Covid Shutdown

In his book called Shutdown, Adam Tooze describes the economic impact of the worldwide shutdown following the emergence of Covid19 in 2020. With all the debate about the virus and vaccines, the economic response by governments and central banks has largely been forgotten or ignored, but the issue is very important.

An initial supply shock occurred as workplaces shut down and trade ground to a halt, but this quickly translated into a demand-driven recession as people lost some of their income. The IMF predicted that world trade could collapse by 10-30 percent.

On 12 March 2020, stock markets collapsed all around the world. The drop in prices was worse than in the Global Financial Crisis (GFC) in 2008. As March progressed, the demand for US Treasuries collapsed. This was hugely concerning because US Treasuries are considered to be one of the safest assets that can be held. They can usually be traded in large volumes without influencing the price (a valuable property for a safe asset).

In 2020, 17 trillion US Treasuries were in circulation. They are usually bought during a crisis for safety, but during this one, they were sold. Economists were concerned that the collapse of this market could bring down the entire financial system.

Following the GFC, the Federal Reserve and the US Treasure had engaged in a massive monetary expansion to sustain markets during the crisis that began with mortgage-backed securities and related financial derivatives. This was supposed to be rolled back when the economy returned to normal, but by 2019 very little progress had been made on tapering the monetary interventions of the previous decade. Every time the Fed attempted to taper, the markets coughed, and the Fed relented. The result was nearly a decade of near-zero interest rates.

The Federal Reserve responded to the economic shock caused by Covid19 with an even greater monetary expansion than in the previous crisis. By 23 March 2020, the Standard & Poors share price index was down 30 percent. Worldwide, $26 trillion had been lost on the equity markets. After reducing interest rates, the Federal Reserve began a program to buy US Treasuries and mortgage-backed securities. Within a few months, the Federal Reserve had brought 1 trillion worth of US Treasuries, which is about 5 percent of the total on issue. The Bank of England also purchased a huge number of Gilts, the UK equivalent government bonds.

At the same time, the Treasury provided fiscal support with various spending programs to support people and businesses through the downturn. My mid-August 2020, the situation had turned around. The Standard and Poors index had recovered all the value that it has lost since February. Once the markets were stabilised, massive corporate bond issuance occurred as large corporates took advantage of the Fed policies.

Treasury and the Federal Reserve support provided massive benefits for the investor class. Tooze estimates that worldwide, the wealth of billionaires increased by $1.9 trillion during 2020. Something seems to be wrong with this outcome. There is no reason why wealthy investors in the financial sector should be exempt from economic pain during a serious pandemic. In both this crisis, and during the GFC of 2008 and 2009, government agencies intervened to support the finance sector because it is supposedly too big to fail. Yet it is government protection and support that has allowed them to become as big as they have become.

Governments all around the world kicked in with fiscal support for their struggling economies to the value of 21 trillion by Jan 2021. Most of this additional spending was funded with debt. The OECD estimated that by the end of 2020 total debt issuance of governments was $18 trillion. This is far in excess of what was issued during the global financial crisis of 2008/9.

When purchasing government bonds, central banks claimed that they were just stabilising the financial system and massaging interest rates to keep them down during a period of uncertainty. Yet, in effect, the central banks were funding government debt, something they claim that they don’t like doing. When the Federal Reserve turns on the monetary spigot, the flow of new money floods around the world and all countries are affected to some degree. The problem with government-created money is that it usually produces inflation. Inflation does not affect an economy evenly. The inflation created by central banks efforts to mitigate the Covid 19 crises initially flowed into share markets. This was seen as a good outcome because it benefited the big investment funds (and the billionaires).

Here in New Zealand, the money creation fed a housing boom. The middle classes welcomed this outcome because they have benefited from a big increase in value for the largest asset they own. However, their gain is at the expense of the poor who cannot afford to own houses. The money gush has vastly increased inequality.

Now the inflation that was caused by the unprecedented money expansion is spreading into the rest of the economy. The prices of consumer goods are now rising fast all over the world. Consumer inflation causes the greatest pain for poor people, so inequality will be further exacerbated.

As the pain of this consumer inflation worsens, central bankers will try to hold it back by pushing up interest rates, but they struggle to turn off their massive monetary support because every time they do, share markets and house prices will fall and they will lose their nerve. Politicians will urge them to keep interest rates low and keep the asset boom going, so they are not punished in the next election.

In Bank Deposits and Loans, I explain the big problem with modern banking that the Federal Reserve is trying to resolve, but actually makes worse.