“I think the most appropriate economic policy response to the pandemic would be for the government to supply adequate ‘survival funds’ to the private sector while the central bank helps with monetary financing of the resulting deficits”, Richard Koo, of “balance sheet recession” fame, writes, in a note dated Tuesday.
That is, of course, precisely what’s unfolding across the world. We are “simulating” incomes, both for individuals and businesses, in an effort to avert a scenario where a liquidity issue morphs into an insolvency crisis, triggering a wave of bankruptcies and inflicting lasting economic damage.
Koo’s latest contains a multitude of notable observations and quotable soundbites, starting with the contention that the decision on the part of most governments not to drive new infections completely to zero has “huge implications”.
This decision makes the COVID-19 crisis different from SARS, and it means some industries may never see their businesses normalize, a view that apparently informed Warren Buffett’s decision to unload his entire stake in airlines.
“Airlines and hotels could expect to return to their traditional business models eventually if the authorities were determined to eliminate new infections, but the likelihood that these sectors will be able to return to normal is greatly reduced if the authorities decide to relax the lockdowns before new infections have been brought down to zero”, Koo writes, adding that “if people think there is a risk–however small–of becoming infected by flying in an airplane, they will keep nonessential travel to an absolute minimum and take their vacations in places that can be reached with a car”.
That is a simple, yet crucial point. It means that life can return to some semblance of normal post-COVID, but it will, in fact, be a “new normal”. That’s because for many people, the risk profile of taking a short flight (for example) will appear asymmetrically skewed to the downside, especially if the same distance can be realistically traversed in a car without undue inconvenience.
That doesn’t mean anybody will substitute a cross-country highway voyage for a plane ride in instances when a trip from LA to New York (for example) is absolutely necessary, but it most assuredly means people will be hesitant to fly short distances, and especially wary when it comes to unnecessary short-distance flights.
When it comes to the readily apparent urgency of reopening western economies, Koo notes that differences in savings habits make a difference. “[One] reason for the relatively early loosening of the lockdowns in the US may be that the nation’s low savings rate makes it difficult for people to withstand a long shutdown, whereas the SARS outbreak was concentrated in Asia, where savings rates are generally quite high”, he says, adding that “these differences also mean we cannot expect the sort of V-shaped recovery seen after the SARS outbreak”.
He then reiterates that a V-shaped recovery is only possible “if there is zero probability of being infected with the virus”.
Next, Koo emphasizes that this is not a balance sheet recession. It is, he says, “entirely different”. Here, for those who need a refresher, is a (very) brief recap of the causes and remedies for balance sheet recessions:
A balance sheet recession happens when a nationwide, debt-financed bubble collapses, forcing the private sector to pay down loans. Their goal is to reduce the debt overhang caused when assets plunge in value but liabilities remain. The recession occurs because an economy will seize up when someone is saving and paying down debt and there is no one to borrow and spend those savings. It is therefore essential that the government serve as “borrower of last resort” and administer fiscal stimulus when businesses and households are collectively saving money to repair their balance sheets. This type of recession can be managed in countries–like Japan and the US–where the governments are both willing and able to act as borrowers of last resort. Unfortunately, fiscal deficit constraints eliminate that option in the eurozone. The economy will also deteriorate if a government is able but not willing to provide fiscal stimulus.
During balance sheet recessions, it’s incumbent upon the government to tap into the attendant private sector savings surplus in order to shore up growth and protect incomes for individuals and businesses which can then continue to repair their balance sheets.
That is, in effect, an accounting identity. As Koo writes, “since the deflationary gap that characterizes such recessions is equal to the excess savings resulting from private-sector debt reduction, private savings are by definition sufficient to finance the necessary fiscal stimulus”.
In that scenario, monetary policy is, at best, constrained in its capacity to help things along. If there’s no demand for credit, then lowering borrowing costs and freeing up banks’ capacity to lend is an exercise in futility. The read-through is that if you prematurely declare victory after a downturn of that sort and then use that declaration as an excuse to implement austerity measures before the private sector is ready to start borrowing and spending again, monetary policy cannot help, and you will likely fall back into recession.
So, what’s different during the pandemic? Well, lots of things, obviously, but for Koo, the crucial point is that this is a time when monetary policy can, should, and must play a role. It is neither impotent nor superfluous in the current circumstances.
