A Greater Depression?

With the COVID-19 pandemic still spiraling out of control, the best economic outcome that anyone can hope for is a recession deeper than that following the 2008 financial crisis. But given the flailing policy response so far, the chances of a far worse outcome are increasing by the day.

Nouriel Roubini

roubini138_JOHANNES EISELEAFP via Getty Images_nyseusstockmarkettrader

NEW YORK – The shock to the global economy from COVID-19 has been both faster and more severe than the 2008 global financial crisis (GFC) and even the Great Depression. In those two previous episodes, stock markets collapsed by 50% or more, credit markets froze up, massive bankruptcies followed, unemployment rates soared above 10%, and GDP contracted at an annualized rate of 10% or more.

But all of this took around three years to play out. In the current crisis, similarly dire macroeconomic and financial outcomes have materialized in three weeks.

Earlier this month, it took just 15 days for the US stock market to plummet into bear territory (a 20% decline from its peak) – the fastest such decline ever. Now, markets are down 35%, credit markets have seized up, and credit spreads (like those for junk bonds) have spiked to 2008 levels.

Even mainstream financial firms such as Goldman Sachs, JP Morgan and Morgan Stanley expect US GDP to fall by an annualized rate of 6% in the first quarter, and by 24% to 30% in the second. US Treasury Secretary Steve Mnuchin has warned that the unemployment rate could skyrocket to above 20% (twice the peak level during the GFC).

In other words, every component of aggregate demand – consumption, capital spending, exports – is in unprecedented free fall. While most self-serving commentatorshave been anticipating a V-shaped downturn – with output falling sharply for one quarter and then rapidly recovering the next – it should now be clear that the COVID-19 crisis is something else entirely.

The contraction that is now underway looks to be neither V- nor U- nor L-shaped (a sharp downturn followed by stagnation). Rather, it looks like an I: a vertical line representing financial markets and the real economy plummeting.

Not even during the Great Depression and World War II did the bulk of economic activity literally shut down, as it has in China, the United States, and Europe today. The best-case scenario would be a downturn that is more severe than the GFC (in terms of reduced cumulative global output) but shorter-lived, allowing for a return to positive growth by the fourth quarter of this year. In that case, markets would start to recover when the light at the end of the tunnel appears.

But the best-case scenario assumes several conditions. First, the US, Europe, and other heavily affected economies would need to roll out widespread COVID-19 testing, tracing, and treatment measures, enforced quarantines, and a full-scale lockdown of the type that China has implemented. And, because it could take 18 months for a vaccine to be developed and produced at scale, antivirals and other therapeutics will need to be deployed on a massive scale.

Second, monetary policymakers – who have already done in less than a month what took them three years to do after the GFC – must continue to throw the kitchen sink of unconventional measures at the crisis. That means zero or negative interest rates; enhanced forward guidance; quantitative easing; and credit easing (the purchase of private assets) to backstop banks, non-banks, money market funds, and even large corporations (commercial paper and corporate bond facilities). The US Federal Reserve has expanded its cross-border swap lines to address the massive dollar liquidity shortage in global markets, but we now need more facilities to encourage banks to lend to illiquid but still-solvent small and medium-size enterprises.

Third, governments need to deploy massive fiscal stimulus, including through “helicopter drops” of direct cash disbursements to households. Given the size of the economic shock, fiscal deficits in advanced economies will need to increase from 2-3% of GDP to around 10% or more. Only central governments have balance sheets large and strong enough to prevent the private sector’s collapse.

But these deficit-financed interventions must be fully monetized. If they are financed through standard government debt, interest rates would rise sharply, and the recovery would be smothered in its cradle. Given the circumstances, interventions long proposed by leftists of the Modern Monetary Theory school, including helicopter drops, have become mainstream.

Unfortunately for the best-case scenario, the public-health response in advanced economies has fallen far short of what is needed to contain the pandemic, and the fiscal-policy package currently being debated is neither large nor rapid enough to create the conditions for a timely recovery. As such, the risk of a new Great Depression, worse than the original – a Greater Depression – is rising by the day.

Unless the pandemic is stopped, economies and markets around the world will continue their free fall. But even if the pandemic is more or less contained, overall growth still might not return by the end of 2020. After all, by then, another virus season is very likely to start with new mutations; therapeutic interventions that many are counting on may turn out to be less effective than hoped. So, economies will contract again and markets will crash again.

Moreover, the fiscal response could hit a wall if the monetization of massive deficits starts to produce high inflation, especially if a series of virus-related negative supply shocks reduces potential growth. And many countries simply cannot undertake such borrowing in their own currency. Who will bail out governments, corporations, banks, and households in emerging markets?

