The current crisis is different from all other crises in economic history, according to Global Chief Investment Officer Yves Bonzon. It presents unique problems that require unique measures to overcome them.
This week, I think it is useful to begin by summarising our understanding of the unique nature of the current recession, the mechanisms it is setting in motion in the economy and the ideal policy response the authorities should provide to minimise the cost of this crisis for all stakeholders in society.
The first recession caused by an external shock
We are facing the first recession of the modern era caused by an external factor, or more precisely, by the partial closure of the economies of the main countries that make up the world economy in response to the threat of the spreading of the coronavirus. This sudden sharp drop in activity is unevenly distributed throughout the economy. Some companies are little or very marginally impacted, others even see their turnover boosted by the crisis (such as e-commerce), but some companies are experiencing a significant or even complete drop in their revenues, such as in the tourism, hotel and restaurant industries. The duration of the closures and containment measures and, above all, the rate at which it will be possible to reopen activities is uncertain, not to mention the risks of false starts in the event of a second infection wave.
A difficult situation for the self-employed
Income losses to the private sector are unevenly compensated. The situation varies from country to country, but in advanced economies, wage earners generally benefit from efficient unemployment systems. The situation is often less favourable for the self-employed, who receive little or no income. For small to medium enterprises (SMEs), bridging loan schemes have been quickly and effectively deployed. However, such loans can only be a short-term solution. Indeed, if the companies that have made use of them have to repay them, they will find themselves durably handicapped when the economy attempts to recover.
The longer the closures last, the more numerous bankruptcies will become.
Moreover, the longer the closures last, the more numerous small, medium and even large company bankruptcies will become. The economic fabric of countries will then be permanently damaged, particularly in Europe, where unpaid loans lead to a declaration of negative net worth that follows you for the rest of your life. This contrasts with the United States, for example, where the creditor writes off the unpaid balance and the borrower can start again.
These critical differences in bankruptcy laws have considerable consequences for the ability to resolve credit crises in different countries. It is, therefore, absolutely critical to prevent businesses that would be perfectly viable in normal times from being forced into bankruptcy and liquidated as a result of government measures to protect the healthcare system.
Transfers from government to private sector are key
Unlike the Great Financial Crisis of 2007/08, the current crisis certainly requires monetary measures, but above all fiscal and budgetary support. The crisis in the real economy cannot be tackled effectively by forcing transfers from private to private balance sheets. The coronavirus shock has brought about an inevitable financial loss for the entire world population. The aim of governments must be to minimise it and to spread its cost equitably over their societies. To achieve this dual objective of minimisation and equitable distribution, transfers from government to private sector balance sheets are absolutely necessary.
Depression and deflation: a toxic mix
These transfers will temporarily increase public deficits, but the alternative, depression and deflation, is infinitely worse and very toxic for democracy and the values Western civilisation stands for. These transitional deficits should eventually be financed partly through tax increases, largely through borrowing and, above all, partly monetised. The aim is to minimise the fall in nominal gross domestic product (GDP), to flatten its decline as has been sought to flatten the pandemic contagion curve, except in reverse. For the record, let us mention that in today’s globalised economy, every country is exposed to other countries that may or may not decisively reflate their economies.
Debt to GDP is a misleading concept
The concept of the debt-to-GDP ratio suffers from several problems and artificially constrains a very effective macroeconomic leeway for spurious reasons. Firstly, let us recall that the objective of the political economy is to maximise the well-being of all citizens. This maximisation and distribution exercise is carried out under the constraint of limited resources and, increasingly, under the additional constraint of what our environment, our planet, can support. Moreover, there is no perfect monetary system. The gold standard artificially constrained the stock of money in circulation, reducing one of the variables for optimising the production and distribution of goods and services in society.
Actual deflation is at least as toxic to the social fabric as out-of-control inflation.
In hindsight, the experiment of fiat money has been associated with a gigantic wealth leap forward on the scale of human history. Just to be clear, of course, one cannot print one’s way to prosperity. Too much money could at some point lead to excessive or even galloping inflation. However, a symmetric approach to the monetary question is needed. Actual deflation is at least as toxic to the social fabric as out-of-control inflation. In times when risks are clearly skewed towards the former rather than the latter, artificially constraining policymaking for the sake of a ratio comparing a stock (debt) to a flow (GDP) is plain counterproductive – actually very dangerous.
Public accounting is very archaic
Originally, corporate accounting was invented for taxation and bank lending purposes and we know it is a rudimentary tool for investing purposes. Yet public accounting is even more archaic. Who would lend money looking just at the liabilities side of a balance sheet, without taking a look at the assets side? Who would lend money without taking into account one’s capacity to service one’s debts? For a country, what matters is precisely the capacity of a government to service debt, not its ability to repay it. This is even more true when one prints the money in which one borrows. This is why, in the case of a natural disaster of the coronavirus kind, a sort of one-off shock, some degree of monetisation of damage compensations is the optimal policy response for the greater good of society across all stakeholders’ income and wealth buckets. Sharing the economic pie is key, but comes second after preventing a deflationary contraction of the said pie caused by axiomatic and asymmetric economic theories. The study of the Japanese economy in the last 30 years is exemplary in this regard.
Central bank measures are concentrated in a few hands
The emergency measures taken by the central banks have borne fruit, allowing the VIX volatility index to return below the critical 40% mark. Subject to an eventual economic recovery, financial stability seems assured. The advantage of monetary measures is that they are taken by a small group of people in a limited number of central banks – the US Federal Reserve, the European Central Bank and the Bank of Japan plus one or two others. Action can therefore be taken quickly and effectively. In the United States, we have in fact already seen a virtual merger of the Treasury and the central bank, since many of the measures announced by the Federal Reserve are being implemented on behalf of the Treasury. Modern Monetary Theory (MMT) is already applied.
Fiscal measures are much harder to get through
The question of budgetary and fiscal support measures is much more complicated. As things stand, decisions are made by elected politicians who have to take the necessary decisions under multiple institutional and administrative constraints. Furthermore, their ability to finance the required deficits varies considerably depending on whether they are able to borrow in their own currency and print (part of) the necessary sums. Therefore, situations vary considerably from one country to another. To be clear, a government must not only understand the scope and nature of the tax measures required, but also be able to pass and implement them and ensure their financing and monetisation.
In view of this, not surprisingly, the measures announced and taken in this phase vary greatly from country to country. We are particularly concerned about the eurozone countries (ex. Germany) and the emerging countries (ex. China). During the first two phases of the crisis, the markets generally evolved in concert. Over the next few months, the dispersion of returns is set to increase as divergences in economic recoveries emerge. There should also be more divergence among currencies, whereas the main movement so far has been the depreciation of emerging currencies, with the exception of the Chinese renminbi.
Risks remain clearly skewed towards deflation for now
From the analysis above it follows that, for the time being and in the coming months, the risks remain clearly tilted in favour of deflation. Indeed, this is the reason why assets that benefit from the continuation of the environment of slow nominal growth and lack of inflation, such as quality growth stocks, have continued to outperform. Ultimately, provided that the policy mix moves towards more fiscal support and economies do not remain partially closed for too long, inflation is likely to rise due to the success of the G7 governments’ efforts to target nominal GDP. However, it is still too early to position ourselves for this environment. Only then will developed central banks have moved into yield curve control mode. One step at a time, let us not dance faster than the music plays.