The Zombie Economy

The Coronavirus Could Cripple Public Finances

The coronavirus has plunged the global economy into a new phase of uncertainty. Governments and central banks are once again trying to shield companies and banks from collapse with massive bailouts. But there is danger in stimulating the economy on credit: It could spark a post-crisis crisis.

Von Martin Hesse und Michael Sauga

Spring forecasts: EU Commissioner for Economy Paolo Gentiloni spoke of a looming recession of historic proportions
Spring forecasts: EU Commissioner for Economy Paolo Gentiloni spoke of a looming recession of historic proportions / Kenzo Tribouillard/ dpa


Johannes Slawig hasn't had a lot of down time in the past few weeks. The head of the coronavirus task force in the German city of Wuppertal has had to procure protective equipment for the health department, hire doctors for the makeshift hospital in a local gymnasium and check the financing of the fire department's new test center.

Slawig hasn't even found the time to check out the webcams on the municipal zoo's website, which have been documenting the first steps of the newborn elephant, Kimana.

The broadcast has been a small consolation for the patrons of the temporarily shuttered zoo.

But for Slawig, who normally works as Wuppertal's treasurer, it's just another source of stress when he looks at the numbers. The closure of the zoo alone had cost the city 600,000 euros ($651,000) in lost income by the end of April.

This only added to lost tax revenues due to the largely shutdown economy (about 75 million euros), lost revenues from municipal theaters (around 2 million euros) and rising expenditures for the unemployed whose incomes have dipped below the threshold for qualifying for welfare (10 million euros).

According to Slawig's calculations, the city's debt will grow to 150 million euros due to the coronavirus. "I'm afraid the pandemic will eat up all the money we've managed to save in recent years," he says.

Prelude to a Massive Crash?

Whether in cities or states, private households or companies, the pandemic is causing revenues to shrink, even as costs continue to mount. For many, the only way out is through debt. Hardly any other event in the post-World War II era has created such a dramatic level of debts as the coronavirus.

Even before the outbreak, the global debt load had reached more than $250 trillion (230 trillion euros) -- three times higher than the world's annual combined gross domestic product. Governments around the world are issuing debt-financed bailouts worth trillions. The European Central Bank (ECB) and other central banks are injecting money into the economy with virtually no limits to prevent a collapse.

But how is this new mountain of debt ever going to be paid off? And by whom? In the end, some economists worry that the bailouts could result in a fatal combination of inflation and stagnation. A sort of post-crisis crisis, the bill for which will be footed by future generations. It begs the question: Is the pandemic merely the prelude to a massive crash? A financial crisis of epochal proportions that will drag companies, banks and governments into the abyss?

It's a bleak scenario. Companies that have lost business have been forced to take on debt and lay off employees. Ordinary people who were already heavily indebted before the coronavirus hit are no longer able to pay back their loans. Particularly in the United States, the land of installment credit, there is growing concern that millions of people could default on their car, house and student loans.

But in Germany, too, consumers have paid for a lot of new things on credit thanks to low interest rates. If people, companies or even governments go bankrupt, this would hit the banks with full force and could trigger a new credit crisis like the one after the collapse of Lehman Brothers in 2008.

Uncharted Territory

Hans-Joachim Ziems has seen many companies go bankrupt. In 2002, the Cologne-based management consultant helped patch up Leo Kirch's media group. In 2009, during the financial crisis, Ziems helped prevent the collapse of Adolf Merckle's empire. Merckle's flagship companies, Heidelberg Cement and Ratiopharm, survived, though the self-made billionaire took his own life out of grief and shame over the debt he had accrued.

But a recession on such a massive scale, "from trade and industry to the service sector. This is uncharted territory for me too," Ziems says. In some sectors, the losses that are now being incurred cannot be made up. The crisis will cause companies' debt loads to rise sharply and lead to a wave of insolvencies.

Ziems is seeing first-hand how quickly liquidity can dwindle as debt piles up. A few months before the coronavirus had reached Europe, he was called in. First as a consultant for the automotive supplier Leoni, then to its restructuring board. The company produces cable harnesses and wiring systems for car manufacturers and had gotten itself into financial trouble.

