Bending the Inflation Curve

By John Mauldin

 

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. … A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth.”

—Milton Friedman, The Counter-Revolution in Monetary Theory (1970)
 

“Well, maybe…”

—John Mauldin, with more than a little hubris, 2020

 
I am widely known as the “muddle through” guy. I describe problems then explain how we will get through them, slowly but surely.

That analogy isn’t appropriate for problems like the coronavirus, which actually kills people. The most seriously affected victims are not muddling through at all, and there are way too many of them.
 
And those who are still waiting for government aid are certainly not muddling through. As we will see below, unemployment rates are anything but “Muddle Through.” This will be the slowest and most difficult Muddle Through of our lives.

But thankfully, we are starting to see the curves bend. The lockdowns and distancing appear to be stabilizing the number of new cases. We aren’t out of danger but this is encouraging.

Nevertheless, much of the economic damage is already done. We are not likely to see anything resembling the previous normal for a long time. I heard someone say we will emerge from lockdown to an “80% economy”—mostly back, but with big pieces missing.
 
That sounds about right. But losing a fifth of the economy will still mean a severe recession, if not outright depression, albeit hopefully not as long as that of the 1930s.

So, our next analytical challenge will be the intersection of previous economic trends, virus-driven behavioral changes, and the policy responses to both. To this point, governments and central banks have just been keeping their ships afloat.
 
They haven’t even started “stimulus” yet.
 
But they will, and it will have consequences.
 
That will be today’s topic.

The first and most important question that we will deal with is prediction of significant inflation/hyperinflation coming from many quarters because of the massive amount of Federal Reserve intervention.
 
This is wrong-headed fearmongering.


Close to 17 million people have filed for unemployment in the last 3 weeks.
 
It would be significantly higher if overwhelmed websites in many states were able to actually take all the claims.
 
The glitches are maddening and they are all hitting at once. I know of one furloughed worker who is unable to even apply in Texas. The system sees his Social Security number from when he was laid off in the last recession (10+ years ago) and insists he use the email address he had back then. He can’t because it was from a company that no longer exists. So he is stuck in an endless loop. And forget about getting through by phone. Come on, guys. Texas should be better than that.

It’s not just Texas, either. I am talking with friends all over the country whose children are legitimately unemployed (like mine) and trying to get benefits. So far, I am not hearing of any successes. You would think with 17 million people who have successfully entered claims there would be a few.

Furthermore, millions of mostly younger people are (or were) working in the so-called gig economy. Often, they don’t get W-2s, at best they get 1099s, and sometimes the work is off the books. Nonetheless, they are unemployed, have no way to get any money and no way to get the paperwork which the various agencies require in order to get unemployment benefits.
 
They are in a catch-22 situation. And because they move around so much what are the chances that the checks the government is sending out will catch up with them? See the problem?

The government has good intentions but the execution is extraordinarily difficult. We are creating massive supply and demand shocks, the rapidity of which is like nothing seen in centuries, if ever.

As I pointed out four weeks ago, this is the most massive deflationary shock of all time. The Federal Reserve has rightly intervened in order to prevent the absolute certainty of a deflationary depression.

I quoted Milton Friedman above where he posits that “… inflation is always and everywhere a monetary phenomenon.” And then I said, “Well, maybe…” During the timeframe in which he and his colleague Anna Schwartz did their famous study, there was clearly a correlation between money supply and inflation. What is not often noted is that the velocity of money (i.e., the rate at which money changes hands) was stable during that time.

I am not going to do a 30-page academic study to explain why that is important. Just accept that it is. When the velocity of money is falling, monetary policy which would otherwise cause inflation doesn’t seem to do so.

Here is Lacy Hunt’s latest velocity chart. You have to go back to 1949 to find a time when it was lower than today, and it was actually rising rapidly off the postwar lows. This was before the coronavirus shutdowns. Let me crawl out on a limb and suggest that the velocity of money is now going to drop even further. Deflation is not your friend.


Source: Hoisington Investment Management

Monetary and Fiscal Policy: Where We Are Today

The US government passed a $2.2 trillion bill some call a “stimulus package.” It is nothing like a traditional stimulus package. By putting the economy in lockdown, taking away the income of multiple tens of millions, much of the CARES act simply replaces lost wages. That is not stimulus. That money doesn’t generate additional spending. The SBA loans are not stimulus in the traditional sense. The money is hopefully going to bring many businesses back from a dead stop. That will be good, but it’s not stimulus.

