This is the question on everybody’s lips with the 2008 financial crisis still lingering in our mind. Not only did the stock market experience a similar dive over the past days but it has actually exceeded the scale of the previous crisis. On Thursday, March 12, the US Dow Jones and S&P 500 stock indices plunged by about 10%, the sharpest since the Black Monday in October 19, 1987.
Clearly, the times ahead will be challenging, but we would be mistaken to see in it a perfect copy of the previous crisis. As the devil is in the details we should be taking a closer look at them.
The fundamental difference between the two situations lies in the cause, the spark that lit the fire. In the previous crisis the root cause had to do with a lack of regulations and proper oversight which allowed poor and at times even preposterous management to occur in systemically important financial institutions. That triggered a large-scale financial crisis which later generated an economic crisis, with global collapse averted by actions taken by governments and central banks as a last resort.
We are now dealing with a different scenario. The root cause is completely unrelated to the fundamentals of the world’s largest economies or financial systems, although for at least a year now the feeling has been that the American stock market, at least, is a bubble looking for a needle. And the needle is here, and it has nothing to do with economics and everything to do with the pandemic. Hence the biggest problem is fear, an EMOTIONAL trigger. Such a cause is operating a substantial paradigm shift and will bring very specific economic developments.
Firstly, some major differences compared to the 2008 events must be noted: the financial systems in the developed world are robust and well-capitalized, fiscal policies, particularly in Europe have been prudent allowing for low deficits and even surpluses. Moreover, we live in a world with low interest rates and cash generously injected by central banks.
Against this backdrop, emotions will spread first to the economy and only collaterally to the financial system. As far as the economy is concerned, there is a major difference compared with a recession as part of a regular economic cycle: the rate at which adverse developments occur in companies. In a “regular” recession the economy gradually slows down, stagnates and then drops with a negative impact on all industries, whereas in a pandemic, developments follow a different pattern. We witnessed a sudden stop in consumption across an array of industries paralleled by a strong increase in product and service demand in others.
Tourism and transports were hit first and hardest, followed later by other categories of goods and services as consumers stayed at home, spending was re-directed to personal care and pharmaceutical items and finally, people turned to saving which is a natural occurrence in troubled times.
The prospect of getting stuck inside, however, created a problem rarely seen in a regular recession: part of the population was unable to get to work and carry out their jobs safely which led to a drastic reduction in activity or complete shutdown of companies of all shapes and sizes. Unlike a typical recession, the employees were not fired, but forced into “letting the companies go” as they put their health first.
Right now, the seriousness of the crisis and its spread through the financial system will to a large extent depend on how fast the pandemic is contained and eventually, defeated. Central banks are playing a rather decorative role at the moment, being in point of fact, helpless. Lowering interest rates stands no chance to produce effects and it is done mostly for show. Rates are very low or even negative, which already means low financing costs for individuals and businesses. And seriously … The wide-spread fear of contamination and associated economic behavior cannot be alleviated by low interest rates. Just as a company shutting down due to a lack of clients or employees cannot be saved by cutting rates by a few basis points. These are facts that central bank professionals are familiar with, which is why I think that interest rate decisions are more of a PR exercise meant to show that these institutions too “contribute their share” to bail out the economy.
Liquidity injections by central banks are equally questionable. On the one hand, repurchase agreements (repos) which are done by lending banks via government security sales, can be considered a normal and efficient approach to managing the banking system liquidity. On the other hand, resuming quantitative easing reminds me of an addictive drug that central banks can no longer come down from. It is an approach that I fail to understand, all the more so as over the past decade printing money has proved more beneficial for a minority of people and by no means for the majority as it excessively inflated financial and real estate assets.
Therefore central banks are and will remain for a while “on the sidelines”. The problems that companies are currently facing cannot be solved by lowering rates or printing money. All the more so as such measures will also help industries thriving during these times of turmoil, including pharmaceutical, medical equipment or online delivery businesses.
In the current setting, protecting small-to-large businesses falls for the most part on governments via tax measures and steps to raise aggregate demand and also on banks.
Both governments and banks benefit greatly from corporate cash as they both continue to be paid by ailing companies, included, from taxes or interest rates. Both of them can, therefore, negotiate flexible terms with taxpayers because it is in their best interest to help companies stay afloat after the crisis. Moreover, they can adopt a case-by-case approach based on how much a business has been affected by the current crisis or, on the contrary, has benefited from it.
Besides tax reliefs, governments can launch projects meant to generate demand in a bid to offset collapsing consumer expenditure. I do not expect spectacular results as boosting demand through government projects takes time which companies do not have as things unfold at an incredible speed.
At the end of the day, the good and equally bad news is that, unlike a typical recession, we are now facing a pandemic-induced shock, which develops exponentially, on the downside, and predictably, on the upside if China’s experience is anything to go by.
This means that in maximum six months, the fear, the emotional trigger, should tail off and we might return to some degree of normalcy. Start to think again about consuming, investing and spurring economic growth. This is why governments’ first priority should be to assist affected business, small or large, in walking through this Valley of Weeping. A deep, but shorter lived and incomparably less expanded than the 2008 experience.
Have a nice weekend!
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