In any case, even if the pandemic and the economic fallout were brought under control, the global economy could still be subject to a number of “white swan” tail risks. With the US presidential election approaching, the COVID-19 crisis will give way to renewed conflicts between the West and at least four revisionist powers: China, Russia, Iran, and North Korea, all of which are already using asymmetric cyberwarfare to undermine the US from within. The inevitable cyber attacks on the US election process may lead to a contested final result, with charges of “rigging” and the possibility of outright violence and civil disorder.1

Similarly, as I have argued previously, markets are vastly underestimating the risk of a war between the US and Iran this year; the deterioration of Sino-American relations is accelerating as each side blames the other for the scale of the COVID-19 pandemic. The current crisis is likely to accelerate the ongoing balkanization and unraveling of the global economy in the months and years ahead.2

This trifecta of risks – uncontained pandemics, insufficient economic-policy arsenals, and geopolitical white swans – will be enough to tip the global economy into persistent depression and a runaway financial-market meltdown.

After the 2008 crash, a forceful (though delayed) response pulled the global economy back from the abyss. We may not be so lucky this time.

Nouriel Roubini, Professor of Economics at New York University's Stern School of Business and Chairman of Roubini Macro Associates, was Senior Economist for International Affairs in the White House’s Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank. His website is NourielRoubini.com.


Share prices fall hard in recessions. It is tricky to take advantage

Seeing through a falling stockmarket

SAM SPADE, the detective in “The Maltese Falcon”, a crime novel by Dashiell Hammett, recounts a story of a missing-person case. Flitcraft, an everyman, is nearly killed by a falling beam. Confronted with the randomness of life, he decides—randomly—to vanish.

After drifting for years, he settles into a new life much like his old one: marriage, kids, and golf at four. “He adjusted himself to beams falling,” says Spade. “And when no more of them fell, he adjusted himself to them not falling.”

The covid-19 virus has dropped from the sky, much like the girder that narrowly missed Flitcraft. Investors are shaken. Many are still adjusting to a world of falling beams. It will be a while before they adjust to them not falling. Meanwhile, the news on the economy gets worse. And bad economic news is generally bad for share prices.

If you are about to retire or derive your income from shares, this will hurt you. But there is a class of investor for which falls in asset values, or drawdowns, are an opportunity. Were prices to fall exactly in line with the value of lost profits, shares would be no cheaper. But in recessions, stocks tend to fall by a lot more than that. A clear-headed investor can pick up some bargains.

Economic downturns are—or should be—a fact of life for investors. A good working definition for them is a change to global GDP that causes a meaningful hit to the near-term corporate cashflows that shareholders lay claim to. A blow of this kind seems certain this year. But downturns eventually give way to recoveries. Only a fraction of firms will go bust. And equities are perpetual securities.

The profits lost to recession can be thought of as an annual dividend cheque that got lost in the post and is not replaced. It hurts your wealth. But you are still entitled to payments stretching into the indefinite future. These account for most of a share’s value.

In principle, then, investors need not demand a big discount to hold stocks in recessions. But in practice they do. During the steep downturn of 2008-09, for instance, the S&P 500 index fell by almost 50% in the space of a few months. Although that was an especially brutal recession, it was not a drawdown for the ages. The peak-to-trough falls in earlier crashes were nearly as big.

Clearly a lot of shareholders cannot look past the downturn. Call this panic, if you like, but it is all-too-human.

When the beam hit the pavement beside him, Flitcraft “felt like somebody had taken the lid off life and let him look at the works”. Big drawdowns affect people in a similar way. Suddenly, risks seem to be everywhere—to your job, to your business, to your pension and your way of life. It seems imprudent to hold on to stocks.

The simplest, rules-based way to take advantage of lower stock prices is portfolio rebalancing. An investor who holds a portfolio split 50-50 or 60-40 between shares and bonds sells the bonds that have gone up in price, as interest rates fall, to buy shares that have fallen in price, and are now cheaper.

She does this once a month or once a quarter to keep the weights constant. A bolder group of investors keeps cash in reserve so they can take advantage of bargain prices when the markets have turned away from risky shares.

“There is a point when I say ‘this is getting interesting’,” says one investor. The threshold for “interesting” is a fall of at least 20%.

For deep-value investors, it might be 40%.

A good stockpicker will have a watch list: a roster of company shares she would like to own should they become cheaper during the current sell-off. Market sages, tapping their nose, boast that they plan to load up on “quality stocks” at good prices when the stockmarket really tanks. If only life were that simple.

Quality stocks (companies with a business model that is hard for rivals to emulate) started off dear and are only a little less so now. Meanwhile unloved value stocks, which sell for a low multiple of their profits, have become even cheaper.