The Federal Reserve and Treasury yesterday announced another $2.2 trillion program to buy bonds and high-yield funds, otherwise known as junk bonds. Their lawyers, in an act of extreme contortion, designed a methodology by which the US Treasury could create a special purpose vehicle, fund it with hundreds of billions of dollars from the CARES Act as a “first loss guarantee,” and then the Federal Reserve could loan approximately 10 times that amount to the SPV.

If losses exceed the base amount, the Treasury and thus the taxpayer would have to fund those. The program will ostensibly be run by the Treasury Department, which actually delegates the operation to BlackRock or PIMCO or another company with the ability to actually do it. That adds another $4 trillion to the overall government program.


I know some are upset about a private company managing this money. I get it, but if we waited for the government to set up the systems to do it, it would take years. The people saying this don’t understand the complexity of what we are asking these companies to do. Furthermore, less has been done than you might think as both the Treasury and the companies try to figure out how to augment the proposals.

My friend Jim Bianco posted a piece on Twitter which was picked up by ZeroHedge.

“As I've argued, the Fed and the Treasury merged. Powell said this was the case today (from his Q&A):

These programs we are using, under the laws, we do these, as I mentioned in my remarks, with the consent of the Treasury Secretary and the fiscal backing from the Congress through the Treasury. And we are doing it to provide credit to households, businesses, state and local governments. As we are directed by the Congress. We are using that fiscal backstop to absorb any losses we have.

Our ability is limited by the law. We have to find unusual, and exigent circumstances and the Treasury Secretary has to agree, and we are using this fiscal backstop. There is really no limit on how much of that we can do other than meet the tests under the law as amended by Dodd-Frank.

The Fed needs the Treasury Secretary's permission to do this.

That means Trump must approve this (as the Treasury Secretary serves at the pleasure of the President). No doubt Kudlow was asked to weigh in (which would be appropriate for the National Economic Chairman to do).

So, Larry was able to know this was coming when we said two days ago:

"The Fed is sitting with the ultimate bazooka."

This program did not appear overnight. It took days, if not weeks, to figure out how to contort the laws in order to do this. Kudlow clearly knew what was coming. (By the way, these lawyers will need physical therapy to deal with the abnormal contortions needed to reach the conclusions they have.)

Let me posit right here: We are going to see more of these programs. Clearly, both the executive branch and the Federal Reserve, with the complicity of Congress, are determined to avoid a deflationary depression. This is Mario Draghi’s “whatever it takes” on serious steroids.

Lacy Hunt told me in an email and then telephone call that this last $2.2 trillion is not money printing. They are simply buying already existing bonds, not unlike QE in the past when the Federal Reserve bought US government bonds. This is not like Venezuela, Argentina, or Zimbabwe. Not even close.

Nonetheless, $8 trillion and counting of government expenditures, funded by the Federal Reserve, is nothing to sneeze at. It will have an effect on the money supply. So is Milton Friedman right? Is inflation on its way back? Let me offer Mauldin’s corollary to his famous statement:

Inflation Is Always and Everywhere a Function of Demand

We have simply destroyed demand by locking down the country. And it should be clear that we cannot turn a switch to bring it back.
 
How soon will we feel like going back into large crowds, restaurants, movie theaters, sporting events, hotels, vacation destinations, and all the other areas where we congregate as human beings?
 
Certainly, some of the economy will start looking normal. But how many workers will it need?

How have our buying patterns changed?
 
We are learning that we can work from home. Zoom and other services have had their weaknesses exposed, but they will improve. This is going to make working from home easier and more common.
 
My son-in-law’s company policies allowed working from home, but his district manager felt that productivity would drop so did not allow it. But having been forced to try, they found productivity actually rose significantly. They are now getting ready to institute this new policy more broadly.

Multiplied across thousands of large companies, that means the demand for office space will drop, which means prices for office space will drop. That is deflation, gentle reader. Even if the Federal Reserve decides to buy office space (which it won’t), that is not going to increase demand.
 
Ditto for 100 other industries.
 
Think about restaurant buildings. Builders and tenants go to tremendous expense to create the kitchens, which means if a restaurant goes out of business, the property owner typically has to find another restaurant.
 
How likely is that to happen today?

At some point supply and demand will balance, but I don’t think it will be in three months. Three years? Maybe.
 
