The pandemic has laid bare underlying “social and economic malfunction, which would have remained latent and unobservable without it”, Deutsche Bank’s Aleksandar Kocic writes, in a note dated Friday.
Kocic’s latest picks up on themes he explored both in recent research and in notes published pre-pandemic. Last week, he characterized the current crisis as multifarious, with countless points of intersection. I called it a kind of Venn diagram that, if only we could comprehend it, would describe a historic period of economic and societal upheaval.
In his latest, Kocic identifies a trio of risks which will define the contours of future economic paths. They are:
- Long-term inflation,
- Post-pandemic scarring of the economy, and
- Political entropy
These risks, Kocic says, “span three horizons but are interwoven with one another”. How each is resolved will help dictate the evolution of the others.
Although fiscal hawks went largely silent during the darkest days of March and April, when lockdowns across the US halted virtually all economic activity, they’ve since resurfaced, just in time to “help” negotiate the next virus relief package which aims to avert a series of fiscal cliffs.
In addition to the notable deadlines mentioned in the figure (above), a moratorium on evictions for federally insured multifamily homes runs out on July 24.
One way or another, fiscal policy will remain loose over the next year or two — it’s just a matter of how loose, which is the issue set to be debated over the next two weeks in Washington.
On Friday, Janet Yellen and Ben Bernanke said Congress should widen the deficit further, especially considering low borrowing costs. “Following our advice would further increase the already record-level federal budget deficit”, the two former Fed chairs wrote, after delivering a series of fiscal policy recommendations. “With interest rates extremely low and likely to remain so for some time, we do not believe that concerns about the deficit and debt should prevent Congress from responding robustly to this emergency”, they went on to say. “The top priorities now… should be protecting our citizens from the pandemic and pursuing a strong and equitable economic recovery”.
In short, Yellen and Bernanke were simply reiterating that we live in a world of monetary-fiscal partnerships. Central banks ensure borrowing costs are low and also purchase massive amounts of government debt in order to facilitate spending. The idea is to enable fiscal policy by making large deficits less problematic, to the extent you believe they’re problematic in the first place for the issuer of a reserve currency. The figure (below) is a bit dated, but it gets the point across.
The constraint on spending for a country which issues a reserve currency is inflation.
“Depending on how fiscal stimulus is administered, inflation could become a problem of varying degrees”, Deutsche’s Kocic writes, noting that “while inadequate fiscal stimulus would be considered a political failure, if not done carefully, inflation could become an issue in the long term”.
Many argue that the longer-run effects of the pandemic (e.g., on-shoring, supply chain disruptions, de-globalization, and a reinvigorated protectionist bent) have the potential to exacerbate inflationary dynamics.
Kocic writes that “both fiscal and monetary policies are expected to remain easy in the next 1-2 years”, but cautions that offsetting the impact of the pandemic and serving as a longer-term catalyst for growth are two different things. Or at least they could be, depending on distributional decisions.
BlackRock’s Larry Fink on Friday warned that the recovery is progressing in a “bipolar” fashion, and that if small- and medium-sized firms do not share in the benefits of stimulus programs, the economy will not recover its former vibrancy. For example, anecdotal accounts in the media suggest that the psychological impact of new lockdown measures associated with governments’ inability to contain the spread of the virus is enough to compel some restaurateurs to shut the doors for good. That’s already happening in Texas. Permanent job losses spiked by the most since the financial crisis last month, even as the headline numbers from the June jobs report were touted as heralding a comeback for the US labor market. This is the very definition of the “scarring” effect that so many economists have warned about.
“The unknown effects of the current crisis present a medium-term risk over a one- to two-year horizon”, Kocic goes on to write, noting that in addition to the social issues in play, “the actual depth of the demand shock, when the economy reopens, and the actual scarring — how many businesses survive and what the new economic landscape will look like”, remain largely out of grasp at the current juncture.
How these issues are ultimately resolved depends in large part on politics. Political entropy, Kocic says, will be the “main driver of market volatility and action in the near term.