Such firms are in industries whose long-term prospects look bleak—banks, carmakers, oil firms and so on. Owning them has been an unrewarding experience. Their profits will be crushed by travel bans, supply-chain snarl-ups and the like. But their cheapness will push bolder investors to take a look.

Flitcraft was shocked to discover how random life can be. The hardboiled Sam Spade already understands this. Investors of the Spade kind know that beams fall, and they adjust to it. They also know that beams eventually stop falling. It is this that allows them to buy stocks when prices hit the pavement.

The seeds of the next debt crisis

With debt levels already at a record high, coronavirus raises the risk of a credit crunch in a world of low interest rates

John Plender in London

© FT montage

The shock that coronavirus has wrought on markets across the world coincides with a dangerous financial backdrop marked by spiralling global debt. According to the Institute of International Finance, a trade group, the ratio of global debt to gross domestic product hit an all-time high of over 322 per cent in the third quarter of 2019, with total debt reaching close to $253tn. The implication, if the virus continues to spread, is that any fragilities in the financial system have the potential to trigger a new debt crisis.

In the short term the behaviour of credit markets will be critical. Despite the decline in bond yields and borrowing costs since the markets took fright, financial conditions have tightened for weaker corporate borrowers. Their access to bond markets has become more difficult. After Tuesday’s 50 basis-point cut, the US Federal Reserve’s policy rate of 1.0-1.5 per cent is still higher than the 0.8 per cent yield on the policy-sensitive two-year Treasury note.

This inversion of the yield curve could intensify the squeeze, says Charles Dumas, chief economist of TS Lombard, if US banks now tighten credit while lending has become less profitable.

This is particularly important because much of the debt build-up since the global financial crisis of 2007-08 has been in the non-bank corporate sector where the current disruption to supply chains and reduced global growth imply lower earnings and greater difficulty in servicing debt.

In effect, the coronavirus raises the extraordinary prospect of a credit crunch in a world of ultra-low and negative interest rates.

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Policymakers in advanced countries have over the past week made clear their readiness to pursue an active fiscal and monetary response to the disruption caused by the virus. Yet such policy activism carries a longer-term risk of entrenching the dysfunctional monetary policy that contributed to the original financial crisis, as well as exacerbating the dangerous debt overhang that the global economy now faces.

The risks have been building in the financial system for decades. From the late 1980s, central banks — and especially the Fed — conducted what came to be known as “asymmetric monetary policy”, whereby they supported markets when they plunged but failed to damp them down when they were prone to bubbles. Excessive risk taking in banking was the natural consequence.

The central banks’ quantitative easing since the crisis, which involves the purchase of government bonds and other assets, is, in effect, a continuation of this asymmetric approach.

The resulting safety net placed under the banking system is unprecedented in scale and duration. Continuing loose policy has brought forward debt financed private expenditure, thereby elongating an already protracted cycle in which extraordinary low or negative interest rates appear to be less and less effective in stimulating demand.

Mandatory Credit: Photo by JIM LO SCALZO/EPA-EFE/Shutterstock (10351517h) Federal Reserve Chairman Jerome Powell announces the Fed's decision to cut interest rates a quarter percent at a news conference following a Federal Open Market Committee meeting in Washington, DC, USA, 31 July 2019. The United States Federal Reserve lowered the key interest rate quarter a point for the first time since the 2008 financial crisis. Federal Reserve Chair Powell announces quarter percent cut on interest rates, Washington, USA - 31 Jul 2019
Jay Powell, chair of the Fed which estimates corporate debt has risen from $3.3tn before the financial crisis to $6.5tn last year / © JIM LO SCALZO/EPA-EFE/Shutterstock

William White, who while head of the monetary and economics department at the Bank for International Settlements in Basel was one of the few economists to predict the financial crisis, says the subsequent great experiment in ultra-loose monetary policy is intensely morally hazardous.

This, he argues, is because unconventional central bank policies may “simply set the stage for the next boom and bust cycle, fuelled by ever declining credit standards and ever expanding debt accumulation”.

A comparison of today’s circumstances with the period before the financial crisis is instructive. As well as a big post-crisis increase in government debt, an important difference now is that the debt focus in the private sector is not on property and mortgage lending, but on loans to the corporate sector. A recent OECD report says that at the end of December 2019 the global outstanding stock of non-financial corporate bonds reached an all-time high of $13.5tn, double the level in real terms against December 2008.

The rise is most striking in the US, where the Fed estimates that corporate debt has risen from $3.3tn before the financial crisis to $6.5tn last year.

Given that Google parent Alphabet, Apple, Facebook and Microsoft alone held net cash at the end of last year of $328bn, this suggests that much of the debt is concentrated in old economy sectors where many companies are less cash generative than Big Tech. Debt servicing is thus more burdensome.