Lacy Hunt thinks it will be a few years longer. So do some of my other economically brilliant friends. (Please ignore government cheerleaders and those with an agenda who suggest it will come back sooner.)

But whether it is three months or three quarters or 3+ years, it will happen.
 
At that point we have the potential for an inflationary episode if the Federal Reserve keeps stimulating and the government keeps running massive deficits. If they act responsibly, inflation could rise to the 2 to 3% level and hopefully not higher. If they don’t act responsibly?
 
All bets are off.

Sidebar: I still don’t think of gold as an “investment,” but I don’t entirely trust central banks to be independent when they need to be in the future.
 
Thus buying gold as central bank insurance is a reasonable idea.

But understand this: Demand has to come back, and in size, in order to spark inflation. Yet in this situation people will want to save, perhaps more than they ever have in their lives. Purchases are going to be put off if they can be.

Now, many economists would not talk about supply and demand so much as about the “output gap.” As businesses go away, potential output also drops. How will that take? No one knows. We have absolutely zero idea of how the future is going to unfold because we have never seen anything like this.

Remember this chart I’ve used a few times in the past year or two? Where I naïvely assumed a 2020 recession would result in a $2 trillion déficit?


 
Wow, was I an optimist. The deficit this year will likely be $4 trillion-plus.
 
Note that we are already at $24 trillion total federal government debt in the US. Add another $3.3 trillion for state and local debt. Our debt projections only a year ago showed the US federal government debt going to $30 trillion by the middle of this decade. It turns out we will be there by 2022. The almost $40 trillion I projected by 2030? That will now happen in the middle of the decade and we will be nearing $50 trillion by the end of the decade.

I was suggesting that the balance sheet of the Federal Reserve might be $20 trillion by the end of the decade. Analysts at the Bank of America now forecast it will reach $9 trillion this year. There are other even higher projections from serious sources. I will have to do a whole letter around this, but a $30 trillion Fed balance sheet by the end of this decade and before The Great Reset is not out of the question.

The Utter Travesty of Unemployment

Mish Shedlock calculates, based on the 16.8 million initial jobless claims in the last three weeks and likely another 8 million in the next two weeks (if not more), we are roughly looking at an unemployment rate near 20%.

The highest unemployment rate during the Great Depression was 24.9% in 1933. Depending on when we move out of lockdown, the US could approach or exceed that number for a short time. Note that the “reference period” for April will be April 12–18. That means anybody who becomes unemployed after April 18 won’t be counted in the April number.

This is beyond tragic. That potential 20–25% of unemployed also represents significant numbers of children and family members who are also without money. The people that are desperately in need is well more than the 20–25% of unemployed. It is hard to wrap my head around such a number.

Have you heard of anyone getting their checks yet? I didn’t think so. My daughter Amanda (who is recovering well from her stroke, thank you!) had a $71,000 hospital bill. I did not realize they did not have insurance when her husband left to go to pilot school. The hospital “renegotiated” the bill down to $56,000, and wants them to make $5,000-a-month payments. They are both now unemployed with two children. How many times is that going to happen because of people going in the hospital for emergencies? Multiply that experience by millions for whom those $1,200 checks won’t go far.

The money being spent by the Federal Reserve and the US government is not going to create inflation in the short term. And by short term I mean 3 to 4 years. It will take longer than that to get through all of this. Are we going to force entire generations to file for bankruptcy? What about student loans which can’t be discharged in bankruptcy court?

What will landlords do when their banks want payment and their renters can’t pay? Think they will easily be able to find renters who can pay? How much bank capital will be destroyed in write-offs?

There will be a time when businesses which were not prepared will need capital to start back up, and we need to plan for the future. But for now, we have to get people back to work, with the ability to get food, housing, and the basics as soon as possible.

Yes, that is going to blow the budget out. It is going to mean even deeper deficits and even then many will be without a job. We may actually need a real infrastructure program to create jobs, spread out over several years, to fix our ailing water systems, electrical grids, roads and bridges, etc. Now that would be honest-to-God stimulus, as opposed to the mere replacement of lost income. At least we would get something real from that money.

Thinking of the Enormity of It All

It is time to hit the send button. This letter could easily run twice as long. There is so much to say and comment on. So much of the Age of Transformation is going to happen faster than we thought. That will mean social and economic shocks in and of itself. The mind simply boggles as I sit here in Puerto Rico, walking around the neighborhood when allowed. And still trying to write books and plan for a Virtual SIC sometime in May. (Details coming soon!)

