Two Crises for the Price of One

The world is facing two economic crises at the same time.

1. Financial Crisis
The first crisis is a financial one that has been going on for a long time. It probably began with the Tech Wreck back at the beginning of the new century when the Dotcom bubble popped and the Federal Reserve reduced interest rates and poured out credit to pump markets up again.

This easy money eventually created a housing bubble. This collapsed in 2008 when markets woke up and realised that many of the loans made to people to buy houses at inflated prices would never be repaid. Because the finance sector had sliced and diced house mortgages into various mortgage-backed securities and related financial derivatives and sold them on to other players in the finance sector, the entire edifice was in danger of collapsing.

Central banks and governments came to the rescue again by reducing interest rates and spending money hand over fist to rescue most of the big players in the finance sector. A few of the worst failed, like Lehman Brother, but the rest were propped up with easy credit and other government bailouts and never really took the lessons on board. Fortunately, apart from the many households left with mortgages greater than the value of their house, most of the real economy was not too badly affected. But the recovery was slow, and the world economy took many years to get back to where it had been.

Unfortunately, the easy money fed into a new bubble, this time in the share market and related activities. Big business borrowed money to pay for share-buy backs, which pumped up their share price. This left the top executives and shareholders better off, but their companies were vulnerable because they had few financial reserves to cover any downturn in activity.

Share markets reached record prices, but the bubble was popped by the emergence of Covid19. This collapse of value affects the entire financial sector, as when the collateral offered as security for loans declines in value, the borrower must stump up more collateral or pay back some of their loans. Big businesses that rely on short-term loans to fund their business have struggled to roll over their debt as the market for corporate bonds dried up.

Over the last few decades, the finance sector has grown massively, far outpacing the rest of the world economy. Banks and other businesses in the finance sector have worked together to create a huge infrastructure of debt that sits on the top of the real economy. This monster adds very little of real value for ordinary people and businesses, but it has made those who work within in the finance system fantastically rich.

Of course, central banks and governments are using every weapon that they have to fight this financial crisis and keep the unruly monster of the finance system from collapsing. Governments are making grants to businesses. Central banks have reduced interest rates to zero and made credit available to the usual culprits. They are buying up a wide variety of government and business securities in order to prop up the price of collateral.

I presume that these desperate policies will succeed in papering over the cracks in the finance system, but this will not resolve the underlying problems that make the modern financial system unstable in the first place. The worst consequence will be an enormous increase in government and business debt that will be a deadweight on the real economy as it tries to deal with the second economic crisis that we are facing at this time.

2. Covid19 Economy
The second economic crisis that the world has to deal with is the collapse of economic activity as a result of measures put in place to prevent the spread of Covid19. This is both a supply shock and a demand shock.

As a result of the collapse of tourism, travel and the hospitality industries, many people will be out of work. With their incomes dramatically reduced, they will stop spending in the way that they did in the past. People who still have jobs will be unsettled by the situation and cut back their spending as a precaution against uncertainty. All types of businesses will be careful about their spending until the long-term consequences of the shutdowns become clear. People who are heading towards retirement will have seen their superannuation funds shrink, so they will need to save more seriously.

This collapse in demand for goods and services will make it difficult for all businesses to recover. As they attempt to get going again, they might find they cannot return quickly to previous levels of activity and may need to cut back on the numbers of staff that they employ, which makes the situation worse.

Attempts to confine Covid19 are also a supply shock to the real economy. Many non-essential businesses have to shut down their production. That lost production might not be recovered. If the lost is production is an input into the production of another business, that business will be constrained until its suppliers can get going again.

In the modern world, many businesses have developed very long supply chains. The longer the supply chain, the more likely it is that there will be a break in the chain where businesses have stopped production, meaning that the required inputs are not available. I suspect that during the next year, many businesses will find that things they need to operate efficiently are not available due to shutdowns in other businesses and other nations.

The state of the Chinese economy is uncertain. We do not know if it really has defeated the virus, or how quickly production will return to previous levels. Companies that rely on parts and equipment that are supplied from China might find that it will take longer to get their production back to normal levels.

Unfortunately, the supply shock and the demand shock work against each other. Businesses that still have good supplies and can keep production going might find there is no demand for their production. Others that face strong demand might find that they do not have the supplies that they need to increase production to meet demand.

Unmeasurable
Economics is an imprecise discipline. It can describe the links that influence the working of the world economy, but it is hopeless at estimating the size of the effects it identifies. I have seen enough of economists’ forecasts to know that they need to be taken with a grain of salt. Therefore, it is uncertain how serious this crisis will become. The economy might recover quickly, or the collapse of activity might drag on a long time.

One thing is clear; the problem is made worse by the reality that we are facing two crises at the same time. Central banks will prop up the finance sector so it can create another bubble in a few years’ time, but the increased debt will be a drag on the real economy where the people who manage real businesses that produce things that people actually need are struggling to keep them going.

The situation distressing, but we should remember that economic uncertainty is normal for most people in the third world, and has been normal for most people throughout history. Maybe we are just returning to the old normal.