Next, Kocic takes you into two possible futures — down two possible paths — defined by two forms of distribution: non-egalitarian and egalitarian.
In a non-egalitarian future, fiscal stimulus is distributed in such a way that the risk of spiraling inflation is held in check, but at the expense of economy vibrancy and with the possible consequence of an inegalitarian spiral even more dramatic than that to which America is accustomed.
“Direct subsidies towards big businesses whose survival alone is less dependent on it, but whose strength [is] view[ed] as more relevant for overall economic well-being” is an inherently uneven distribution, quite possibly predicated on a mistaken view of how the US economy is structured and an overly optimistic assessment of the pandemic’s evolution, Kocic suggests.
“Scarring would likely be deeper and irreversible for many small businesses and significant sectors of service economy”, he adds.
That would be catastrophic. Small employers (i.e., those with 1—499 employees), account for nearly half of America’s private-sector workforce. The services sector is the backbone of the country.
“If this turns out indeed to be the case, big businesses would come out of the crisis stronger with reinforced monopolistic power and, facing weaker competition, with a higher level of market domination”, Kocic remarks, cautioning that this outcome may trigger self-fulfilling prophecies with the potential to “exacerbate economic fragmentation further”. He uses the following rather unnerving example:
…without additional restrictions, which in essence is a distributional issue, companies that were given subsidies to develop a cure or vaccine could sell their products at a premium to standard market prices — and consumers could find them prohibitively expensive or outright unaffordable. Many have lost their jobs — and thus their health insurance. This mechanism, whereby fiscal stimulus is used as leverage to increase profits, could indeed push price levels higher, but would also have a negative effect on aggregate demand.
It’s not difficult to conjure any number of additional scenarios where demand is capped in a world where large corporations see their power concentrated by non-egalitarian distributional outcomes.
Of course, subdued demand reduces the risk of surging inflation, but the social cost would be tremendous. The economy would not look the same. Rather, it could be defined by “high unemployment and low wages, slow growth and medium or low inflation, and a terminally broken Phillips curve”, Kocic writes.
The “good” news is, that would give monetary policy all the plausible deniability it needs to remain ultra-accommodative, to the benefit or risk assets. At that point, both fiscal and monetary policy would “feed directly into big business”, Kocic writes.
If, for whatever reason, you don’t see any of that as problematic, then do note that should inflation somehow manage to surge in that environment, monetary policy would be all but helpless. With demand and growth structurally depressed and unemployment elevated, draconian rate hikes would sink the economy into a depression.
So, that’s one path — one potential future. The other is an egalitarian distribution, defined by a “comprehensive” and “even” approach to fiscal stimulus aimed at muting the demand shock from the pandemic and turbocharging the recovery.
In this scenario, Kocic writes, “scarring would be minimized, the economy should resume its ‘normal’ functioning [and] with the temporarily unemployed being properly subsidized, prices would be supported and would go up if unemployment declines and growth resumes”. As labor market slack disappears, and prices rise, the Phillips curve is restored.
The worry in this scenario, however, is that if demand falters materially at any point, the risk of inflation comes calling. And, with demand faltering, politicians may be tempted to resort to more fiscal stimulus, which could beget more inflation.
Although readers are free to come to their own conclusions about which of these two futures is more desirable, I suppose what I would gently note is that one is decidedly dystopian, while the other entails some risk of inflation at some indeterminate future date.
When assessing that risk (inflation in the egalitarian distribution scenario) you should note that if unemployment has been successfully brought down and if demand slippage comes on the heels of a robust expansion, there is room for monetary policy to lean against inflation.
As for risk assets in the egalitarian distribution scenario, Kocic writes that they “could do well if the program proves successful, but their performance will be based on a rise in aggregate demand and growth rather than pure liquidity injection and implicit protection from policy reversal”.
That is conceptually similar to points I’ve made in these pages before. Corporations (and, by extension, stocks) do not have to suffer in a scenario where the primary dealer middlemen are cut out of the QE equation in favor of direct debt monetization. Rather, the benefits to corporate America would accrue in “second-order” (if you will) fashion, as the direct injection of stimulus into the veins of the US economy reinvigorates demand, thereby boosting activity, and revenue.
