There is no doubt that the coronavirus is driving a macroeconomic meltdown around the world. In the U.S. and elsewhere, heavy job losses will likely drive unemployment figures to levels not seen since the Great Depression. Fiscal efforts to contain the crisis are pushing deficits to levels last seen during World War II. Both developments have spurred fears and commentary that the crisis is spiraling into either a depression or a debt crisis.
But is it too soon for such pessimism? The intensity of this shock isn’t in question — the depth and speed of the fall in output is unparalleled and frightening. And coronavirus will also leave a structural macroeconomic legacy if economies don’t return fully to their old-growth trajectory or rates. But it’s a long way from a macroeconomic shock — even a severe one — to a structural regime break, such as a depression or a debt crisis.
Price stability is the parameter to watch — it’s the key to a favorable macroeconomic regime. A break such as a depression or a debt crisis is marked by a shift to extreme deflation or inflation, respectively, and thus a breakdown of the normal functioning of the economy. Over the last 30 years, the U.S. economy has enjoyed falling, low, and stable inflation, which in turn, has driven low-interest rates, longer business cycles, and high asset valuations. But if price stability falters, there would be massive consequences for the real and financial economies.
So, knowing that, how worried should we be?
The Four Paths to a Structural Regime Break
Policy and politics are what stand between a severe crisis and a structural regime break. Persistently inadequate policy responses — rooted either in an inability or a political unwillingness — are what fail to stop the negative trajectory of a crisis-ridden economy. We’ve mapped four paths that lead to a structural regime break, using historical examples to illustrate each.
1. Policy Error
The first path to a depression occurs when politicians and policymakers conceptually struggle to diagnose and remedy the problem. The Great Depression is a classic example — it was an epic policy failure, which facilitated not only the depth of the crisis but also its length and legacy. Two conceptual misunderstandings were involved:
Monetary policy error and banking crisis: Limited oversight of the banking system, tight monetary policy, and bank runs resulted in thousands of bank failures and enormous losses to depositors between 1929 and 1933. The collapsing banking system crippled the flow of credit to firms and households. Even though the Federal Reserve was created in 1913, ostensibly to fight such crises, it stood by as the banking system collapsed, believing that monetary policy was on easy footing. In reality, it was stuck in a conceptual error.
Fiscal policy error and austerity: Politicians also stood by and watched the economy bleed out for much too long. The New Deal came too late to prevent the depression, and it was too little to reverse its impact. And when fiscal policy tightened again in 1937-38, the economy collapsed again. Eventually, World War II decisively ended the Great Depression by massively boosting aggregate demand, and even returning economic output to its pre-depression trend.
The result of these policy mistakes was severe deflation (collapse in the price level) by well over 20%. This meant that while unemployment was at very high levels, the nominal value of many assets fell sharply, while the real burden of most debts rose sharply — leaving households and firms struggling to regain their footing.
2. Political Willingness
The second path from a deep crisis to a depression happens when the economic diagnosis is clear, and the remedies are known, but politicians stand in the path of solution. It’s a problem of willingness, more than understanding and mindsets.
To illustrate this risk, we don’t have to look far: A lack of political will drove the U.S. economy dangerously close to a deflationary depression in 2008, when the U.S. Congress could not agree on a path forward in the global financial crisis.
By late 2008, bank capital losses were piling up, leading to a credit crunch that was crippling the economy. With a rickety banking system, the risk of a path to a deflationary depression was real — as underlined by collapsing inflation expectations in the depth of the crisis.
The most dangerous moment came on Sept. 29, 2008, when the House of Representatives voted down TARP, the $700 billion rescue package to recapitalize (or bailout) banks. The ensuing market collapse helped change the political price of standing in TARP’s way, and a few days later, on Oct. 3, the bill was passed.
Effectively, political willingness came together in the last minute to prevent a structural regime break and contained the structural legacy to a U-shaped shock. While the U.S. economy regained its growth rate after a few years, it never found its way back to the pre-crisis growth path, which is the definition of a U-shaped shock.
3. Policy Dependence
A third potential path from severe crisis to depression is when policymakers do not have the operational autonomy, authority, or fiscal resources to act. This happens in countries or territories that lack monetary sovereignty, or central bank autonomy — in other words, in times of crisis they can’t use the central bank to ensure a healthy flow of credit even if their currency is stable. Internal depression — price and wage deflation — is the only way for such economies to rebalance and satisfy the constraints of monetary dependence. Perhaps the best example of such dependence is Greece’s relationship with the European Central Bank in the context of the global financial crisis. Unable to use the ECB for access to financing, Greece had to enter a depression that came with severe deflationary pressures.
