Moving Forward After Covid
MOVING FORWARD AFTER COVID
Looking back on the 2008-2009 Global Financial Crisis (GFC) and its aftermath may give us a clue as to how our current Covid crisis will play out. In hindsight, the GFC proved to be more of a bump in the road rather than a serious hit to our economy. The GFC caused the banking system to seize up momentarily due to fear of the impact of defaulting subprime loans, which were owned world-wide. The EU failed to respond adequately to this global crisis. As a result, Europe hadn’t fully recovered from the GFC before Covid hit. They now face dual problems to solve.
In contrast, the US responded aggressively. The Federal Reserve (Fed) took prompt actions to restore confidence in banks by easing monetary policy. They cut interest rates from 4.25% to .25%. The Fed implemented several lending programs to create “easy money” by ensuring that banks had adequate liquidity. It was not long before people realized that the crisis was over and the economy returned to normal.
In response to the GFC, there was copious talk about providing fiscal stimulus as well as easy money to aid the recovery. Fiscal stimulus can either be provided by tax cuts or spending programs, including infrastructure improvements. It turned out that “shovel ready” fiscal projects were few and far between. Even though there was general agreement that our roads and bridges needed lots of work, Congress couldn’t get its act together. Little was spent on the fiscal front to address the weak economy. So monetary policy had to go it alone.
Nearly two years later, the recovery was still patchy. The unemployment rate remained elevated at nearly 10%. In late 2010, the Fed moved into uncharted waters by implementing QE2. The term QE2 refers to this second round of the Fed's quantitative easing program that sought to stimulate the U.S. economy by buying assets instead of the more conventional policy of reducing interest rates. This unconventional approach was required because interest rates were already near zero due to the weak recovery from the 2009 bottom. Strangely, fiscal policy to directly address high unemployment never seemed to enter the conversation.
QE2 helped some, but the unemployment rate stalled at a still-too-high 8%. Congress continued to dither, so fiscal policy remained missing. The Fed doubled down on QE2 by implementing further monetary ease in the form of QE3, which involved the Fed ramping up its purchases of mortgage-backed bonds. Unsurprisingly, QE3 was also unsuccessful in stimulating growth. Surely now the government would revert to fiscal policy?
Yet fiscal policy remained on the sidelines for another five years until tax cuts were finally enacted in 2017. Tax cuts got the economy humming. Unemployment fell to a 70-year-low of 3.5%. The growth rate of average hourly earnings rose from 2.5% to 3.5%. However, an unanticipated side effect of the prior decade of monetary ease came into view: only the rich grew richer. New money sloshing around found a ready outlet in the markets. Stock and bond prices soared. The top 20% of families grew wealthier. All the rest grew poorer. Many suggest that this growing gap between rich and poor has been a factor in the social unrest we’ve recently experienced.
Unfortunately, Covid has shifted the economy into reverse gear. We fell off a cliff in the second quarter, with GDP falling at a nearly 32% annual rate. By comparison, at the peak of the GFC stress, the GDP fell at an 8% annual rate. Covid lockdowns have put us into a much deeper hole than did the GFC. The silver lining is that this time, in addition to monetary ease, the government acted quickly and strongly with ample fiscal policy in the form of direct payments to consumers and Paycheck Protection Program (PPP) loans. These provided effective short term solutions, but created an estimated deficit for the year of 18% of GDP -- about twice the level of the 2009 deficit.
Three problems need to be addressed:
The first is the mushrooming deficit and resulting debt stemming from the stimulus check program. Over the years many have suggested this type of fiscal policy is superior to expenditures planned by the government. This way people get to decide what to spend it on. Voting with their feet, households have chosen to focus on retail spending, debt paydown, and savings. The deficit/debt mess is made more tenable because government debt bears a near 0% interest rate. As long as rates remain low, government debt which comes due can be easily refinanced into replacement debt that isn’t immediately due. The challenge is to gently glide the deficit/debt downwards without too much economic disruption.
The second problem which needs to be dealt with is the excess liquidity resulting from monetary ease. This liquidity has distorted market prices that typically help distinguish between investments which are productive and those which are not. When interest
rates are so low that money is effectively free, unproductive “zombie” companies remain alive. A recent example was a bankrupt Hertz attempting to raise a billion dollars as its stock spiked from less than a dollar to more than $5. The obstacle to removing the excess liquidity is the Fed’s unwillingness to tolerate a likely decline in stock and bond prices. Over the last decade the Fed has avoided dealing with the pain. Whenever stock prices have weakened in response to Fed tightening, the Fed has quickly backed down and reversed course.
The final problem, and perhaps the most important of all, is to reduce the gap between rich and poor. Somehow we’ve managed to violate the “law of holes.” It suggests that if you find yourself in a hole, stop digging. Some have advocated that the best way to stop digging is to enact a Universal Basic Income. This would ensure a minimum standard of living for all. Others have suggested education and training programs that would increase the ability of the poor to get jobs and earn higher wages. The good news is that this most-difficult mess is theoretically the easiest to address.
Potential solutions are complicated by the fact that the three economic problems are interrelated. What we do to address one problem affects what we do to clean up another. For example, implementing a guaranteed income program will likely lead to greater deficits. The reverse is also true: reducing deficits will likely widen the gap between rich and poor.
As this will be my final comments prior to the Presidential election, I would like to offer one observation about the outcome. Although the election is being hotly contested, we have painted ourselves into a corner such that whoever wins will have little choice in how to address these problems. As much as we like to think that the difference between Trump and Biden is enormous, the reality is that whoever wins will have only limited economic policy options.
Fortunately, the US is not a fragile nation. We have deep roots. We know how to survive. We have overcome profound internal divisions before. We have succeeded in producing the world’s strongest economy. We will solve our Covid problems.
Sincerely,
Sam Stewart,
Partner
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