Ziems was asked to help get Leoni back on track. On March 13, the companies' lenders signed off on the company's restructuring plan. Ziems could expect 200 million euros in new liquidity. "A few days later, the lockdown began and we had to come up with a new plan," he says.

Leoni had to close down some of its plants and scale back employees' hours. The company wasn't able to lower its costs as quickly as its sales collapsed, and Ziems had to again ask the banks for more liquidity. The German government ultimately provided guarantees for new loans worth 330 million euros.

No Guarantees

Like Leoni, countless other companies have been going through the same thing in recent weeks. Corporations like Lufthansa as well as some tourism, catering and retail companies have watched as their sales have plummeted by more than 90 percent.

Meanwhile, they're still on the hook for salaries, rent and other expenses. "Many companies must close the gap between revenues and costs by incurring new debts," says Jörg Krämer, chief economist at Commerzbank.

According to the Bank for International Settlements, no other recession in the modern era has hit companies around the world as hard as the shock from COVID-19. Without government assistance, half of all businesses would not be able to pay back their loans on time.

Wherever possible, firms have obtained money from capital markets or banks. The ECB has relaxed its capital rules and allowed European banks to grant up to 1.8 trillion euros in additional loans. Corporations like Daimler, Bertelsmann and Eon have issued bonds worth more than 100 billion euros since mid-March.

For companies that are unable to raise money in this way, the government is offering its assistance. Berlin is providing loans and guarantees worth more than a trillion euros through the state-owned development bank KfW. Within five weeks, the bank received more than 25,500 applications for loans worth 33 billion euros.

But this is only alleviating the immediate need for cash. The companies will eventually have to make good on their bonds and pay back their KfW loans, plus interest. Once the economy bounces back -- an outcome everyone is hoping will come sooner rather than later -- many companies will enter the next phase with a heavy debt load. And even that's not guaranteed.

A High Risk of Defaults

Credit rating agencies such as Standard & Poor's (S&P) assess the creditworthiness of companies, banks and countries. Currently, they're lowering ratings across the board due to soaring debts, indicating an increased risk of default. For companies seeking new loans, this means they'll have to pay higher interest rates to lenders, thereby further aggravating the difficult financial situation.

At the same time, if an economic rebound is going to be possible, companies will need more capital in order to ramp up their production again. "Often it's the upswing after a crisis that breaks companies' backs," says Tobias Mock, S&P's managing director for corporates in Germany, Switzerland and Austria.

Mock expects that many companies won't be able to free themselves from this vicious cycle. "Defaults will increase significantly in the coming months and are expected to peak in 2021," he says. For bonds that S&P has rated "speculative," Mock expects the default rate in Europe to rise as high as 10 percent. Last December, that rate was only 2 percent.

That kind of development is not unusual. After the bursting of the dot com bubble in 2000, the real estate bubble in 2007 and the euro debt crisis in 2012, many companies started saving as their debt loads grew. "That was a brake on growth," says Commerzbank's Krämer. He suspects this will happen again: Companies will invest less and cut back on staff, which will "noticeably slow down the economic recovery."

Whether companies will even have time to recover from the crisis will largely depend on the banks. If experts like Mock are right, bad loans will soon begin piling up on bank's balance sheets. Then, just like in 2008 and 2009, it will become apparent which banks are strong enough to support ailing companies.

Even before the coronavirus struck, European banks already had close to 600 billion euros worth of non-performing loans on their books. In Greece, bad loans account for more than 30 percent of banks' loan portfolios. In Italy, they account for 6.7 percent.

First Public Health, Then Public Finances

Concerns over banks' stability has apparently also reached the political realm. There is currently a debate in the European Union over whether rules for bailing out banks that were established after 2008 should be relaxed in order to provide ailing institutions with taxpayer money.

In the end, governments will be saddled with much of the risk anyway. Governments cannot allow a wave of bankruptcies among businesses or another crash in the banking sector. Former ECB President Mario Draghi recently admonished governments to take on the deficits of the private sector.