Before getting to that discussion, Koo lays out the risk of widespread economic destruction in stark terms. The following excerpts echo the sentiments of every, single Fed official who has weighed in over the past two weeks and, incidentally, are entirely consistent with virtually everything written in these pages over the course of the COVID-19 crisis. Here’s Koo:
The single most important point to remember when considering economic measures in the pandemic is that otherwise healthy companies forced into bankruptcy because they run out of funds during the lockdown will not come back to life even if a vaccine is subsequently developed and the virus goes away. A subsequent economic recovery may take much longer as a result.
Today’s recession has very different causes [than the Great Depression], but the economy may be similarly unable to recover if many otherwise healthy companies are allowed to fail because of a sharp drop in GDP. We need to consider the possibility that the cost of preventing these corporate bankruptcies would be far less than the cost of engineering an economic rebound after they fail.
Not to put too fine a point on it, but that is precisely what I attempted to communicate on Tuesday in “Don’t Fear The Zombies“. For anyone who missed that post, you should read it, but below is one relevant passage which speaks to the excerpts above. Again, this is me writing:
Is a company that was able to cover its debt service costs many times over as late as February really “insolvent” because the government told all consumers to board themselves up at home to avoid catching a deadly respiratory illness? Maybe. But taken to its logical extreme, that means that in an event where total lockdowns last for more than, say, three months, nearly every company in America that doesn’t generate the majority of its revenue and earnings from online activities (or can’t substitute sales made at physical locations with home deliveries of those same goods or services) will be “insolvent”. What happens after that? How do you sort that out? Spoiler alert: You can’t.
Koo also notes that the funds to stave off an economic apocalypse have to come from the government. “The ‘survival funds’ needed to prevent the economic death of these businesses must be provided via fiscal stimulus, which in turn will require massive government borrowing”, he writes.
There is no private sector solution to this, partly because the problem is too big, but also because financial market conditions are prone to tightening severely in the current circumstances absent support from monetary and fiscal authorities. Corporates were drawing down revolvers and exhausting credit lines in March. Banks, meanwhile, provisioned for massive losses during Q1.
Thanks to the Fed and the government backstop for businesses, financial conditions are now easing rapidly, but that wouldn’t have been possible absent a backstop.
“Whereas financial markets are awash in funds during a balance sheet recession, when the private sector is paying down debt, financial market conditions will be much tighter during the pandemic recession because everyone is drawing down savings”, Koo says.
Issuance of government debt to fund the survival packages needed to avert an outright economic collapse must be accompanied by central bank buying of government debt, he goes on to write, before dispensing with the idea that inflation concerns and worries about the monetary financing taboo should override the necessity of ensuring our economies survive. Here’s how he puts it:
But if inflation fears leave governments and central banks reluctant to act, forcing many otherwise healthy businesses into bankruptcy, the time and money needed for an economic recovery could be far greater, ushering in the very phenomenon of “Japanization” that Western pundits are so worried about. There have already been many human deaths as most of the developed nations– Taiwan and New Zealand being two exceptions–fell behind the curve in their response to the virus. There will be a further price to pay if a half-hearted economic response to the pandemic causes large numbers of economic deaths. In that sense, I think the central banks of the world ought to use quantitative easing for the moment to buy up as many government bonds as necessary to enable governments to supply the “survival funds” needed to prevent the failure of otherwise viable companies.
He then makes similar points to those espoused repeatedly in these pages. This survival funding is not “stimulus”. It is life support. Or, if you prefer Steve Mnuchin’s tone-deaf characterization, “bridge liquidity”. This cannot fuel inflation precisely because the proximate cause of the problem (i.e., the reason the transfer payments are necessary in the first place) is a deflationary shock the likes of which hasn’t been since in a century.
Koo acknowledges that prices for some items will rise (e.g., grocery prices), but he notes there’s “almost no chance of inflation accelerating at a time when the pandemic has caused demand to plunge”.
Grocery prices surged the most in 46 years in April thanks in no small part to supply chain issues and demand for staples as Americans stocked up for the figurative apocalypse.
But core inflation dropped the most MoM in the entire history of the series (in red, below).
As detailed extensively in “After The Virus, Hyperinflation Or Deflationary Spiral?“, there are multiple channels through which the crisis could stoke inflation down the road, and the latest University of Michigan sentiment survey suggests some consumers are anticipating just that. But in simple terms, the self-fulfilling dynamic associated with inflation expectations will likely be blunted in the near- to medium-term by the fact that tens of millions of people are jobless and hence unable to pull forward consumption by virtue of being broke.
Yes, those incomes have been replaced, but with the exception of blatant fraud (e.g., PPP fund recipients buying expensive watches, to use one high profile example from the news cycle), jobless Americans and imperiled businesses aren’t likely to use emergency funding for the type of expenditures that would stoke inflation. For all the talk about the unemployed “making more” than they made when they were working, it’s important to remember that fixed costs for households and businesses haven’t simply gone away. The rent must be paid. Mortgages are due. People may suddenly be without health insurance, which may need to be funded out of pocket. The lights and the water need to stay on. Etc.
“Survival funds and other forms of fiscal stimulus being considered are not meant to fund capex or other real demand; they are… to help businesses and households pay their rent and other expenses”, Koo goes on to say. “These expenditures are designed to prevent a further drop in demand and forestall deflation and are unlikely to raise the price of goods and services”.
Capex, you’re reminded, is expected to plunge in 2020.
Ultimately, Koo says the pandemic will “have many irreversible impacts on the economy and society”, but none perhaps greater (from a macroeconomic perspective, anyway), than a possible change in attitudes towards savings.
This crisis laid bare the extent to which a disconcertingly large percentage of households and businesses were one disruption away from oblivion. We knew this was true in a narrow sense. How many times, for example, have you seen an article lamenting the number of Americans who are “one major household repair away from being broke”? Another popular headline reads “One in four Americans have just XYZ dollars in savings”.
But this crisis has shown us that the entire system is at risk of evaporating and ceasing forever to exist in the event the economy has to be shut down for a single month. I’m not sure anybody fully appreciated that previously.
“The truth is simple”, Deutsche Bank’s Aleksandar Kocic wrote, in an instant classic note out last month, underscoring the point. “A surprisingly large segment of the population is practically one paycheck away from some kind of insolvency”.
“In the absence of a major disruption, the system is capable of moving along by collecting small installments of rent (‘clipping the coupons’) from a large segment of the population”, Kocic continued. “However, if an exogenous shock disrupts the fragile order of these cashflows, there is a chain reaction of collective insolvency ready to sink the entire system”.
Realizing this (if only in hindsight) individuals and businesses may save more going forward for fear of experiencing a similar brush with insolvency in the future.
But if attitudes towards savings change, it will be important to remember the lessons learned over decades of pushing on strings.
(Nomura)
“If people who placed relatively little importance on savings until now decide that they need to set aside more money for a rainy day, we could experience the same sort of private-sector savings surplus seen during a balance sheet recession”, Koo says.
He then closes by cautioning that “a savings surplus in the private sector means that no matter how much liquidity the central bank supplies, those funds will not leave the financial institutions because the private sector is in aggregate a net saver”.
This is dire. I was of the “moral hazard” school in February. By March, I jettisoned that thinking. “Moral hazard” any longer is retro thinking. Richard Duncan helped changed my thinking, Then I found H.
it doesn’t matter that someone bought a luxury watch. It doesn’t matter if reporters around the country find 1,000 people who bought luxury watches with their $600. (The 10,000 people who sold the watches each received $600 income.) This is a depression. There will be some unsavory uses of the funds. So what. It beats a deflationary winter.
I was in the same boat as you. I didn’t trust the rally the past couple years as I saw corporate debt balloon and thought I would wait patiently in cash along with Buffett until we had some sort of crisis. I was admittedly frustrated at first seeing the market rebound so quickly as I didn’t move quickly enough to take advantage, but agree that H has helped make sense of all that’s happening and why all these support programs are critical.
H, I greatly appreciate your writing and have found myself much calmer and less resentful as I watch the markets. Now I feel like I have a much better grasp of the dynamics driving the market and also have taken a much less judgmental view of the fed. There are people and businesses that need all the help they can get right now which is far more important than me making a couple extra bucks on their backs.
I have no idea where we go from here, but I’ll just continue to be patient as we assess the ongoing damage and hope that things don’t get worse.
Not wearing a mask in a privately held public place of business being a trampling of rights??? Moral hazards always abound. Morals are what we grew up on. Adult humans have many decisions to make and prefer to defer and use the age old survival mechanism; Denial. Powell mentioned the fiscal side right from the beginning. Politics is the ultimate ongoing denial of reality. We have a hard road ahead, no denying. Religionism and nihilism are currently the strange bedfellows we are up against. That has got to be wrong and so what, may trump foresight and wisdom. Very many investors and economists are coming around to sudden realizations about what we are up against. Jealousy about a watch is so trite. Trees and forest.
Really interesting reading and a lot of ideas to think about here.
INFO for those who didn’t Google Richard Koo…..He is Taiwanese , American Educated Economist….Grew up in Japan and is currently at Nomura (with Charlie)…after working with Fed in US…
Anyway , what comes to mind is this Pandemic and how it exploits different parts of the World in different ways based on the characteristics of different economies and their relative position as regards development and prosperity..
