As the global economy exits “lockdown”, improving macro data will provide a further boost to investors determined to look-through the deepest economic contraction they will see in their lifetimes. Yet the economic danger associated with COVID-19 is far from over, especially given the noises in both the US and Europe about the importance of rebalancing the budget once the pandemic has passed. This would be a mistake, not least because – in the unlikely event that the world returns to normal faster than most economists expect – a large part of the 2020 budget deterioration would correct itself. If the deficit doesn’t decline automatically, it will be because we are left with permanently higher unemployment and lower incomes – hardly a reason for austerity. Governments that attempt to balance their books too soon would only prove that modern fiscal policy has somehow developed a weird deflation bias. This would make life even harder for central banks, which have already spent a decade wrestling a liquidity trap.In our recent research, we have analysed the policy response to COVID-19 in detail. The measures put in place so far deserve a huge amount of praise. Central banks, in particular, showed they had learned the lessons of the 2008 crash. Not only did they act decisively and on a scale nobody could have imagined, they also targeted their stimulus directly where it was needed – the specific vulnerabilities that had built up before COVID-19. A decade of monitoring ‘systemic risk’ paid off and officials prevented a serious financial crisis in March. The contrast with what happened in 2008 was stark. Back then, policymakers didn’t seem to understand systemic risk, or the feedback loops between the financial sector and the real economy. This time, central banks immediately provided a critical backstop for markets (including global USD liquidity) while becoming the lender of last resort for corporates, the epicentre of a cash-flow crisis. In doing so, they prevented what would surely have become a serious ‘run’ on the shadow-banking sector.
If part (i) of the policy response was about providing a backstop for markets, part (ii) was all about the corporate sector. The fiscal authorities realized that ‘stay at home’ orders would have a devastating impact on corporate cash flow. Revenues would collapse but costs would decline more slowly, creating a massive deficit. Plugging this hole was essential to avoid permanent job losses and bankruptcies, averting a depression. Estimates from the BIS and the BoE suggest these deficits will hit at least 10% of GDP in 2020, even if the lockdowns are temporary. This would cause massive strains on corporate liquidity. Economists at the Chicago Fed showed 30% of US companies would run out of cash within six months. Though the details differed across jurisdictions, governments used their balance sheets to plug this hole, by absorbing a large part of the corporate wage bill. Companies stayed in business, workers got paid and macro data became irrelevant. The biggest contraction since the Great Frost in 1709? “Yeah, but the economy was closed”. Depression levels of unemployment? “Good… the policy is working”.
The perfect policy response, SO FAR. But now things get trickier. The measures the authorities have introduced were designed to address a short-term problem, to support their economies through the official lockdown period. Yet the stay at home orders were not the only thing holding back economic growth. Many people – especially the older demographic – will continue to social distance even if they are not officially required to do so. Some sectors - especially those that require social interaction – will take many months, if not years, to get back to normal (what even is "normal" now?). People are likely to save more, businesses are likely to invest less. In short, the world will be reopening to a serious and persistent recession. Even on consensus forecasts, output will remain below 2019 levels into the second half of 2021. Compared to where we thought we would be before COVID-19, this is a substantial cumulative loss in income. Run Okun’s rule through consensus GDP forecasts and you would expect to see a serious labour-market recession, even after the lockdowns have ended. And usually at those levels of unemployment – which are extremely conservative since companies have already laid off their workers, meaning there will be less “hoarding” of labour in this recession – we would expect to see a large number of corporate bankruptcies and a big deterioration in credit markets.
Looking further ahead, you have to wonder where the balance sheet is going to come from to drive the next cyclical expansion. Global debt levels rose during the 2010s, mainly thanks to: (i) China’s domestic credit boom, and (ii) the DM corporate debt response to the insatiable search for yield in financial markets (especially for USD denominated securities). China is already stimulating its post pandemic economy, but doesn’t want to play the global ‘stabilizer’ role it played after the subprime crash. It would rather accept lower trend growth and blame the United States. Corporates are also in a weak position and will emerge from COVID-19 with even higher debt levels, having already leveraged up for the best part of a decade (to record levels). While there is no magic metric for measuring the sustainability of corporate debt levels, it seems many of these companies will not be in a position to ramp up their capex or hiring, even if policymakers can prevent mass bankruptcies. So DM governments are going to have to play a bigger role in the next cycle, ideally with a multi-year public investment programme. Yields at 700-year lows are screaming for these sort of actions, yet some politicians are already asking the “How are we going to pay for it?” question. Perhaps politicians have got used to free-riding on monetary policy. Or perhaps this is part of a new budget ideology, which creates an inherent deflation bias and contradicts everything we thought we knew about fiscal policy. Will the public tolerate it?