How economic policy can prevent a financial crisis

Amid the unprecedented circumstances of the COVID-19 crisis, there are grounds for optimism, argues Kallum Pickering

No one can say for sure what the ultimate scale and duration of the COVID-19 recession will be. Fundamentally, this is a medical emergency and containing the virus is priority number one.

However, doing so entails ever-more restrictive social-distancing policies across the world that are crippling global demand and supply. As the global economy contracts, the gears and plumbing of the financial system are straining worldwide.

That strain is giving rise to some uncomfortable questions:

• How many companies need a full year of revenues to break even or make a profit?
• What happens to those firms while economies are partially shut down until the virus is contained?
• How many firms can suffer a fall in revenues for six weeks while they still have significant costs to pay on leases, taxes, wages and, critically, credit?
• What if the shutdown lasts 12 weeks?
• How many firms will default, and what is the knock-on effect to the wider economy?

These are the imponderables that financial markets are trying to contend with as risk assets like equities are sold and investors rush towards safe-haven assets and cash.

Landmark response

Each day the financial press covers more and more stories showing pockets of corporate debt flashing red – especially high yield and US shale oil – along with surging costs to insure against defaults on such paper.

Across the world, central banks and governments are now working hard to prevent the coronavirus recession from developing into a financial crisis.

The policy response so far is unprecedented: huge central bank liquidity injections plus rate cuts and massive bond-buying schemes alongside government-backed loan-guarantee schemes for businesses and generous employment subsidies.

These targeted policies are designed to minimise layoffs and bankruptcies so that economies can get back to normal quickly once containment measures are lifted.

Although the hit to global economic activity in the coming months will likely exceed the initial damage from the great financial crisis, it will likely be much more short-lived. Of course, no one can say for sure what the future entails, but this does not look like the early days of a Great Financial Crisis 2.0.

The economic and financial problems facing us in 2008/09 were orders of magnitude greater than today. Years of excess in housing and consumer credit, fuelled by misguided regulation, poor market oversight and reductions to banks’ capital – altogether an accident waiting to happen.

The critical lesson from 2008/09 is that policymakers play a major role in deciding the size and scale of the downturn. And 2008/09 would have been a much smaller problem without the huge mistake to let Lehman go under without safeguarding its counterparties. Through trial and effort, and lots (lots) of money, the holes were plugged eventually.

Root cause

In the end, policymakers stopped the panic that they had partly triggered themselves with their decision to let Lehman fail, instead of winding it down in an orderly fashion, as they had done with Bear Stearns.

Today there are at least three reasons why ending the financial panic should be easier this time around:

1. We know the nature of the financial problem – a potential cash-flow crunch linked to the direct and indirect virus-related disruptions, which could lead to dislocations in credit markets.
2. We know that the root cause of the problem will not last forever – eventually we either build herd immunity to the virus, we contain it or we find a vaccine. Central banks and governments can prop up economies for months if they have to – they may indeed have to.
3. The global economy is fundamentally healthier than it was a decade ago. Fewer excesses and better balance sheets equal less underlying fragility. The problem areas should be easier to spot, while the strong parts of the economy should be better able to cope for a while without much help.

Policymakers cannot stop the pandemic with monetary, fiscal or regulatory tools. However, they can prevent the impact of the pandemic and its economic fallout from developing into a financial crisis on top of the underlying medical emergency.

Today, the message across the world is that fiscal and monetary policymakers will do whatever it takes, and for as long as it takes, until the storm passes. With luck, they will pull it off.

About the author

Kallum Pickering is senior economist at Berenberg Bank

This article was taken from the April/May 2020 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership