“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.
“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”.