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The shift to corporate indebtedness is in one sense less risky for the financial system than the earlier surge in subprime mortgage borrowing because banks, which by their nature are fragile because they borrow short and lend long, are not as heavily exposed to corporate debt as investors, such as insurance companies, pension funds, mutual funds and exchange traded funds.

That said, banks cannot escape the consequences of a wider collapse in markets in the event of a continued loss of investor confidence and or a rise in interest rates from today’s extraordinary low levels. Such an outcome would lead to increased defaults on banks’ loans together with shrinkage in the value of collateral in the banking system.

And asset prices could be vulnerable even after the coronavirus scare because the central banks’ asset purchases drove investors to search for yield regardless of the dangers. As a result, risk is still systematically mispriced around the financial system.

The OECD report notes that compared with previous credit cycles today’s stock of corporate bonds has lower overall credit quality, longer maturities, inferior covenant protection — bondholder rights such as restrictions on future borrowing or dividend payments — and higher payback requirements.

Longer maturities are associated with higher price sensitivity to changes in interest rates, so together with declining credit quality that makes bond markets more sensitive to changes in monetary policy. Current market volatility is further exacerbated by banks’ withdrawal from market-making activities in response to tougher capital adequacy requirements since the crisis.
epa000221930 William White, Economic Adviser and Head of the Monetary and Economic Departement (L) and Malcolm Knight, General Manager of the Bank for International Settlements (BIS) during a press conference in Basel on Monday, 28 June 2004. The Basel-based institution, known as the central bank of central bankers, said there was a "consensus forecast" for a continuation of the "happy combination" of robust growth without significant inflation. EPA/MARKUS STUECKLIN
Economist William White says the great experiment in ultra-loose monetary policy is intensely morally hazardous © MARKUS STUECKLIN/EPA

In a downturn, some of the disproportionately large recent issuance of BBB bonds — the lowest investment grade category — could end up being downgraded. That would lead to big increases in borrowing costs because many investors are constrained by regulation or self-imposed restrictions from investing in non-investment grade bonds.

The deterioration in bond quality is particularly striking in the $1.3tn global market for leveraged loans, which are loans arranged by syndicates of banks to companies that are heavily indebted or have weak credit ratings.

Such loans are called leveraged because the ratio of the borrower’s debt to assets or earnings is well above industry norms. New issuance in this sector hit a record $788bn in 2017, higher than the peak of $762bn before the crisis. The US accounted for $564bn of that total.

Much of this debt has financed mergers and acquisitions and stock buybacks. Executives have a powerful incentive to engage in buybacks despite very full valuations in the equity market because they boost earnings per share by shrinking the company’s equity capital and thus inflate performance related pay. Yet this financial engineering is a recipe for systematically weakening corporate balance sheets.

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A graphic with no description

Otmar Issing, former chief economist of the European Central Bank, says prolonged low central bank interest rates also have wider consequences because they lead to a serious misallocation of capital. This helps keep unproductive “zombie” banks and companies — those that cannot meet interest payments from earnings — alive.

The IMF’s latest global financial stability report amplifies this point with a simulation showing that a recession half as severe as 2009 would result in companies with $19tn of outstanding debt having insufficient profits to service that debt.

Overall, this huge accumulation of corporate debt of increasingly poor quality is likely to exacerbate the next recession. The central banks’ ultra-loose monetary policy has also fostered what economists call disaster myopia — complacency, in a word, which is a prerequisite of financial crises.

The greatest complacency today is over inflation and the possibility that central banks will inflict a financial shock by raising interest rates sooner than most expect.

FILE - In this June 17, 2015, file photo, a television screen at the trading post of specialist John Parisi, left, shows the decision of the Federal Reserve, on the floor of the New York Stock Exchange. In December 2008, at the height of the financial crisis, the Fed cut its benchmark rate, called the federal funds rate, to a record-low range between zero and 0.25 percent. The goal was to reduce loan rates for companies and individuals as much as possible to spur borrowing and spending and thereby help stimulate the economy. (AP Photo/Richard Drew, File)
Traders at the New York Stock Exchange. A pressing question is whether the regulatory response to the financial crisis has been sufficient to rule out another systemic crisis © Richard Drew/AP

This myopia is understandable and not just because of the coronavirus. Since the financial crisis the debt laden advanced economies have suffered from deficient demand. Hence the central banks’ recent difficulties in meeting inflation targets. At the same time tightening labour markets have not led to increased wage inflation, leading many economists to assume the traditional relationship between falling unemployment and rising price inflation has broken down.

Clearly there is still a deflationary impulse at work in the global economy, causing growth to be both anaemic and debt dependent. Yet inflation may not be quiescent for as long as markets assume.

