Although it has now been declared a pandemic by the WHO, it is hard to know how serious the coronavirus pandemic will become. Whatever the outcome, it is likely that the economic consequences will be more serious than the health effects.
It seems that the best way to prevent the disease from spreading so fast that it overwhelms hospital systems is to quarantine people from infected areas. The speed of the spread can be slowed by creating social distance and reducing human contact by action such as limiting travel and preventing attendance at large sports and entertainment events. Unfortunately, government actions to slow the spread of the disease have a significant economic cost. Spreading the advance of the disease out over several months means that the changes introduced by the government will have to stay in place for much longer. And the more serious the disease, the longer that it will take for people to revert back to their normal behaviour.
Governments have had to choose between health outcomes and economic outcomes. Most have put people's health ahead of the economy.
Even before the coronavirus struck, the world economy seemed to be turning down, although the consequences were not entirely clear. Therefore, although the coronavirus was a catalyst for the recession that had already begun, the outcome will be determined by the other factors that were already in play.
Europe has been struggling for some time. The uncertainty of Brexit makes it hard to know how this will play out.
The US trade war with China has had an effect on the economic performance of both countries by reducing trade and increasing costs. US agriculture has been seriously impacted.
The recovery from the 2008 Global Financial Crisis has been sluggish at. Part of the problem is that the government solutions, which saved badly managed financial institutions from disaster, left a dead-weight hanging over the rest of the economy. Lax monetary policy helped the banks created artificial conditions that enhanced the underlying problems that were never resolved.
Share markets have fallen sharply all over the world. Concern about the impact of the coronavirus triggered the fall, but most shares were probably already seriously overpriced with price/earnings ratios well above the long-term average. Loose monetary policy had fed the boom by encouraging share buy-back schemes, which make shareholders wealthy, but do nothing for the real economy. Low-interest rates also encouraged excessive margin buying. Given that share markets had got out of touch with the performance of the real economy, a serious correction was well overdue before the coronavirus arrived. All that was needed was a trigger.
Declining oil process have contributed to the decline in share prices. However, the oil market was already suffering from excess production prior to the coronavirus emerging, so a fall in price was inevitable. The virus was just the trigger of the inevitable collapse.
US shale-oil production had contributed to the excess production of oil. This production was usually funded by low-interest debt, so it was not really sustainable. Once oil prices fell a collapse of the fracking sector was unavoidable.
Current economic problems are exacerbated by the high levels of debt, due to the low-interest-rate policies of central banks. Household debt has soared again. The greatest risks are student debts and auto loans. Corporate debt has grown rapidly too, and some of this debt is very poor quality. At the same time, government debt has grown all over the world. This high level of debt leaves household and businesses vulnerable to economic troubles.
The finance sector in most developed countries has grown enormously in recent decades, but adds very little of value to the real economy. The sector claims that it mediates between lenders and borrowers, but in reality, it does very little of that. A vastly shrunk finance sector could carry out the financial intermediation need to support an economy.
What the sector has really done is to create a vast range of financial products and derivatives and then sold these on to other financial institutions, effectively betting against each other in a "giant financial casino". They claim that these activities improve the transmission of information and reduce risk, but the experience during the GFC showed that the opposite was the case. The finance sector has become a massive dead-weight that sits on top of the real economy, weighing it down with additional costs, and massively increasing risk when things unravel. The only people that benefit from these activities is the highly paid staff and shareholders of the companies that dominate the sector.
Monetary policy was over-used in the last financial crisis, so there is limited room for it to be used with the next, as low-interest rates cannot be pushed much lower before the go negative. This gives central banks very little room to move. Other monetary measures, such as quantitative easing have not proven effective in dealing with serious economic problems.
A modern economy has so many inter-dependencies that once it is slowed down, it will take time for it to get back up to speed again. Some businesses will have failed and will not start again. Many employees will have shifted to other work, and will not go back to doing what they were previously. Their skills will not be available for the restart of the economy. When people stop travelling, it might take a long time to be confident to travel again. In a less globalised world, some industries might never become competitive again. Businesses that have found new suppliers might never go back to their old one.
Many large businesses have weak balance sheets. Since the GFC, they have used cheap loans to finance share buybacks. These have pushed up the share prices for the benefit of shareholders, and particularly senior executives who are paid in shares or share options. Unfortunately, this practice leaves the business without financial reserves to tide them through a difficult time. For example, aerospace analyst Dhierin Bechai reports that:
Boeing spent roughly $60B in buybacks ($40.6B) and dividends ($19.4B) in the past years while it generated roughly $55B in cash flows. Boeing returns all of its cash flow from operations to shareholders... Excluding 2019, we found that Boeing returns 92 percent of its operating cash flow and 113 percent of its free cash flow to shareholders.
Coincidentally, or not, the $60 billion returned to shareholders is the exact amount Boeing requested in federal support for the aerospace industry.Jesse Fedler explains that the total net asset value of the McDonalds, Caterpillar, Boeing and 3M has fallen 90% from $70 billion just a few years ago to about $7 billion today. On average, these companies each spent $200 million per year on issuance of options to top management. Those very same managers were the ones who decided it was a good idea to leverage the balance sheet to buy back stock. This was done at the long-term expense of the resilience of their balance sheets.
The problem with the current economic crisis and mounting job losses is the vast majority of workers are woefully unprepared for any type of disruption to their income going into recession. This will be a problem all over the world.
The Chinese economy is weaker than it was in 2008/9 when it led the world out of the GFC.
Financial Markets
All over the world, financial markets have tanked. The main US share price indexes have fallen by a third in the last week. The falls have been similar in other markets and other countries. This represents a massive loss of wealth for people who own shares and other financial instruments directly, or indirectly through their superannuation funds and insurance companies.
But there is another consequence, which is even more serious. Over the last few decades, the finance sector has grown massively, far outpacing the rest of the world economy. Banks and other businesses in the finance sector have worked together to create a huge infrastructure of debt that sits on the top of the real economy. Most of these debts have some form of collateral attached to them for the security of the lender. This collateral often consists of shares and other financial instruments.
The big fall in the financial markets significantly reduces the value of the collateral that has been posted for security. This leaves the borrower with two choices. They can either post more collateral as security (if they have it) or pay down some of their loan until it matches their collateral. Both these options can be difficult in uncertain times, but the alternative is to default on the debt, which would have a snowball effect, weakening other financial institutions that are connected to the one that fails.
A significant portion of the debt is denominated in US dollars, often using foreign exchange swaps (partly because US interest rates have been so low). The need to beef up collateral against debt may be one reason why the US dollar has strengthened so much against other currencies. It is not a sign that the US economy is strong, but that the financial system is weak.
The central banks will try to paper over the cracks in the system by creating money and making loans, but this will not resolve the underlying problems that make the modern financial system unstable in the first place.
March 2020