I hope you enjoy your Easter weekend. It is traditionally a time of renewal and optimism. And that is something we truly need right now. Have a great week!

Your sitting at home and busier than ever analyst,

 
John Mauldin
Co-Founder, Mauldin Economics

Trucks, queues and blues

If you thought the trade war was bad for global commerce…

The disruption from the pandemic will be much worse




Container-ship navigators, box-ticking customs officials, logistics wizards, truck drivers and warehouse nightwatchmen: all are familiar with dealing with glitches involving international trade, from strikes to trade wars.

But with forecasters predicting a slump in global GDP this year, even their most creative thinking cannot keep $25trn of goods and services flowing around the world.

Trade is the conduit through which economic pain passes from one country to another. Even simple products rely on elaborate supply chains: a humble cup of coffee requires 29 firms to collaborate across 18 countries, according to one estimate. Shocks convulse in either direction.

A port closure or customs delay can cripple production elsewhere. If consumers stop buying cars and phones, manufacturers and workers in distant lands feel the pinch.

When world output, at purchasing-power parity, fell by 0.1% in 2009, trade volumes collapsed by a whopping 13%. Quarterly volumes fell by even more (see chart). Weaker demand in America and the European Union rippled along trade routes to Canada, China, emerging Asia, Japan and Mexico. One study finds that 27% of the decline in American demand and 18% of that in the European Union was borne by foreign producers.



The shock coming this year threatens to be far more brutal. When one of the world’s economic giants sneezes, the rest of the world catches cold.

Now everyone is coughing. Factory closures are being exacerbated by a rise in trade barriers.

And global demand is plummeting as households’ incomes dry up and cash-strapped firms put their investment plans on ice.

At first the virus infected manufacturing in China, which typically supplies nearly 10% of the world’s intermediate-goods trade. The dollar value of Chinese exports in January and February was 17% below what it was a year earlier (though American tariffs may also have contributed to the weakness). As delivery times stretched out for longer and longer, companies had to pause production for lack of components.

Now factories across Europe, North America and Asia must cope not only with uncertain supplies of parts from China but also with sick workers and a dizzying array of local and national shutdowns. Audrey Ross of Orchard International, a company based in Canada that trades products including mascara and bath sponges, says planning has become a nightmare.

One customer in Germany is closed; another in France is open. Warehouses in America have shorter opening hours. Diversifying away from China had at first seemed like a sensible strategy. Now nowhere is safe.

To make matters worse, barriers to trade are going up. More than 50 governments have restricted exports of medical supplies, 33 of which acted after the beginning of March. Tourism has been crushed—it accounts for 8% of global services trade.

Flight cancellations have seen the cost of air freight, much of which goes in the belly of passenger jets, soar. Vaughn Moore of ait Worldwide Logistics, a freight-forwarding company, reports that rates have risen from $2-3 per kilo to $9-11, which for some goods is prohibitively expensive.

Land borders are becoming harder to cross too. Countries from America to Armenia have placed new restrictions on free movement. In almost all cases there are meant to be exceptions for people transporting goods. But haphazard implementation has led to queues that stretch for miles.

On March 15th the Italian transport minister had to call her Hungarian counterpart to request that a blockade be removed. Restricted border crossings have in some cases made it hard for drivers to get to work. “Everybody wants to do their own thing,” grumbles Umberto de Pretto of the International Road Transport Union. “If road transport stops the world stops.”

Bunged-up borders mean that it gets harder to refill empty supermarket shelves as people stockpile food, and to meet rocketing demand for medical equipment. Mario Aronovich, a customs broker in Mexico, remembers receiving calls when the crisis started about whether it was possible to export medical masks from Mexico to China. Now he is getting calls about trade in the opposite direction.

So just how big will the drop in overall trade be? In 2009 declining demand accounted for over two-thirds of the crash in trade, a far bigger share than the 15-20% caused by the credit crunch. The extent of the pandemic-induced slowdown in consumer spending and investment is already becoming clear.

And it has already dented trade activity badly—a survey of factory bosses in March suggests sharp falls in export orders in advanced countries. Simon Macadam of Capital Economics, a consultancy, has pencilled in a 20% drop in trade volumes this year.

That is bigger than in 2009. The drop in trade could be worse if the most pessimistic forecasts of jaw-dropping double-digit year-on-year declines in gdp in some rich countries over the next quarter or two come true.