One reason is that with the central banks’ unconventional measures becoming less effective, there is a pressing question about how to respond to stagnation when interest rates are close to zero, together with a growing consensus, helped by coronavirus, that a more activist fiscal policy may be necessary.

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With the rise of populism there are growing calls for monetary finance of increased fiscal deficits — that is, direct financing of government deficits by central banks of the kind currently happening in Japan. Monetary finance has been a precursor of high inflation and while its proponents argue that the risks can be contained provided the quantity of such finance is controlled by independent central banks, central bank independence has been increasingly under threat since the crisis.

Demography is also relevant. Charles Goodhart of the London School of Economics and Philipp Erfurth of Morgan Stanley have argued that low and negative interest rates are not the new normal because the world is on the cusp of a dramatic demographic shift.

A decline in the working population relative to the retired population potentially returns bargaining power to labour. Combined with a decline in household savings because elderly populations have become less thrifty, they say, this makes it almost inevitable that real interest rates will reverse trend and go back up.

Nor, in the shorter term, is it clear that the relationship between unemployment and wage inflation has really broken. Chris Watling, founder of Longview Economics, says the sogginess of wage data in the US is substantially to do with the oil-producing states, which suffered a marked slowdown last year as a result of the fall in crude prices in late 2018. Non-oil wage inflation has remained in a relatively robust uptrend as unemployment rates have fallen.

TOPSHOT - Commuters, wearing facemasks amid fears of the spread of the COVID-19 novel coronavirus, wait for a canal boat in Bangkok on March 2, 2020. - A Thai man has died from complications doctors say were due to the deadly coronavirus, though health officials were reluctant on March 2 to conclusively confirm the cause of his death. (Photo by Mladen ANTONOV / AFP) (Photo by MLADEN ANTONOV/AFP via Getty Images)
Commuters in Bangkok. It seems unlikely that a full-blown crisis is imminent, notwithstanding coronavirus © Mladen Antonov/AFP/Getty

A pressing question, in the light of the debt build-up, is whether the regulatory response to the great financial crisis has been sufficient to rule out another systemic crisis and whether the increase in banks’ capital will provide an adequate buffer against the losses that will result from widespread mispricing of risk.

History matters here. The one period in the last 200 years when banking was relatively free of crises was between the 1930s and early 1970s. This was because the regulatory response to the 1929 crash and the subsequent banking failures was so draconian that banking was turned into a low-risk, utility-like business.

It was the progressive removal of this regulatory straitjacket, which began in the 1970s, that paved the way for the property based crises of the mid-1970s, the Latin American debt crisis of the 1980s, more property based crises of the early 1990s and the rest.

Column chart of Annual global issuance, $bn showing The value of leveraged loans has risen since the crisis

While there has been a plethora of reforms since 2008 — though conspicuously not including the removal of the privileged tax status of debt relative to equity — the operations of the likes of Goldman Sachs, Barclays or Deutsche Bank could scarcely be called utility-like. And when very rapid changes in financial structure are taking place, as today, regulators are often left behind by the new reality and wrong footed by regulatory arbitrage.

It is impossible to predict the trigger or timing of a financial crisis. And it seems unlikely that a full-blown crisis is imminent, notwithstanding coronavirus.

But the potentially unsustainable accumulation of public sector debt and of debt in the non-financial corporate sector highlights serious vulnerabilities, notably in China and other emerging markets, but also in the US and UK.

And the continental European banking system is conspicuously weaker than that of the US.

Against such a background, the conclusion has to be that of the late Herb Stein, the American economist who remarked that if something can’t go on for ever, then it will stop.

When coronavirus is long gone, that will be when systemic trouble starts.

The Virus Aftermath Won’t Be Like a Hurricane

Even if recession is avoided, recovery is likely to be U-shaped and uncomfortably long

By Justin Lahart

Photo: WSJ PHOTO ILLUSTRATION/iStockphoto (2)

When a hurricane rolls in, a river breaches its levee or suddenly shifting tectonic plates shake the earth, the economy can experience a big hit. The ensuing recovery is often even bigger.

But the coronavirus epidemic is no hurricane. It will weigh on the U.S. and global economy far longer, it won’t end with a sudden burst of blue skies and it won’t lead to types of rebuilding efforts—there are no roofs to be reshingled—that have historically helped the economy bounce back from natural disasters.

The shape of the economy as it absorbs and eventually recovers from the coronavirus epidemic is more likely to be U-shaped than V-shaped—with a prolonged bottom.

Ever since the scope of the coronavirus epidemic in Wuhan started becoming clearer in January, economists have been cutting their growth forecasts. Early this year, for example, Deutsche Bankforecast that U.S. gross domestic product would grow at a 1.7% annual rate in the first quarter, and 2.2% in the second. Now its economists are looking for GDP growth of 0.6% in the first quarter, followed by a 0.6% contraction in the second.

