Monday, March 16, 2020

Thoughts on the Fed's Coronavirus QE and the Economy in General

Click here to read the original Cautious Optimism Facebook post with comments

4 MIN READ – The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff concedes to being better at writing about the past than predicting the future. So don’t bet your pension on it, but here are some thoughts on the recent Fed rate cut, $500 billion QE announcement, and state of the economy in general.

1) This will arguably be the first recession precipitated by something other than Federal Reserve monetary policy going back to World War II.

In fact if the U.S. economy slips into recession (and the Economics Correspondent believes it’s more likely than not that it will), it will signify the first purely exogenous shock recession in memory.

An exogenous shock is a disruption that arises from outside the economy such as the coronavirus/Wuhan virus—or a natural disaster or war. This is the opposite of the more common endogenous shock which is a disruption that originates from within the economy itself—such as too many bad mortgages in the 2000’s, overinvestment in dot-com companies in the late 1990’s, bad commercial real estate investments in the late 1980’s, or runway central bank inflation in the 1970’s.

It can be argued the last exogenous shock recession was 1973-74 when OPEC imposed an oil embargo against the United States. However the economy was already experiencing stresses from Fed inflation/stagflation, departure from the gold standard, and Nixon-era price controls so the slump was not caused entirely by exogenous factors.

But in 2020 the U.S. economy was functioning smoothly and then unexpectedly threatened with a contraction due completely to external—in fact foreign—factors.

As an exogenous shock in 2020, many of the old standard rules and prescriptions that have been applied in the past may be far less effective.

2) Previous recessions involved large bad investments going sour that the Fed and fiscal policy attempted to save or prop up with cheap money and government stimulus. Not to say there are absolutely no bad investments in 2020, but this time the Fed is not responding to a collapse in a major sector like the housing market, even though it might just create some new bad investments along the way now that rates are going to zero again.

Instead the demand curve for many consumer items and even some business investments has rapidly gone inelastic. That is, no matter how much money you put in people's pockets they still won’t pay to get on a plane, or a cruise ship, buy movie tickets, attend sporting events, or go to restaurants.

Furthermore government-mandated closures to limit the virus’s spread will further force the demand curve to go vertical such as closing schools, churches, bars, night clubs, retail stores, or imposing domestic travel restrictions. Thus the Fed’s traditional monetary response will have less impact than in the past.

(see diagram... price moves up or down on the Y-axis, but the quantity demanded on the X-axis remains unchanged, ie. a perfectly inelastic demand curve)

Homeowners can refinance and put more money in their pockets, but they may not show any greater propensity to spend that money. Businesses may be able to finance future projects more cheaply, but may not be willing to commit to large investment projects. Both parties may want to see more progress in the fight against the virus that has so acutely altered their spending behavior.

3) In the early analysis the fallout from the outbreak was being called a supply shock by most economists since it disrupted supply chains stemming from China and was predicted to have an impact on the ability of firms to produce at normal capacity when employees can’t come into work or travel.

However the Economics Correspondent sees potential for an equally large demand shock as both consumers and companies are pulling back on spending for items that could put themselves or their workers at risk of infection.

In the months to come talk of supply may give way to far more discussion about demand.

4) The Fed’s aggressive move to zero interest rates and a $500 billion QE should put to rest the theory that central bank governors are plotting to bring the economy down just to rid themselves of Donald Trump in 2020.

With the economy in such a vulnerable state, and in an election year no less, if the Fed truly wanted to cripple Trump’s chances of re-election it would raise rates or at the very least sit on its hands, not cut rates to zero—during an emergency meeting, on a Sunday.

5) We can likely expect the current $800 billion and $900 billion federal budget deficits to balloon to well over $1 trillion when tax revenues fall while simultaneously the government spends more on unemployment, “support” for hard hit industries, and possibly old fashioned bailouts.

This is the problem with running large deficits during economic good times: the good times inevitably end.

However deficits as a percentage of GDP matter more than in nominal dollars. For deficits to run as high as during the first term of the Obama administration (9.8%, 8.6%, 8.3%, and 6.6% of GDP for the fiscal years 2009-2012) they would have to reach $2.3 trillion, $2.0 trillion, $1.9 trillion, and $1.5 trillion today—assuming a $23 trillion GDP.

But don’t expect the media to report the deficit in those terms.

Fortunately or sadly, depending on you point of view, the Economics Correspondent believes the U.S. government has far more room to borrow than most people suspect. Running one trillion dollar deficits and saddling future generations with $23 , $24, and $25 trillion in debt may be morally unconscionable, but Japan has amassed a debt-to-GDP ratio of over 250% for nearly a decade while the U.S. stands at 107%.

6) On this last point the Economics Correspondent is really going out on a limb with a theoretical prediction:

Given that a potential coronavirus/Wuhan virus recession will not be the result of a huge collapse in bad investments or major imbalances in certain sectors, when the outbreak is finally resolved via a vaccine, or benign mutation, or aggressive mitigation controls, or favorable warm weather odds are the recovery will be more rapid and V-shaped than past recoveries. Because there are fewer overhangs from bad loans or overbuilt industries going through the painful process of readjustment and resource reallocation to match traditional consumer preferences.

In the case of the virus, consumer preferences are changing very quickly based on safety concerns, and when the virus is no longer a major threat they will return to something pretty close to where they were prior to the outbreak. This is not a case of building lots of mansions that people either didn’t want, didn’t need, or couldn’t afford that need to be liquidated. It’s consumers hunkering down who will re-emerge when the crisis ends and probably go on a relief spending binge.

However the Economics Correspondent will hedge with an “on the other hand” scenario that Harry Truman so famously despised (an irritated Truman exclaimed “I want an economist with one arm!”). If the slump is bad enough to drag the financial system into crisis again, the recovery could be stretched out.

Or worse yet, if government decides to “medicate” the recovery with a slew of new regulations and taxes a la Herbert Hoover and Franklin Roosevelt, full recovery could be postponed for years.

That said, Donald Trump doesn’t seem like the sort of President who would jump in and start overregulating the economy to death like the 1930’s New Deal, setting price controls throughout the economy, and jacking tax rates up to 79% in 1936.

And thank goodness Joe Biden looks poised to win the Democratic presidential nomination, because at most he might be "bold" enough to launch a miniature version of Obama’s recovery package which might retard recovery for a few years.

But if Bernie Sanders were to become President and get his way, his prescription for recovery would include the Green New Deal, a government takeover of medicine, and sharply higher taxes on everyone. Franklin Roosevelt’s New Deal is the closest historical analogue and the Great Depression lingered on for another thirteen years.

Fortunately in the middle of a global medical crisis, voters are less likely to want socialist revolution than the Democratic establishment candidate.

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