This would cause national debt all over the world to explode at a rate that is otherwise only seen in times of war. This year alone, the International Monetary Fund (IMF) expects government debt loads to grow by $8 trillion. That would put it at around 100 percent of annual global economic output. That would be almost as much as in Greece before the euro crisis.

Once it's finished ravishing public health, does this mean the virus will also destroy public finances?

Many economists consider this unlikely. In most developed countries, such loans are "easily affordable," says Olivier Blanchard of the New York-based Peterson Institute. Low interest rates made it easy for many governments to live on credit. Therefore, Blanchard says, there's little reason not to spend a lot of money. The more loans, the better.

But not all economists are convinced that the crisis can be overcome so easily. Hans-Werner Sinn, for example, the former president of the Munich-based Ifo Institute, considers it "appropriate to cushion the temporary crisis with higher government debt." But he's concerned by the fact that central banks around the world are helping governments by buying bonds on such a large scale.

Dangerous Inflation

The amount of central bank money in the eurozone will quadruple this year compared to what it was before the financial crisis, Sinn says. The coronavirus is causing the supply of goods and services to shrink. Too much money for too few goods -- this could usher back in an economic evil that seemed to have been eradicated: inflation. It's not a huge threat at the moment, Sinn says. "But once prices start to rise, it's hard to slow them down again."

Relieving the government's debt load through devaluation was a method that even late Roman rulers used. Since then, governments have repeatedly rid themselves of debt through inflation. Economists, including Sinn, therefore predicted a new wave of inflation even after the eurozone debt crisis was over.

But this never materialized. Instead, key interest rates fell to zero -- and in some cases, into negative territory or at least under the inflation rate. This has caused debt to shrink, albeit slowly. At the same time, however, it has caused the savings of those who invested their money in interest-bearing accounts or securities to shrink as well.

The pandemic could keep interest rates extremely low for years or even decades to come. This is the only way for states, banks and companies to bear their debt burden without going bankrupt.

The countries most in danger of going bankrupt are the ones that were highly indebted long before the coronavirus struck. Many emerging and developing countries have taken out massive loans, often in foreign currencies like the dollar.

Now the markets for raw materials are collapsing, tourism has practically come to a standstill and their currencies are losing value. All this makes it even more difficult for these countries to service their debts.

It's true that the International Monetary Fund recently temporarily suspended its interest and repayment claims for 25 of the world's poorest countries. But this is little more than symbolism.

Without drastic debt relief, economists predict that a number of states in Africa, Latin America and Asia will be forced to declare bankruptcy. The consequences for the financial industry would be catastrophic.

An 'Economy of Creeping Stagnation'

In Europe, too, the pandemic is exacerbating the economic divide. While northern countries have enough leeway to issue bailouts in the billions, many southern European states in the eurozone are being driven to the brink of ruin.

In Spain, the looming recession will cause the country's debt ratio to skyrocket to just under 116 percent of its gross domestic product this year. In Italy, that ratio will jump to around 159 percent.

Ever since eurozone members began debating coronabonds and bickering over reconstruction loans again, the old doubts over the viability of the monetary union have returned. While southern countries feel abandoned by their northern bretheren, countries like the Netherlands, Austria and Germany are worried that Italy in particular could collapse under the weight of its credit burden.

"Euroskeptics" in some important countries are "on the rise again," says Holger Schmieding, chief economist at the Hamburg investment bank Berenberg. This "political risk" for the monetary union is making financial markets nervous, he says. The interest rate differential between Italian and German government bonds has almost doubled since mid-February, increasing the danger that Europe could plunge into a currency crisis.

This new debt reality is creating a two-tiered global society. Many countries won't find it difficult to live on credit for a long time. For others, the loans they take on to get them through the coronavirus could be their downfall.

They are facing a difficult balancing act: On the one hand, economic depression and unemployment are lurking. On the other, government bankruptcy.

Some countries could also face a fate like Japan's, which for many years has lived with extremely high national debt and an ultra-loose monetary policy.

For Sinn, the former Ifo head, this could lead to a zombie economy of sorts, an "economy of creeping stagnation" characterized by ailing banks, sluggish companies and weak growth figures.

"Germany should not strive for this outcome."

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