In the third quarter, they look for growth to resume, but, says Deutsche’s global head of economic research Peter Hooper, “there is no question there will be an overall loss of consumption and investment activity that does not come back.”

Like most of his peers, Mr. Hooper believes the U.S. will skirt a recession. That is by no means a given, though. The risk of a downturn is very real.

Even without taking into account the effects of full-scale spread of the virus in the U.S., it isn’t difficult to imagine a scenario where as people avoid things such as travel and dining out to reduce risk, businesses cut back on employment, leading to an adverse feedback loop that further hurts spending. Nor is it hard to imagine that small and midsize businesses forced to temporarily halt operations will get pushed to failure.

There are two major ways the epidemic will affect the economy: through disruptions to the supply of goods from China and elsewhere, and through the measures adopted in the U.S. to curtail the virus’s spread. There is plenty of uncertainty on both counts.

China’s economy has taken a severe hit from the aggressive measures its leaders imposed to curtail the virus’s spread. Data such as daily coal consumption and passenger traffic remain far below year-earlier levels and, while there has been some pickup in business as many provinces and municipalities have relaxed restrictions, the country is struggling to get back to work. That has disrupted global supply chains, and the U.S. economy is getting hurt as a result.

The good news is that China’s actions appear to have worked, or at least slowed the speed of the spread, laying the groundwork for an eventual recovery in activity. One key question: Will the lifting of quarantines and other restrictions lead to fresh outbreaks in China? That could make the resumption of Chinese manufacturing uneven.

Moreover, the spread of the virus to other countries making goods the U.S. depends upon, such as South Korea, is only making supply-chain problems worse. Shortages of key manufacturing components as well as finished goods could be a persistent problem for American businesses, sapping the strength of any recovery.

The other big way the virus will affect the economy is through how people respond to its threat. Already, people are canceling travel plans and avoiding gatherings. How bad the economic damage gets will ultimately depend on how far such social-distancing measures extend and what types of measures state and local governments might adopt to stem coronavirus’s spread.

But it is hard to gauge the scope of such measures as epidemiologists are struggling to understand some basic facts about the virus, such as how fatal and transmissible it is, The underlying problem is that nobody knows how many people have actually been infected, says Caroline Buckee, an epidemiologist at the Harvard T.H. Chan School of Public Health. “We don’t know how many people have no symptoms at all, or who have minor symptoms.”

It could be a while before that information is available. Meanwhile, Americans may only become increasingly cautious, placing spending at further risk.

And absent a vaccine—something that, if it comes, realistically won’t be available for quite some time—signs that the epidemic are starting to be contained probably won’t lead to people, businesses and authorities to abruptly lower their guards. Rather, they will continue to engage in many of the cautious behaviors that helped arrest the virus’s spread. Scattered outbreaks may only reinforce that message.

So there will be no sudden booking of vacations and no immediate resumption of major business conventions.

No V, in other words. The coronavirus epidemic will weaken the economy, and that weakness is likely to last an uncomfortably long time.

“We’ve Written Off the First Half of the Year’

Coronavirus Attacks Core of the Economy

Politicians and bankers are looking for ways to limit the damage that coronavirus is doing to the German economy. But with uncertainty so high, it is currently unclear how much relief stimulus or any other measure can deliver.

By David Böcking, Dinah Deckstein, Martin Hesse, Armin Mahler, Martin U. Müller, Michael Sauga, Gerald Traufetter

A cruise ship in Venice: "The psychology is a much bigger problem than the virus itself."
A cruise ship in Venice: "The psychology is a much bigger problem than the virus itself."

The Liedl carpentry workshop in the town of Pfarrkirchen, in southeastern Bavaria, is a family business founded in 1914. Stefan Liedl is the fourth generation of the family to head the company, but he and his father, Franz Liedl, have never experienced a situation quite like this.

Each year, Liedl presents two room arrangements at the International Handwerk Messe, a trade fair for construction, renovation and refurbishment products in Munich that the company attends in order to attract potential customers. But this year, the fair got cancelled at short notice because of the coronavirus. "We’re shocked,” says Franz Liedl. The company fortunately still has a buffer of contracts to keep things going for few months. But what happens after that? The carpenter doesn’t know. "We’re a bit concerned,” he says.

Although the number of people with the virus in Germany is comparatively small, it has already managed to infect the economy, even in tranquil Pfarrkirchen.

It’s affecting not only companies that export products to or import key parts from China, but also service providers, distributors and craftspeople. The more rigidly Germany attempts to prevent the virus’ spread, the more severe the collateral damage to the local economy will be. Hotels and restaurants are losing revenues and travel companies and airlines are suffering as the result of trade fair and business trip cancellations.