Of course, in that environment, corporate margins will likely be lower for a host of reasons, but considering they were perched at record highs not so long ago, that seems like a result society can tolerate.
In his latest, Kocic quotes Yogi Berra: “We made too many wrong mistakes”.
Read more:
‘5 Major Crises’ And ‘The Big Whipsaw Of 2020’
The Last Two Months Show The Intrinsic Instability Of Our Entire Economic System
About the header image (via The Whitney):
Early Sunday Morning is one of Edward Hopper’s most iconic paintings. Although he described this work as “almost a literal translation of Seventh Avenue,” Hopper reduced the New York City street to bare essentials. The lettering in the window signs is illegible, architectural ornament is loosely sketched, and human presence is merely suggested by the various curtains differentiating discrete apartments. The long, early morning shadows in the painting would never appear on a north-south street such as Seventh Avenue. Yet these very contrasts of light and shadow, and the succession of verticals and horizontals, create the charged, almost theatrical, atmosphere of empty buildings on an unpopulated street at the beginning of the day.
Could it be that Hopper was clairvoyant and anticipated New York under a Covid lockdown.
I lived in the South Bend, IN area growing up and watched what happened when Singer Sewing Machine, Oliver Tractor, Studebaker, and Keds moved on at roughly the same time, killing not only jobs at those bigger firms, but huge numbers of jobs at the SMEs that would normally be supported when those large firms were prosperous. It took a generation to come back from this hit. Later, I was in Waterloo, IA when the so-called farm crisis hit in the early eighties. That bump wiped out Rath Packing, 60% of Deere’s local labor force, a couple of malls and six of the seven area S&Ls. The mortgage defaults were crushing. The labor force shrunk by 20%, many of whom simply left the area. Again, it was SMEs that suffered most. While basic stuff like your bigger supermarkets survive, the businesses that supply life with flavor and nuance go away and mostly don’t come back, at least for ten or 20 years. We will be down to bare bones for the rest of my life, at least. It won’t be any fun at all.
Mr Lucky, I work nearby in St Joe MI, same thing happened there. Auto Specialties and Whirlpool (manufacturing, not corporate) pulled out leaving once proud Benton Harbor in shambles.
2003-2008 I was doing work comp consulting for manufacturing in South Bend, Elkhart, Middlebury, and Three Rivers. They all went down to skeleton crews. Some closed. I remember tearing up when Gunite pulled out. Those losses have never been replaced. It’s heartbreaking watching the community unravel as a result
Trickle up or trickle down… I am simplifying. Fiscal side is the masses safety net. The FED is the wealthy’s safety net. Damaged lives versus damaged egos.
H-Man
Great food for thought but a couple of significant variables in the equation by Kocic have been omitted. First, when does the vaccine arrive? Second, on November 3 political entropy disappears. Third, what is the time horizon for inflation? I agree with his premise these are intertwined but the time horizon controls the variance.
Short term our country cannot afford not to engage stimulus per the Bernanke/Yellen argument.until there is a vaccine. The Fed and Congress are the ventilators. Once the vaccine arrives, the logic for this narrative evaporates. Then we pick up the pieces of what is left over and start to rebuild. Small businesses flourish on the inefficiencies of large corporations. That dynamic will never change.
Once we start to rebuild, that is when we deal with the inflation genie which is farther down the road.
We should know the answers to these questions except for inflation in the next six months.
Risk #3 – Political Entropy / Societal Critical Thinking Entropy.
In what passes for the current political economy, an egalitarian outcome seems unlikely. Large corporate interests “own” the rule makers. They have resources that small ones do not. Capitalism is not at its heart about egalitarianism. It is about winners and losers and competition and part of that devolves unfortunately to advantages that the rich and powerful have. If searching for egalitarian, the current institutions, including government are not going to help. “MBNA Biden” might not be any better than what we have now as far as it goes to redressing the advantages of the big. What we need is the Brandeis-style Court.