Here in the US a developed economy relatively prosperous the large portion of the GDP is Consumer Spending (generally quoted at 70% ) This creates a situation where the jobs especially in the lower 50% (earnings wise that is) are in services and thus nonessential to the functioning of a society except as regards people having income and perpetuating the system. When the apple cart is upset (as currently it is) the magnitude of the problem is phenomenal in it’s scale . Elsewhere the dynamics change based on the ratio of services to essential activity.. It as I recall was my initial argument against Globalization which was a trend during the Clinton Years and was a factor in American Prosperity for 4 decades to come… It will be interesting to watch the Recovery Rate of different economies on the Global scale… I sort of see this feature as being a relevant part of future discussions and Political trends…..Actually it already is……!!
Can you imagine what the Bundesbank would be doing if they were still independent? No doubt they would be cranking up rates and tightening monetary conditions!!
Otherwise healthy/viable companies.. is like saying a person has a tumor which will eventually kill him, but he’s otherwise healthy, or an animal that didn’t eat up to survive next hunger season, but otherwise healthy.
No matter where you look in a world around us, you will find examples of moving fast but dying quickly, or moving slowly but surviving dangers.
It’s the same with humans. We either spend like there is no tomorrow, enjoy life in beautiful places – or we brace for long run, we sacrifice ability to live in places we like with places less developed, but economically more viable.
It is impossible to fix the fact that people in USA, and large cities like NY, SF, LA, are living paycheck to paycheck. An attractive place always brings enough population that competes with each other to the point of worst possible quality of living conditions, and worst possible savings. You can’t demand higher salaries, you can’t save, because there is always someone else willing to accept a job and living on less sqft and saving less.
And so there are people who recognize how deadly these places are, and they purposely build their families and life in remote and harsh places.
It’s the same with companies. Company as a whole represents psychology of it’s owners and managers.
When someone starts speaking about “saving” population, or a business, or an economy – to me it looks like a God complex. Wanna play with rules of the nature? Simulate this and that? Save those who’ve been more greedy and less prepared for end of a party? You can do it, for some time, but there will be consequences.
By “patching” the system with money, we just extend lifespan of a broken policy and unhealthy individuals and organizations. But sooner or later change will happen anyway.
I think Sociological like Economic phenomenon are played out in generational cycles .. Witness the mood and actions of people (next 2-3 generations) following the Great Depression of the 1930’s..and compare to today … Those lessons are going to be relearned as we will likely see.
So your contention is that any company which cannot ride out a 3-month cessation of all economic activity should be pushed into bankruptcy? Do you have any idea what that would entail? This is like the people on Twitter who suggest the Fed shouldn’t have reinstated the commercial paper funding facility. What you’re suggesting is economic oblivion. If that’s what you really think you’re prepared for, then more power to you. But my guess would be you’re like the rest of us: Not really excited about the notion of the ATMs going dark and tens of millions of businesses closing their doors forever, leaving entire communities with nothing left other than a lonely gas station and abandoned store fronts.
There’s lots of talk about the coming change in consumer behavior, moving from profligate spending to saving where this new saving pattern will represent a drag on economic recovery. The oft-quoted “only $000 away from disaster”, where that amount is in the hundreds of dollars, is misunderstood I think.
I think I heard around 50% as the portion of the population is in this situation.
I’m going to say that this was not due to their spending but rather because that’s all they COULD save.
If that’s true I’m not sure that will change in the new normal. What effect will that have on the savings assumptions? As more policies continually shift wealth to the top it will be more difficult for a great part of society to save or possibly even be employed.
I also have a problem with minimizing the idea that inflation is only occurring in groceries. Not because it’s wrong but because groceries constitute such a large portion of many people’s income. Grocery inflation is not nothing and shouldn’t be relegated to parentheses. It’s more blatant in the “core CPI ex food and energy”
“I’m going to say that this was not due to their spending but rather because that’s all they COULD save.”
Agree with this and would add that many of the folks who struggle with buying groceries pay more for groceries because they don’t all have access to businesses like Costco to help maximize their grocery budget.
The other thing I would add is that they also don’t have a reliable way to grow whatever savings they can scrape together. If you barely have enough to cover a few weeks, let alone a few months, of expenses, you surely aren’t and shouldn’t be putting that money in the market, but you also can’t earn any sort of interest either.