Only the Beginning

And this is only the start. As soon as the warehouses are empty, the companies that depend on products from China will need to limit or even stop production. If the virus spreads even further, entire workforces might end up having to stay home, and consumers will consume less, because they will feel safest in their homes or apartments.

If the situation deteriorates severely, many companies will run out of cash and will have to file for bankruptcy. Unemployment will also rise. Meanwhile, banks could run into serious problems.

At the moment, no one wants to speculate on whether that extreme situation will unfold. It all depends on how long it takes for the virus to be brought under control. As a result, no economist can predict how deep the crash will be and whether the economy will quickly rebound, with a v-shaped recovery, or whether it will be a slower, u-shaped one or a far-slower l-shaped one.

On Tuesday, the U.S. Federal Reserve showed how dangerous it considers current developments to be by lowering the interest rate by half a percentage point, even though the U.S. economy is still booming.

It was the largest interest decrease since 2008 and the first one since the financial crisis to be made between regularly scheduled meetings. The move was primarily meant to calm the stock market - which seems to have worked, at least for now.

Are Measures Still Available?

But what options do governments and central bankers actually have for mitigating the economic side-effects of the coronavirus?

Calls for government intervention are growing louder in the business world. Michael Frenzel, president of the Federal Association of the German Tourism Industry, argued this week that his sector -- which employs over 3 million people and includes several hundreds of thousands of primarily small- to midsized companies -- must "necessarily” be "part of a federal government stimulus package.”

German national airline Lufthansa has drastically cut its flight schedule and has grounded 150 planes, or 20 percent of its fleet. But if Lufthansa is no longer regularly using its slots at highly trafficked airports, it could wind up losing its takeoff and landing rights.

"Corona is affecting the entire airline industry,” says Lufthansa CEO Carsten Spohr. "These are exceptional circumstances to which we are having to adjust our flight plans. That's why we need a targeted suspension of the current slot regulation, so that airlines are not being forced to fly with empty aircraft merely to maintain their takeoff and landing rights,” says Spohr. "That makes no sense environmentally or economically.”

On Friday, the company made the even more dramatic announcement that it would reduce as many as 50 percent of its flights in the coming weeks to offset the lack of demand. 

Stimulus Measures?

In Berlin, government leaders are now discussing ways to fight the crisis. On the one hand, the government doesn’t want to be seen as sitting on its hands.  
But it also doesn’t want to do anything that will further fuel fears.  

"The psychology is a much bigger problem than the virus itself,” says an official at the Economics Ministry.

Economics Minister Peter Altmaier has worked out a three-step plan to be implemented if the situation worsens. In the first step, companies who run into financial problems are to be supported by credit guarantees or loans from the state-owned KfW development bank.

These funds can be increased, if necessary, in step two. Financial authorities could also delay tax payments from businesses in order to preempt any liquidity problems for companies. Only step three would involve taking measures to boost demand.
There is enough money available for a classic economic stimulus package. Germany has 50 billion euros of reserves that were earmarked to help overcome the refugee crisis but haven't been spent. Because German and EU debt rules allow for higher borrowing during times of crisis, they wouldn't be an obstacle to additional spending.
.The question, however, is how that money can best be spent. After the 2008 financial crisis, municipalities and other entities were provided with extra money to build streets and schools. But the construction industry is operating at such a high capacity at the moment that additional money would mostly just drive up the prices. The government could also try to stimulate consumption, for example, by temporarily lowering the value-added tax (VAT). But if people are avoiding stores and restaurants out of fear of the virus, that would also only have a limited effect. .The coronavirus is affecting the supply and demand sides of the economy in equal measure, making it difficult for politicians and central banks to provide an adequate response. Some companies are losing revenues, while others are unable to manufacture their wares because their staff needs to stay at home. Ifo Institute for Economic Research President Clemens Fuest believes that this limits politicians’ options for countering the crisis. "This can't be controlled,” he says. "All you can do is react.”

Memories of 2008

For example, by implementing the kind of "short-time work” measures adopted during the 2008 recession, which saw workers’ hours cut by their companies but the government temporarily covering the difference in their salaries. If an "unavoidable event” leads to interruptions in manufacturing and work, the Federal Labor Office can take over the payment of 67 percent of wages for a maximum of 12 months. The idea is to prevent layoffs until the economy can recover.

Federal Employment Minister Hubertus Heil is also currently working on an amendment to the law that could be implemented quickly and used during the epidemic that would allow the short-time work subsidy to be paid out for a total of 24 months. In the event of short-time work, up to 100 percent of an employer’s contributions to a worker’s social benefits could be refunded, easing businesses’ concerns about sliding into bankruptcy as a result of the virus.