4. Policy Rejection
The fourth path differs from the previous three in that it leads to a debt crisis, rather than a depression. In this case, policymakers know what to do, have the political will, yet they can’t raise the real resources to do anything, as the markets reject their actions. This is distinct from the other three paths in that instead of deflation, it leads to high inflation.
Think Argentina at various points in time, the Asian financial crisis of 1997, the Latin American debt crisis of the 1980s, and, further back, Weimar Germany: In all of these instances, policy makers were unable to raise the real resources to finance their spending because debt and currency markets reject it.
When looking at debt crisis risks, commentators too often are preoccupied with debt levels, but this is a misunderstanding of debt crises. They happen — and do not happen — at all levels of debt-to-GDP. Other factors, including anchored inflation expectations, negative risk-rate correlations (when risk goes up, rates go down), global demand for the currency in question, as well as the difference between nominal interest and growth rates all influence an economy’s ability to finance itself more than the debt-to-GDP ratio.
Why the U.S. Is Unlikely to be Headed Towards a Structural Regime Break
Though the path from the crisis we’re in now to either depression or debt crisis is not impossible, it’s not easy or natural, if we examine each of the four paths in regards to the current situation:
Policy Error — The policy challenge of coronavirus is enormous, but what is on display is the opposite of the inaction of the Great Depression. On the monetary side, the first signs of stress in the banking system — in the repo and commercial paper markets — were met with timely and sizable monetary policy action. On the fiscal side, it didn’t take long — certainly by Washington standards — to pass the $2 trillion CARES Act to provide funds to counteract the wave of liquidity and capital problems for the real economy (households and firms). Beyond any specific policy action, we are seeing a mindset in which policy makers will keep throwing policy innovations at the problem until something sticks — quite the opposite of the 1930s.
Political Willingness — It certainly is possible that political calculus gets in the way of averting a structural breakdown, but not very plausible because the political costs are high. To be sure there are two risks involved: 1) The unwillingness to craft a piece of legislation, perhaps because of differences in analysis, beliefs, or dogma; and 2) the failure to pass legislation because one side sees greater political gain in obstruction. While the TARP fiasco reminds us that both risks are real and shouldn’t be dismissed, crises tend to lubricate deal-making, and the costs of political obstruction are particularly high, even in a hyper-partisan election year.
Policy Dependence — This path is not applicable in the U.S. because of monetary sovereignty. The Federal Reserve will always facilitate fiscal policy in a time of low and stable inflation and a healthy currency.
Policy Rejection — A debt crisis seems improbable for the U.S.: Inflation expectations are very well anchored (and, if anything, too low). The rate-risk correlation is very solid, wherein risk-off periods (the moment when investors are less tolerant of risk and prices of risk assets like stocks fall) bond prices rally (yields fall). The USD reserve currency status is deeply entrenched as the rest of the world needs to hold U.S. safe assets (and don’t wish to see their currencies appreciate). And nominal interest rates are generally lower than nominal growth (r – g < 0). All of these factors make for favorable financing conditions. Can coronavirus damage all that and deliver a crisis where markets refuse to purchase U.S. debt? It’s possible but very implausible, and it would be a long and painful process. A break in the inflation regime plays out over several years.
Why, then, are we seeing fears of a break take hold?
We think at least part of the answer is the extreme intensity of the coronavirus shock. The depth and speed of output contraction threatens to influence perceptions and risk assessment in other dimensions of this shock, such as the structural legacy (the shape of the recovery) and the risks of structural regime break. While these fears are understandable, the analytical errors resulting from them could have significant consequences in terms of setting false expectations and encouraging inappropriate plans. A few principles of intellectual discipline may help leaders avoid these analytical traps:
Beware implicit and explicit equivalences to historical events. If describing the future, be aware of historical benchmarks. Meanwhile, if using historical benchmarks, be aware of their drivers and relevance to the present day.
Be wary of single data points and the inferences that can be drawn from them. Is there a passing resemblance or causal equivalence? Record outcomes in any data set always make great headlines, particularly in financial and economic reports, but the overall context determines their true significance.
Step back when fear is dominating the thought process and when extrapolating from high-intensity events. Even the worst ever in one dimension doesn’t mean the worst along all dimensions.
Be cognizant of what your scenarios imply: A depression-driven regime break also means large-scale deflation. A debt crisis regime break also means a weak currency and high inflation. Are these corollary conditions consistent and do they fit the facts?
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