and 18% of outright homeowners appear on the verge of financial troubles. 1/3 of the British population are cash on hand, you stop their flow of income it’ll stop their consumption of income.
At first, COVID -19 may look like a supply shock:
- Disruption in global supply chains
- Quarantine and social distancing decrease the number of hours worked
Different from previous crises:
- Great recession of 2007-09: the origin of supply shock was in the financial sector
- War/natural disaster: the origin of the supply shock is the destruction of infrastructure or large-scale permanent loss in the labour force.
Then, demand effects materialize:
- Uncertainty about the progress of the disease
- Uncertainty about economic policies that will alleviate
- Non-permanent workers will lose income, particularly in affected industries (e.g. hospitality, manufacturing)
- Households increase precautionary savings
- Firms wary of investing until the situation clears; also lack the liquidity to do so
Feedback loop into supply:
- Firms (especially those more dependent on cash flows) lack the liquidity to fulfil commitments while facing lower demand and thus are forced to file for bankruptcies.
Demand and supply loop similarly to the financial crisis, though uncertainty is about the disease.
Different from war/disaster: there, demand might increase as governments redirect war efforts towards fight/rebuild and so potentially inflationary.
Feedback loop into demand:
- Workers who lose jobs from closing businesses do not have an income anymore and therefore lower consumption, eventually depressing aggregate demand.
Assume only a temporary drop in economic activities: 50% for a month and 25% in the two following months. Then, GDP drop of almost 10% of annual output!
Make the countries lock down longer and add the supply/demand downward spiral, then the actual costs (without policy interventions) could exceed 15% of GDP!
Output loss associated with the Great Recession was about 4.5% and still unrecovered.
The policies that are chosen to fix this will need to:
- Be now and be massive, of the same order of magnitude of the output loss. UK announced a package worth about 15% of GDP. Unprecedented!
- Start from health expenditure: invest in testing and expansion of supply. Too late now for the first peak but still time to contain the second peak in the Fall of 2020.
- Be about cash disbursements to households and businesses and incentivise labour deployment. Tax incentives or cuts, emergency loans and borrowing on better terms, by their own, are unlikely to prevent a collapse in aggregate demand.
- Use a coordination of fiscal and monetary interventions to maximize and multiply impact and provide financial backing to each other policy.
- Be global: interconnected society and economy require global coordination.
Consolidation of SME?
The cycle is forcing the business, change what they do. For example, a taxi company won’t have much demand so it could use its resources to deliver food. The firms could also ask the government for subsidization into a new area. Much more of reallocation and retraining of resources will be needed for a lot of businesses to survive. The government can push salaries to a higher level if employees retrain to a different sector. IT, home delivery, the conversion needs to take place and the government needs to facilitate that.
Should the government cover all the debts of businesses?
The firms will have incentives to take on bad loans like this. The problem is that down the road the taxpayer will have to pay the bad loans that develop. 100% of the debts should be helped by gov as it’ll require cash to keep flowing. But we don’t want firms to sit at home and do nothing and get paid. They also need to make sure that these firms are creating value and carry on working.
The government has been executing some heavy emergency measures. It’ll be hard for the government to exit from these emergency measures. Since 2008 the UK hasn’t even recovered, the interest rates haven’t even got back to 1% and now we are cutting again. With this heavy government support, we lock our-self into a zombie economy. Everything becomes dependent on it and if the government doesn’t become stricter with who gets a life jacket markets will get addicted to this support. Do you think this will be one of the main drivers that cause a lot of the businesses to fail during this crisis and will the quality of entrepreneurship will be reduced due to this?
During the GFC it used to be a decision on bailing out the bank or not. Now it is a decision about bailing out the corner shop down the road. This downturn is 10-20 times larger than anything we’ve seen before. This could trigger a large policy convention but also make the exception of the situation clear.
Debt to GDP being high right now, is it unsustainable?
Debt is attractive, especially given the ultra-low interest rates. But guaranteed by whom? UK/US governments have sufficient credibility to afford it without too much sovereign risk but would still require coordination with the central bank.But Italy can’t! Lack of both government credibility and independent national central bank. An Italian problem? Not really. Just timing is different: “Europeans are all Italians”
In this chart there is hope, the government can go to higher levels as it has in the past. It took 100 years to reduce the debt from 200% to 30%. Most of the reductions of the past didn’t come with debt but with output growth. Growth in performance can reduce the debt. It could take 20-30 years to bring down the ratio that we are expecting to have after this recession.