Uwe Burkert, the chief economist at the Landesbank Baden-Wurttemberg (LBBW), a state-owned bank, remembers the financial and economic crisis of 2008/2009 well. His bank had to obtain a government bailout at the time, and many other companies only survived the crisis thanks to various forms of aid from Germany’s federal and state governments.

Burkert and his team are certain that the virus will have a severe impact on the German economy. "We’ve written off the first half of the year,” he says, explaining that the bank is expecting the economy to shrink for two successive quarters.

The Wrong Medicine?

Burkert says he’s concerned that the regulations imposed by countries in the wake of the financial crisis could actually exacerbate the current situation. As part of efforts to shore up banks, they were required to increase their risk provisions for loan defaults and to maintain greater capital reserves for the event that their credit ratings are downgraded.

But those rules have also narrowed banks’ profit margins, leading them to turn away from lending, which only worsens other companies’ problems. Standard & Poor’s, the rating agency, is already warning that the coronavirus epidemic could lead to a wave of downgrades for highly indebted companies.

Burkert is calling for the implementation of the state liquidity-aid and guarantees that proved highly successful during the financial crisis. He believes this could help the contagious shock set off by the coronavirus from growing into a financial crisis. He says it’s possible that many banks wouldn’t be strong enough to withstand the wave of loan defaults.

Burkert believes a further decrease in interest rates by the European Central Bank (ECB) would make little difference. He argues that would do more harm than good to banks, which are already suffering from the negative interest rates, and thus also hurt companies.

Unlike the Federal Reserve, the ECB has little room for maneuver. But the further the crisis deepens, the greater the pressure will become on Christine Lagarde, the new ECB president, to act.

"The Uncertainty Remains Unchanged”

Generally speaking, the entities that benefit the most from changes in monetary policy are stock exchanges.

Usually, however, market prices initially go down after a large adjustment before they start to rise again for the longer term.

That could happen again this time, once the extent to which the coronavirus is affecting the economy it becomes clear.

Even The Best-Case Scenario Is Pretty Grim

by John Rubino

Let’s say President Trump is right about the coronavirus “miraculously” fading away as temperatures rise in the Summer.

Will things then go back to the old normal of globalization, free trade and finance-driven “growth”?

Almost certainly not, because the psychological damage has already been done. Over the past couple of weeks the modern globalized economy with its multi-nation supply chains and just-in-time inventory systems has been forced to recognize that such a system only works in a nearly-perfect environment.

Take the iPhone: It is designed in the US, its constituent raw materials are mined and processed in numerous other countries and the resulting components are then shipped for assembly to vast Chinese factories.

Break any link in this chain and the whole thing grinds to a halt. One unavailable commodity or component, one out-of-service assembly plant, one country with closed borders or out-of-control civil unrest, and a multi-billion dollar revenue stream evaporates.

To varying degrees, the same threat hangs over pretty much every major product these days.

Most of the world’s pharmaceutical building blocks come from China and India, for instance.

Car parts are made in multiple countries before being shipped to assembly plants near consumers.

Virtually all of this depends on an environment where trade flows are unhindered, capital is free to find its most efficient home, and shipping is frictionless. That’s the system the developed and developing worlds have collaborated to build in the past few decades.

And now — in the blink of an eye — everyone recognizes it as ridiculously fragile and therefore way too risky to maintain.

Put yourself in the expensive shoes of a multinational company CEO.

You’re staring into the abyss on this Monday morning, praying to your version of God and promising that if He lets you off the hook this time you’ll mend you ways.

You’ll simplify those supply lines, bring as much action as possible back home, and end your reliance on debt-ridden “global manufacturing platforms” with unreliable public health systems. And you’ll start stockpiling inventory against what you now understand to be inevitable future disruptions.

These aren’t idle promeses, to be forgotten the minute the crisis is past. Your board of directors and most of your shareholders now understand that globalization means “excessive risk” and while they may give you a pass on some bad earnings comparisons in 2020, they won’t accept a repeat performance in later years.

So…major companies in pretty much every sector of manufacturing will be forced to scale back their work in Asia and the rest of the developing world and bring much of it in-house or at least physically closer.

This is at first glance a good thing for the US and maybe Europe, but it will be more than offset its devastating impact on China’s vast and massively over-indebted contract manufacturing sector and hyper-leveraged municipalities.

Which means the best case scenario is the long-awaited Chinese financial crisis.

And with the rest of the world just as over-leveraged as China, the implications of the second biggest economy shifting into reverse and possibly descending into chaos are hard to predict in detail but easy to envision generally: turmoil in the currency, fixed income and stock markets which force the governments to push interest rates into negative territory and run deficits that dwarf those of the Great Recession.

If any major fiat currency is still functioning at the end of this process, that will be the real miracle.