A lesson from 2009 is that trade bounces back. Some of the precipitous drop then reflected companies drawing down their inventories; that reversed quickly enough when things returned to normal. Gloomier types point out the colossal uncertainty about when the rebound might come.

Trade thrives on trust and predictability. Today, with supply chains buckling and borders closing, both are in short supply.

Hidden Chinese Lending Puts Emerging-Market Economies at Risk

About $200 billion of emerging-markets debt owed to China has gone unreported in official statistics in recent years

By Brian Spegele and Anna Isaac

   Zambian and Chinese officials celebrated the completion of a China-funded village TV project in Zambia last year. Plj/Xinhua/Zuma Press


A hidden pile of debt threatens dozens of emerging-market countries as the global economy stalls and commodity prices tumble.

An estimated $200 billion of emerging-market debt owed to China has gone unreported in official statistics in recent years. The money is upending assumptions made by yield-hungry investors who have poured roughly $2 trillion into risky emerging markets over the last decade.

Even before the market crash, some borrowers were buckling under their debts to China. Pakistan turned to the International Monetary Fund in 2018 for a bailout. Sri Lanka was forced to cede China control of a strategically located port to shore up state finances.


U.S. and European economists are drawing parallels to the 1980s debt crisis that shattered growth in Latin America. A global recession would magnify the problem, economists and investors say.

Since the start of the year, dollar-denominated government bond prices have fallen by around 50% or more for some resource-rich countries like Angola and Ecuador that also owe heavy debts to China. An index tracking emerging-market sovereign bond performance has fallen around 16% while more than $80 billion has flowed out of emerging-markets stocks and bonds since the market turmoil began, according to the Institute of International Finance.



China’s rise as a trading and manufacturing power has been extensively studied over the last four decades, but its impact as a financial power is less understood. Exactly how much China has lent is kept under wraps by state-run banks such as China Development Bank and the countries receiving the loans.

China’s opaque lending can lead investors and organizations to underestimate the risk they are taking when they make loans to these countries or buy their bonds, leading them to lend at rates that might be too low given the potential losses. These include global investors and multilateral lenders such as the World Bank.

Investors “have to be very, very leery of what’s going on,” said Carmen Reinhart, a Harvard University economist and former IMF official who has studied China’s lending practices.

Ms. Reinhart, one of the most influential U.S. economists on financial crises, was part of a team that over the last two years pieced together a data set of Chinese loans. A resulting study by Ms. Reinhart and economists Sebastian Horn and Christoph Trebesch concluded more than $200 billion of Chinese overseas loans–around half of all its cross-border lending–was hidden from public view. Around a dozen of the poorest countries owed debts to China equal to 20% or more of their annual GDP, the research estimated.

“The problem gets most acute in crisis situations,” said Mr. Trebesch.

Much of the growth can be traced to China’s sprawling “Belt and Road” initiative, which seeks to open up new trade routes, expand overseas opportunities for Chinese firms and deepen the country’s strategic influence through the financing and building of infrastructure.

A security-forces member observed construction at the M8 motorway in Pakistan in 2016. It was part of China’s Belt and Road project to rebuild the ancient Silk Road, a trading route connecting China to the Arabian Sea. Photo: Asim Hafeez/Bloomberg News .


Large commodity exporters that seek to sell to China are among the roughly 70 countries taking part in China’s program, many of which took on Chinese debt during the boom in commodities prices, but whose finances are particularly vulnerable to plunging commodity markets today.



“The debt burden from these projects is very quickly going to become unsustainable for many, many, many countries,” said Danny Russel, the State Department’s top diplomat for East Asia affairs under President Obama. “This is scary stuff.”

Nigeria, Africa’s largest economy and which depends heavily on oil exports, was one such recipient. Official statistics have presented China as a modest financier for Nigeria in recent years. By the end of 2017, Nigerian government statistics show external debt owed to China was under $2 billion.

In reality, the total debts Nigeria owed to China were more than double that amount, according to the research. Chinese loans have financed infrastructure such as a light-rail project for the capital city of Abuja. Last year, China also committed $629 million in financing for the country’s first deep-sea port. Nigeria’s government is trying to borrow an additional $17 billion from the state-controlled Export-Import Bank of China.

China’s lending, most of which is done in dollars, starkly contrasts that of multinational institutions such as the World Bank. While these groups lend money at below-market rates, China tends to lend at commercial rates, at times securing loans with a country’s oil or other natural resources.

