The first instinct could be to apply the standard ‘Keynesian’ remedies to mitigate a fall in effective demand. And since the usual monetary weapons (interest rates) are running low on ammunition, the call has gone out to rally the government’s fiscal reinforcements (tax cuts and payments).
" It is good for society overall to limit the spread of the virus through the dramatic reduction of travel and large gatherings.”
But traditional demand-side stimulus – more government spending, tax or interest-rate cuts - in a world where many supply avenues have been suddenly blocked could simply fail to gain traction. Economies might need to be smarter than that.
Naturally the current situation is being compared with the global financial crisis (GFC) but there are important differences. Yes, the GFC was triggered by sub-prime mortgage losses and amplified by various forms of fraud but at its core it was a global liquidity event where the funding of new and untested credit structures disappeared in a black hole of mutual suspicion.
Contrary to popular opinion, the GFC wasn’t really a ‘Minsky moment’ – that is, it wasn’t due to a build-up of leverage in the non-financial sector. The current situation has more of the Minsky ingredients.
Hyman Minsky (American economist 1919-1996) recognised the fragility at the heart of the capitalist system - external finance leads to instability. Compared with investment through retained profits, debt financing comes with a commitment to periodic interest payments. Any difficulty in meeting these obligations can lead to a crisis of bankruptcies and a fire sale of assets.
I wouldn’t start from here
The flipside of the much-discussed ‘global savings glut’ is a lack of global investment. The attempted remedy - ever lower, even negative, interest rates – has encouraged the use of external financing as a means of fluffing up profit per share. But not the investment required to boost profits themselves.
Another post-GFC phenomenon is the sluggish growth of real wages and even rising inequality. Rather than addressing the issue directly, living standards have been propped up by encouraging credit-funded spending against increasing asset prices. The savings of some have been redirected into the non-productive consumption of others.
The outcome is an increase in cash flow obligations – both corporate and individual – that would make Minsky wince.
The economic heart attack is restricting the flow of cash to those relying on it to meet their own payments and these missed payments affect others in turn. This domino effect triggers the Minsky moment.
Any prolonged interruption to cash inflows makes prior cash outflow commitments ever more difficult to meet. A failure to receive cash to meet a scheduled payment can be fatal, even to those who pass more conventional measures of solvency.
It is good for society overall to limit the spread of the virus through the dramatic reduction of travel and large gatherings but these restrictions will leave some operating at a level where they struggle to maintain sufficient cash inflows.
Consider an example from history: in a small village the blacksmith may sometimes not be fully occupied. But if the villagers cannot do without these specialist skills, they must find a way of providing for the blacksmith. Left to the ‘efficiency’ of free markets, however, the blacksmith may well starve!
So now, for the good of us all, some industries – through no fault of their own - must suspend operations for an unknowable length of time. And if we still want them to exist when this is all over we all have to help them, both financially and emotionally.
The alternative, as we can see in many places, is uncontrolled infection and the devastation associated with an exponential growth in cases colliding with finite health resources.
Authorities should not focus on preventing the inevitable fall in gross domestic product; this is the time for them to consider community welfare – public health, the safety of the vulnerable, the provision of essentials.
We must prioritise keeping the blacksmith alive and well.
James Culham is Director, Institutional Portfolio Management at ANZ