Today, we’re hurtling toward an economic crisis borne of the global pandemic of COVID-19. Unlike previous crises, the root of today’s turmoil may render certain policy measures ineffective—and it could mean a massive fiscal response is required to ensure things don’t go from bad to worse.
As we consider today’s predicament, it’s only natural to think back to the last big dislocation that shook the global economy: the global financial crisis of 2008/2009. That event was a gigantic liquidity crisis—a situation where access to cash, or the convertibility of assets to a more liquid form such as cash, became severely limited. It led to a recession but proved to be largely treatable through monetary policy measures and fiscal support. In the United States, these steps included novel monetary and fiscal solutions, quantitative easing (QE), and the Troubled Asset Relief Program (TARP).
In my 50 years of working in finance, it was my most terrifying experience to live through. The world as we knew it felt like it was perpetually on the verge of imploding. But it didn’t, thanks in large part to the mixture of TARP and QE.
How is the current environment different?
The COVID-19 pandemic of 2020 is a very different situation. From an economic perspective, we face a huge demand shock rather than a financial liquidity shock. Consumers and businesses have radically curtailed or rerouted their consumption habits. As huge swaths of the population reduce their time outside the home or are forced to “shelter in place,” that will have a drastic, immediate, and potentially long-lasting impact on businesses of all sizes. Without an offset, we're likely to then face a supply shock as unemployment may rise substantially and productivity measures crumble.
In my view, this important difference from 2008 must be solved with fiscal policy rather than monetary policy, as the latter cannot address the problem we face today. For one thing, the current crisis comes at a time when corporate balance sheets are highly leveraged.1 In addition, COVID-19 emerged as the global manufacturing base was already flirting with recession, as reflected in global manufacturing Purchasing Manager Indexes (PMIs).2 What’s more, lingering trade tensions with China and the deglobalization of supply chains were already undermining global economic stability. Just as margins were peaking, manufacturing PMIs were falling, corporate debt leverage was touching new highs, and the outlook for global trade was anything but certain.
From demand shock to recession
As we begin to grasp both the human and economic consequences of this pandemic, a recession appears to us to be inevitable. This is especially the case when one considers the forces in motion and the growing consensus that only fiscal policy can address the broadening consequences of the exploding demand shock.
Think of COVID-19 as a point on a curve. Early on, the incidence of the virus expands as it rides up the curve. Every data point is higher than the previous one, and the rate of change increases as well. At some level, we reach an inflection point. After that, the curve continues to rise, but at a decreasing rate before it reaches an asymptotic state (which means it becomes flat).
We still don’t have a good picture of where we are on the curve globally. China and South Korea appear to have passed the inflection point, but that doesn't appear to be the case elsewhere, as of this writing.3 The key is to hit the inflection point as soon as possible and hope that we can bend the curve to something close to flat. Achieving that will require significant social distancing now, and eventually a COVID-19 vaccine.
The faster we flatten the line, the better for our health. However, the actions we take to accomplish that are likely to worsen the economic outlook. This is why we need fiscal stimulus—and it will have to be big. Only the federal government is adequately equipped to minimize the length of any economic slowdown. We must offset the demand shock arising from the “treatments” (primarily social distancing policies) required to eliminate the virus.
Consider the following model, which demonstrates the linkage between the real economy and the financial economy.
Real GDP is the sum of the levels of employment and productivity. The growth rate is the sum of the growth rate of the work force plus the growth rate of productivity. Add inflation to that number, and you have nominal GDP.
If one holds profit margins constant, the growth rate of nominal GDP tends to equal the growth in corporate earnings over long periods of time. The valuation metric for those earnings is largely driven by the inflation rate as reflected through interest rates. The absence of inflation would cause one to use what economists call a “normal” interest rate.
Here's where many things changed during the last decade. QE dropped—or even eliminated—the “normal” rate, causing the present value of financial assets to soar. The idea was that the higher level of financial asset values would induce higher GDP because higher wealth, combined with the marginal propensity to consume, would accelerate growth in employment and productivity and lead to overall GDP growth accelerating. While it was helpful to the economy—even if not to the degree that was hoped for—it was fabulous for financial asset valuations.
Now, let’s look at the model through the lens of the demand shock induced by COVID-19. Services represent more than 50% of the U.S. economy, and services require human interaction.4 Social distancing is likely to impair that activity and eventually result in lower employment and productivity. As these components decline, so will real GDP, which is highly likely, in our estimation, to lead to a recession.
The shape of the future recovery
Monetary policy cannot address this problem, but fiscal policy can, in my view. Stimulus is needed in the form of a U.S. infrastructure investment program. Such a program could be relatively easy to finance, given the current low interest rates that the government is paying on its U.S. Treasury debt.
If we use only monetary policy to address the current crisis, I believe we'll fail badly. The demand shock will lead to a supply shock as unemployment rises and productivity falls. We must use fiscal policy to solve this problem, even if it means mailing a check each month to households that are suddenly left without income earners because of the social distancing policies required to defeat the biological effects of the virus.
The U.S. Federal Reserve has cut interest rates to near zero,5 but that step will not be enough, in my view. If fiscal policy is deployed in a timely and efficient manner, the future shape of the economic growth is more likely to resemble the letter V than the letters U or L. The equity markets are likely, in my view, to reflect that shape as well.
1 “OECD warns over pileup of low-quality corporate debt,” CNBC, February 19, 2020. 2 “Global manufacturing sees steepest contraction since 2009 as coronavirus impacts China,” Axios, March 3, 2020. 3 “Grim milestone: Italy's coronavirus deaths surpass China's,” USA Today, March 19, 2020. 4 “The services powerhouse: Increasingly vital to world economic growth,” Deloitte Insights, July 12, 2018. 5 U.S. Federal Reserve Federal Open Market Committee Statement, March 15, 2020.