A view in early February of the construction of the first rail line linking China to Laos, in Luang Prabang, Laos. Photo: aidan jones/Agence France-Presse/Getty Images .


Parallels to the 1980s debt crisis in Latin America—which spurred a “lost decade” of growth for Mexico and others—concern economists today. Just like the earlier case, a prolonged commodities boom fueled lending to resource-rich developing nations. Some economists say China’s opaqueness in its lending is reminiscent of the syndicated U.S. bank loans that crippled Latin America decades ago.

“The thing about the Chinese lending is it’s not transparent,” said Kevin Daly, investment manager for emerging-market debt at Aberdeen Standard Investments Inc. “Countries that do borrow from the Chinese, when you meet with their officials they do offer you a figure, but they don’t offer you details of the breakdown or the repayment schedule.”

    An expressway section of the Karakoram Highway project was inaugurated in November in Havelian, in northwestern Pakistan, under the China-Pakistan Economic Corridor program.
Photo: Liu Tian/Xinhua/Zuma Press .


Southeast Asia has proven a particular focus for Belt and Road projects. Malaysian debts owed to China are estimated to have surged from less than a billion dollars when the initiative launched to more than $12 billion at the end of 2017. In Indonesia, a $4.5 billion loan agreement with China Development Bank is helping the country to push ahead with its first high-speed rail project.

An economic crisis in Pakistan exemplified the risks. As a showcase of the Belt and Road program, China planned a $62 billion building spree across Pakistan, with China-backed ports, railways and other infrastructure to boost growth.

But Pakistani officials now say they hadn’t properly assessed Pakistan’s fiscal outlook when accepting Chinese loans and projects, which required the use of Chinese contractors in exchange for financing.

Chinese-financed power plants, for instance, placed onerous financial obligations on the government, and contributed to a debt crunch that forced Pakistan to seek a bailout from the IMF. Islamabad denies that its debt problem is related to China.

  A Chinese-backed power plant under construction in Islamkot, Pakistan, in 2018. Photo: rizwan tabassum/Agence France-Presse/Getty Images .


China’s government has also denied engaging in what critics call “debt-trap diplomacy.” State-run lenders China Development Bank and the Export-Import Bank of China didn’t respond for comment.

China’s actions have garnered deeper scrutiny among U.S. officials, with the Trump administration nominating a critic of China’s foreign lending practices to lead the World Bank. David Malpass has used the position as the institution’s president to continue pushing China for more transparency, recently criticizing what he described as nondisclosure agreements written into Chinese foreign lending contracts.

“So, as the IMF or the World Bank goes into a developing country and says, ‘What are your debts?’, the country can’t tell you because they have a nondisclosure clause that’s really tightly written,” Mr. Malpass said in February.



U.S. criticism comes against the backdrop of an intensifying rivalry between the world’s two biggest economies, which the coronavirus crisis has only inflamed. A specific concern, current and former U.S. officials say, is that China uses indebtedness of weaker neighbors to gain leverage over them and pursue strategic aims.

A global recession may lead indebted countries to seek new terms with Chinese lenders, investors say, although it is too early to know how China will respond. Domestic economic constraints in China stemming from the coronavirus may make China less willing to roll over debts as they mature, which could exacerbate emerging-market liquidity challenges.

“China itself is also still recovering from a very huge shock,” said Esther Law, senior investment manager for emerging-markets debt at asset manager Amundi SA. The country “has lots of demands on its resources now.”

The Coronavirus Closes Borders

By: George Friedman


The border between the United States and Canada has been closed. I don’t recall that ever happening before; I’m not sure what it is supposed to achieve, given that the coronavirus is rampant in both countries, and I don’t know how to close a border that is wide open for miles and miles. I only know that Ottawa and Washington are satisfied with the arrangement.

One of the most important consequences of the pandemic is that borders have been becoming barriers. Borders have always mattered, of course, but as international trade intensified, they were in some cases more checkpoints than barriers, and in other cases more mile markers than checkpoints.

By no means was this universal or universally accepted, but the principles of unhindered international trade, what some called globalism, were pressing toward the kind of border the U.S.-Canada frontier typified.

Nowhere was this principle embraced more than in Europe. As Europe recovered from World War II, the notion of economic integration became more powerful and, with it, so too did the idea that borders were not to be barriers. In 1991, the Maastricht treaty was signed, institutionalizing the idea of open borders. The European Union embraced four freedoms: the free movement of goods, the free movement of capital, freedom to establish and provide services, and the free movement of people.

