What We Really Need Is a Centralised Fiscal Response

One of the reasons the market is “cheering” any hint of a potential end to the lockdown is the hope of limiting the damage to the real economy caused by COVID-19. Developed world governments decided to go into lockdown knowing that it may cause the deepest recession we have seen since the 1930s. We are talking about millions of jobs being lost, kids and students not being able to go to school, etc. This is even worse for the developing world where the majority of jobs are manual labour. In economies like Bangladesh, India, Mexico and some African countries, working from home is not an option. You don’t work you don’t eat, it’s as simple as that. Leaders in the developing world have to weigh the cost of the lockdown vs the cost of letting people go about their daily activities and dealing with the consequences. There are no easy options.

Morgan Stanley, JP Morgan and Goldman Sachs are predicting that US Q1 GDP growth will be hit by between 5% and 10% with Q2 GDP falling at the annual rate of 25% to 30%. We have not seen anything like this since the 1930s. But this might already be priced into the market as everyone is talking about it. So, the real question is whether instead of a great recession, we end up with a depression? In other words, permanently higher unemployment.

During the 2008 crisis it took around two years for the MBS markets to seize and take its toll on the wider market and the economy. Things are happening a lot faster this time. It took two weeks for the 20% plus market correction in equities credit (both IG and HY). It took three to four weeks for layoffs and a huge contraction in GDP. This means some countries could start reporting double-digit unemployment in a matter of months not years.

“The good news this time around is that most developed world central banks have stepped in immediately to support the financial system.”

They threw the whole kitchen sink at this crisis making sure we don’t have any nasty liquidity surprises. The ECB will spend a total of 1.1 trillion euros on Eurozone bonds over the next nine months, the most it has ever spent on assets in such a short period of time.

Now it’s time for fiscal stimulus to start feeding through to support the economy. The trick here is to funnel the money to households and not only offer credit lines to corporates. We have to fix the demand issue when it comes to households and not only the insolvency risk of the corporate sector. So if fiscal stimulus is not reaching households fast enough and is not targeted enough we might get into a depressionary scenario very quickly. This is especially true for the so-called gig economy where people could get laid off quickly and without compensation.

The eurozone is estimated to have shrunk 10% and we believe the worse is still to come. Italian PMI for hotels, restaurants and other hospitality sectors shrank to 15 in March. These aren’t numbers from a recession. It’s an economic disaster, depression-like dynamics.  In times like these if we don’t get a powerful and coordinated fiscal response, individual countries would start looking to exit or at least challenge the status quo, looking towards protectionism.

One of Europe’s challenges is that it suffers from policy limitations. There is a common currency with a single central bank but no common fiscal authority. We are seeing some serious firepower from the UK, Spain and Italy but what we really need is a centralised fiscal response. The simplest and quickest way could be through a single EU debt instrument issue. So-called Coronabonds would be a form of debt mutualisation, which has been criticised by Germany during the last round of talks. The problem is that Germany still sees this solution as equal to accepting a lack of budgetary discipline for southern European countries. Germany appears to not realise that now is really not the time to have such complicated arguments. By holding out on a point of principle, Germany and the Netherlands are risking permanent impairment of some sectors of the European economy and its consumer demand.  They are probably worried that once the first Coronabond is issued the floodgates to risk-sharing debt instruments will open.

The SURE fund loan solution is a good start, in addition to the national level policies, although we do not know whether €100bn is anywhere near what’s needed.  If this solution is essentially a pan EU version of Kurzarbeit it might be sensible, as the people benefitting from this would claim unemployment anyway, and it at least gives companies breathing space regarding salaries, which for many businesses are a large portion of the fixed costs.

The EU tends to learn and evolve during times of crisis so let’s hope this time it’s the same. We hope European policymakers, just like central bankers, use what was learnt a decade ago and will be quick to respond.