I agree with you on the poorest people. But I know lots of middle class people that live from paycheque to paycheque, have the latest iPhone, live in the biggest house they can mortgage, eat in restaurants, and wear nice clothes because their friends do. My grandfather grew up scarred from the Great Depression, and even when he was older and well off, couldn’t freely part with money. Society is going to change.
I don’t buy the argument regarding that’s all people COULD save. Is there a portion of the population in that boat? Of course. There’s also a lot of people who have decent salaries and yet spend more than they earn.
I think the belief people will dramatically change their spending/saving habits due to the pandemic is wrong. A few will. Most won’t and a few will go the opposite direction (stop saving and start spending).
Agreed.
The truth is that the savings rate in the United States has been decreasing over the last half a century. To be sure the lack of a living wage at the low end of the socio-economic ladder is partially responsible for this trend. Personally, I find the fact that the federal minimum wage is not indexed profoundly troubling. Regardless, the phenomenon of Americans living paycheck to paycheck extends well beyond the lowest income strata of society. It is only mildly hyperbolic to say that for a large segment of the population of the United States living at the limit of their means is part of the national psyche.
Through mass media – primarily entertainment – Americans are conditioned to celebrate the trappings of wealth from early childhood. I am not suggesting that Americans are unique in this regard, after all human beings are naturally drawn to shiny things. That said, whether the all-out pursuit of material possessions has been focused by ideas like American exceptionalism or ideals like the American Dream it is, at this point, very much a part of the national fabric.
While (outside of dystopian novels) corporate culture is not monolithic, I don’t believe that it is exaggeration to say that, in general, big business has reinforced the ‘keeping up with the Joneses’ phenomenon in popular culture to such a degree that only large scale social upheaval might lead to a new paradigm.
No H… I do not view this as a blame game or criticism of actions taken the last three months. I was strictly talking about the fact that we as a Nation forgot about the lessons of the past and were grossly unprepared for this virus as if something like this would never occur… Lack of Preemptive actions in Health care as well as the trajectory on the Economic front creating vulnerabilities that we all see and talk about on this site need to be put on the Political and Legislative table seriously so situations like this can hopefully be avoided.. Corporate Tax breaks ,as well the excessive stock buybacks of the last half decade as well as role of Politics in the Fed need a serious second look potentially avoiding issues that once again destabilize an already fragile Economic structure.
As the public goes they will hopefully adjust their priorities based on this last years experiences as well…
Reply was to the other commenter — the one you replied to.
Whoops my screw up.. Lol
Before the pandemic there were millions of Americans living on the edge with little choice to do anything else. After the pandemic is over, even if NO businesses went bankrupt, they would still be looking at nothing better than picking up where they left off. A huge problem before and an even bigger problem looming on restart. (And an even bigger problem if Trump and the GOP remain in office ready to continue to siphon off their billions on whatever governmental programs that are put in place to try to put the masses to work again). We are just now coming to grips with how hard life is going to be in the coming decades for a hell of a lot of people. God help us.
Besides the permanent closure of otherwise viable businesses, if there’s another thing this house of cards of an economy cannot withstand, it is a significantly higher rate of savings from regular consumers. That would likely set in motion the endgame of a deflationary spiral, and a debt jubilee as the only way out. Barring some radical fiscal changes, and soon, I think that is likely already baked in the cake. The problem continues to be skyrocketing levels of insecurity, and an almost total lack of visibility even to the near future. Every fiscal move so far has been life support, as H-man correctly points out. Unfortunately, the nature of the life support is temporary, and it has generally been too little, too late. Not to mention the fact that tens of millions of families have also just lost their health insurance along with their incomes. If every life line comes a day late and a dollar short, as they say, with a short sunset attached, all but the most irresponsible will ask, “but what about next month, next year?” and likely save as much as they can. Like I said, I think we’ve baked the cake we’re just not eating it yet.
I’ll add to those of you above who believe that saving is somehow unAmerican, or that Americans simply cannot help but continue to spend beyond their means ad infinitum, or that saving is some vague, Asian cultural phenomenon, that your position stands against all of biology (it may also be Orientalist). It is anti-biological. When the horizon darkens and winter approaches, squirrels bury their treasure of acorns, bears fatten up to hibernate until it’s over, and humans preserve the harvest: they pickle, they ferment, they salt, they fill the root cellars. This is the same phenomenon, and it really is that simple, regardless of what propaganda CNBC is spewing at the moment.
When it comes to Economic cycles and equity pricing the system managed to do away with reversion to the mean in less than 10 years…. I suspect , as you state , peoples basic instincts will not altered quite so easily once the Wolf shows up at the door on a repetitive basis.