Europe also established the Schengen zone, which allowed citizens to move between nations as if they were actually a single country. Nations continued to exist, and national governments were elected, but at the same time the borders became markers. That movement has now been interrupted and national borders have once again become barriers.

Each nation is responsible for the well-being of its population. Leaders are selected according to their nation’s political process and are responsible to their own public. The EU in Brussels is not responsible for managing the current crisis, nor would publics accept the practical implications of a pan-European solution.

Germans were Germans and Poles were Poles, and in a moment of crisis, national identity and autonomy mattered more. Put differently, economic well-being depends on managing the pandemic. Without success in that, the Europeans feel that the economic issues are trivial. The key decisions are being made by nation-states, not a transnational entity.

There is, as we have seen, little to be done beyond maintaining unprecedented separation between citizens of a country. The disease is spreading through contact with people, so minimizing contact is essential. But there is another dimension. During the economic crisis that will follow the quarantines, it is essential that basic necessities and services remain available to each nation. Each national government has to face the fact that European principles have for a time been transcended by national interest.

COVID-19 European Border Restrictions


The borders have been blocked for the protection of resources and the prevention of movement by those who are infected by the coronavirus. In some ways, the latter imperative makes little sense. Just about every country has coronavirus patients; some have so many that they are overwhelmed. By the time controls were put in place, closing the borders to outsiders had little effect. As for protecting resources, closing borders is not useless, but it is a policy that will have consequences.

Italy has been one of the hardest-hit countries and the first to be staggered by the virus. For a period the willingness of Europeans, particularly Germans, Europe’s wealthiest, to come to Italy’s material assistance was extremely limited. As the pressure of being bound together by the EU confronted the obligation of states to protect their own, support became more generous. But at no time was the “European identity” the governing principle. The assistance was from one nation to another nation, but not from one part of a single entity to another part.

It is not clear what effect this will have on the European Union. I think it will come to realize that in extremis, or at least the illusion of extremis, the nation will take precedence over the union. The nature of a marriage is not measured by the good times but the times of sacrifice. In the time of sacrifice in Europe, each nation looked to itself first and then considered others. This is not a surprise. As I have written, we love our own, those who share our language, our history and our Gods. The EU sought to transcend that. This is in many ways another test of the EU.

All of this is not, of course, unique to the EU. Russia closed its border with China early on. The closure of borders and the sequestering of supplies along with people is inevitable. There are already some reports of nations hoarding food that would normally be shipped elsewhere.

The governor of Texas has imposed restrictions on some travelers coming from Louisiana, whose infections dwarf those of Texas. But Texas also has many infected, and the numbers will most likely go up, even without Louisiana’s help. Still, there is a sense that those who come from a place where the virus has struck intensely are more infectious than the neighbor who is infected but doesn’t know it yet. In times like these, fear runs deep, and governors must placate their frightened citizens, if only by gestures since no other solution is yet available.

This is not therefore a European phenomenon, but in Europe there is history, and that history is of war and fear between nations that are now joined in a union. Relations between Louisiana and Texas will likely return to a distrust between UT and LSU football fans, but while intense, it pales in comparison to European malice or to the general mistrust in the U.S. for the rest of the world.

In the meantime, the walls built within the United States will come down as the pandemic eventually goes away. Whether the European walls will come down is another question. What’s clear is that for now Italians are Italians, Germans are Germans, and the European identity that transcends nations is not nearly as solid as hoped.

The institutions might return to what they were, but the trust that has been slowly emerging may seem to have been misplaced. And that will change the world.

Foreseeable Unforeseeables

Contrary to what US President Donald Trump would like to believe, a pandemic like COVID-19 was predicted as recently as last year. After being caught off guard by yet another catastrophe, one wonders when political leaders, markets, and average citizens will start to take risk seriously.

Jeffrey Frankel

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CAMBRIDGE – Events like the COVID-19 pandemic, the US housing-market crash of 2007-2009, and the terrorist attacks of September 11, 2001, are often called “black swans.” The term is meant to suggest that no one could have seen them coming. But, in fact, these episodes each involved known unknowns, rather than what former US Secretary of Defense Donald Rumsfeld famously called “unknown unknowns.”

