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Anatomy of a post-Covid Economic Depression  

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miguel
(@miguel)
Eminent Member
Joined: 9 months ago
Posts: 31
25/04/2020 12:26 pm  

Anatomy of a Post-Covid Economic Depression 

(I saw this post by an anonymous author on one of my Viber groups. I wonder how accurate this assessment is of the aftermath of this Covid-19 pandemic.)

The following examines what could happen to the  US economy in 2021.  (As US economy goes, so do the economies of the rest of the world).

  1. There could be a  lingering fear of a relapse of Covid 19 (before a vaccine is found), and deep concern about the emergence of a new pandemic. Thus, households will spend less than they did pre-Covid on travel, dining out, etc. in order to avoid infection and to save up in case a new pandemic breaks out. Decline in consumption -> lower GDP. Demand is also affected by layoffs or even fear of layoffs in a fragile economy, contributing to lower consumption -> prices soften. 

When farmers can not bring produce to market, they practically give away their produce. When not as many cars and trucks are on the road as in the past, oil prices drop -> general decrease in price levels, which if prolonged, becomes deflationary. 

  1. In a deflationary environment, households that have discretionary income postpone their purchases of non-essential items because during a period of falling prices, the same item will still be available in the future, and cheaper. Falling prices results in less consumption causing further lowering of prices, and so on. Postponing purchases in anticipation of lower prices in the future, becomes a self-fulfilling prophesy, a feedback loop, a deflationary spiral. 

So, what’s wrong with lower prices? Aren’t they good for households? For the answer, see #4 below. 

  1. With falling prices, lower sales and higher inventories, manufacturers realize that running their factories at say 40% of rated capacity, is inefficient. To manage their now limited cash flows, they shut down their factories. Employees are laid off -> higher unemployment -> greater burden on government to ameliorate. 

Less people employed also means less consumption in the economy, depressing growth further. 

(In the Great Recession of 2008, US unemployment reached a high of 8.8 million during a 106 week period between 2008-2010.  In just the last 2 weeks of March 2020 alone, there were already 10 million unemployed in the US.)

  1. According to JPMorgan’s N. Roubini, around 15% of companies listed on the exchange are overleveraged (even before the Covid 19 crisis) and could run out of cash in a slight economic downturn. They are candidates for bankruptcy -> banks’ capital adequacy ratios are affected -> slow down in banks’ lending, limited to banks’ prime clients, killing SMEs -> dampening any stimulus to the economy. With other listed companies that are still open for business but now reporting lower earnings or even quarterly losses, market sentiment tanks and the stock market crashes (recall Black Monday October 1929) -> values of pension and investment funds steeply decline -> business confidence falls to an all time low. 

(Between Jan 1, 2020 and March 31, 2020, the Dow Jones index declined 25%, the largest quarterly drop since 1929.)

  1. Insecurity about health, job retention and retirement  -> social unrest (food riots, higher crime)

In summary, low consumer demand -> deflation + high unemployment  + corporate insolvency + credit market illiquidity -> low business confidence -> stock market crash -> pension and health insecurity -> social unrest ===> DEPRESSION, defined as extended quarters of negative GDP growth. But it could also refer to a collective mental state. 

  1. Can the US Federal Reserve Bank (Fed) help?

On Sunday, March 15, 2020, the Fed announced it would lower its benchmark interest rate to 0% in order to encourage business borrowing that could stimulate the economy. The reference rate had never reached 0% in the US before. Instead of welcoming this news, the market dropped 13%, the largest one day drop since Black Monday. 

A week later, on March 22, 2020, the Fed promised unlimited quantitative easing, if it ever becomes necessary to rescue the credit market from illiquidity. This compared to “only” $800B in 2008. The stock market continued  its decline, signaling lack of confidence that this measure was enough. 

These two audacious Fed moves are by far, the two biggest weapons in their arsenal. The recession has barely began and Fed has already blown its whole wad. 

This can only be explained by the economic theory of a “liquidity trap” whereby throwing more money (liquidity) at the problem (lack of growth), does not solve the problem. 

  1. Can Congress help with a stimulus package? 

Nobel laureate Paul Krugman calls the unprecedented $2.2 trillion package (10% of GDP) merely a disaster relief package that won’t provide much real stimulus to the real economy. 

  1. There are other demand destroying factors not mentioned above, that contribute to a depression. These include: Trump’s trade war with China (US farmers bankrupted, US consumers buying less goods due to tarrified prices), maxed out household debt  (from credit card debt to student loans) discouraging further consumption, and unprecedented level of US government debt,  limiting fiscal space for Congress to stimulate the economy.

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