After all, in each case, knowledgeable analysts were aware not only that such a thing could happen, but also that it was likely to happen eventually. Although the precise nature and timing of these events were not predictable with high probability, the severity of the consequences were. Had policymakers considered the risks and taken more preventive steps in advance, they might have averted or mitigated disaster.

In the case of COVID-19, epidemiologists and other health experts have been warning about the danger of a viral pandemic for decades, including as recently as last year. But that has not stopped US President Donald Trump from claiming that the crisis was “unforeseen,” that it is an issue that “nobody ever thought would be a problem.”

Likewise, after the attacks of September 11, 2001, President George W. Bush wrongly asserted that, “There was nobody in our government, at least, and I don’t think the prior government that could envision flying airplanes into buildings on such a massive scale.”

In light of such statements, it is tempting to attribute these disasters solely to executive incompetence. But human error at the top is too facile to be a complete explanation, considering that the general public and financial markets have also often been caught by surprise.

Stock markets had reached historic highs just before the 2008 financial crisis, and again before the latest crash that began in late February. In both cases, there were plenty of foreseeable tail risks that should have militated against irrational exuberance.

On these occasions, investors were not just following overly optimistic baseline forecasts. Rather, they saw essentially no risks at all. The VIX – a measure of perceived financial-market volatility (sometimes known as the “fear index”) – was near record lows in advance of both 2007-2009 and 2020.

Several factors help to explain why extreme events so often catch us by surprise. First, even technical experts can miss the big picture if they do not cast their net wide enough when analyzing the data. They sometimes look only at recent data sets, assuming that in a fast-changing world, events from 100 years ago are irrelevant. Americans often come with an additional set of blinders: an excessive focus on the United States. Giving little mind to the rest of the world is one of the perils of American exceptionalism.

In 2006, for example, the finance whizzes who priced US mortgage-backed securities relied primarily on the recent history of US housing prices, effectively operating under the rule that housing prices never fall in nominal terms. But that rule merely reflected the fact that the analysts themselves had never witnessed housing prices falling in nominal terms simultaneously.

Housing prices had indeed fallen in the US in the 1930s, and in Japan as recently as the 1990s.

But those episodes did not coincide with the lived experience of US-based financial analysts.

If those analysts had only consulted a broader data set, their statistical estimates would have allowed for the probability that housing prices would eventually fall, and that mortgage-backed securities would therefore crash. Financial analysts who limit their data to their own country and time period are like nineteenth-century British philosophers who concluded by induction from personal observation that all swans are white. They had never been to Australia, where black swans had been discovered in a previous century, nor had they consulted an ornithologist.

Moreover, even when experts get it right, political leaders often don’t listen. Here, the problem is that political systems tend not to respond to warnings that estimate the risk of some disaster at a seemingly low figure like 5% per year, even when the predictable costs of ignoring such probabilities are massive.

The experts who had warned of a serious pandemic got the risk assessment right. So, too, did Bill Gates and many other astute observers working in sectors as far afield as public health and the movie business. But the US federal government was not prepared.

Worse, in 2018, the Trump administration actually eliminated the National Security Council unit that had been created by President Barack Obama to deal with the risk of pandemics; and it has regularly tried to slash the budgets of the Centers for Disease Control and Prevention and other public-health agencies. It is little wonder that America’s handling of the pandemic – the lack of testing and the dangerous shortage of critical-care equipment and facilities – has fallen so far short of other advanced economies, not least Singapore and South Korea.

But, in addition to reducing America’s capacity to respond to pandemics, the White House simply had no plan, nor recognized that it would need one, even after it had become obvious that the coronavirus outbreak in China would spread globally. Instead, the administration dithered and diverted blame, failed to ramp up testing, and thereby kept the number of confirmed cases artificially low, perhaps to support stock prices.

As for Trump’s claim that, “Nobody has ever seen anything like this before,” one need only look back four years to the deadly Ebola outbreak that killed 11,000 people. But they were far away, in West Africa. The 1918-19 influenza pandemic killed 675,000 Americans (along with some 50 million worldwide), but that was 100 years ago.

Apparently, our political leaders are impressed only when a disaster has killed a large number of citizens within their own country and within living memory. If you have never seen a black swan with your own eyes, they must not exist.

The world is now learning about pandemics the hard way. Let us hope that the price in lives is not too high – and that the right lessons are learned.


Jeffrey Frankel, Professor of Capital Formation and Growth at Harvard University, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He is a research associate at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.