Broker Check

Crisis Economics

May 01, 2020

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps,  the end of the beginning.”  

Winston Churchill: November 10, 1942  

We present this Churchill quote for two reasons. First, we understand that PIM clients are avid readers so we  thought you might enjoy a book recommendation. Erik Larson, formerly of Seattle and a prolific writer with  whom many of you are familiar, has a new book out: The Splendid and the Vile: A Saga of Churchill, Family and  Defiance During the Blitz. If you know and appreciate Larson’s work, and if this topic is of interest, give it a  look.  

Second, we think it important to put the COVID-19 public health crisis and resulting economic situation into  chronological context. The first battle against COVID-19 may be won, but the not the war. Opening the  economy without a significant spike in new cases will require social distancing and other preventive measures  until there is a vaccine. According to the Financial Times, there are 87 candidates in some form of clinical  testing now. While perhaps optimistic, a vaccine may materialize by the end of the year. Such a timeline, from  early development to final approval, would be unprecedented. As mentioned somewhat cynically in last  week’s letter, there will be significant economic benefits to the company that is first to market with a vaccine.  Financial enrichment is a strong motivator. Indeed, it is the primary tenet of a market economy.  

The economic impact will stretch far beyond a year or two. What follows is a deeper dive into crisis economics  than we have offered before. We were prompted by questions about the economy from PIM clients. Indeed,  the topics presented in our communications are often answers to questions asked by one or a small number of  

you, and that we assume may be on the minds of many more. We hope that what follows is understandable  and interesting.  

Crisis Economics:

A crisis reveals fragility. The common theme in each economic downturn of the past forty years is excessive  financial leverage, and this one is no different. From the Savings and Loan crisis of the ‘80s to the tech bubble  of the ‘90s and the financial crisis of the ‘00s, the core of the problem was too much debt. The COVID-19 crisis  was not triggered by bad debt, but excessive financial leverage in corporate America today negates any ability  for many companies to remain solvent without government intervention. That support has been immense.  The Federal Reserve has added two trillion dollars to its balance sheet since the end of February and will likely  add another three trillion by year-end. This is effectively moving private debt to the public balance sheet. The  Federal Government has provided $2.9 trillion in stimulus spending over the same period.  

It is deeply ironic that the answer to too much debt in the economy has been to add even more debt. In this  bailout process, the debtholder shifts from private sector participants to the government. In the financial  crisis, the bad actors were over-leveraged individuals and the banks that enabled, even encouraged their  behavior. Today, it is largely non-financial corporations and hedge funds. These institutions took advantage of  a decade of low interest rates to borrow capital to raise share prices through financial engineering, which is no  replacement for real profit growth. Even after adjusting for increased output, corporate debt increased by 13%  over the past decade to 15 trillion dollars, making it the largest source of private debt in the country. In both  the financial crisis and the current COVID-19 crisis the Federal Reserve was forced, by moral hazard, to bail out  the guilty parties from the consequences of their actions.  

We are not arguing that policy makers should have played the role of Nero during the COVID-19 crisis, playing  the violin as the global economy burned. What they have done has been an appropriate response given the  speed and impact of the epidemic. Both deserving and undeserving firms are receiving government support.  Yet, to more fully understand the long-term consequences, it is important to recognize the cyclical pattern that  has emerged.  


Capitalist economies used to be characterized by what famous Austrian Economist Joseph Schumpeter called  “creative destruction.” This is a euphemism for the ruthless economic efficiency that existed before modern  central banking. When a firm became obsolete due to stronger competition, or a crisis for which they were ill  

prepared, they were liquidated, and their resources were reallocated for more productive uses. The “invisible  hand of the market” worked without being encumbered by artificial influence such as government  intervention.  

This laissez-faire approach is painful but does feature the accurate pricing of investment risk, something made  more ambiguous by the current approach. If the Federal Reserve will bail out financial risk-takers, there are no  consequences for making bad investment decisions. Responsible investors may not realize the fruits of their  wise decisions because assets are not priced to reflect their true value. Poorly managed firms can stay in  business due to the mispricing of risk and the low interest rates that allow them to remain just profitable  enough to keep the doors open. These poorly performing firms tie up capital resources that could be more  productively used elsewhere, resulting in higher growth rates of the overall economy. The Bank of  International Settlements estimates that 12% of firms globally earn just enough money to pay the interest on  their outstanding debt, with no remaining income to pay the principal. These “zombie” firms cannot exist in a  normal interest-rate environment.  

Rising Debt: 

Our current system has produced an ever-increasing level of debt at the Federal Reserve and the US Treasury,  along with a less dynamic and slower growing economy. U.S. federal debt has recently reached $24 trillion,  but as the holder of the reserve currency of the world, the U.S. Government has incredible borrowing power.  Let us pause briefly to explain. To raise money, the United States sells Treasury Securities (Bills, Notes, Bonds),  generally considered the only true risk-free asset (free of default risk, certainly not free of interest rate risk).  On Monday of this week, the government sold $190 billion (yes, billion), in Treasury Bills and Notes. Demand  was strong, despite historically low interest rates.  

The amount of outstanding U.S. Government debt is high, but relative to the size of the U.S. economy it is  manageable at this point. Japan is the poster child for long-term deficit spending, with a debt to GDP ratio of  237%. U.S. debt to GDP is 137%, according to the most current information from the Organization for  Economic Cooperation and Development (OECD). Despite our flaws, the U.S. is still an open, transparent  democracy, and is the economic and financial engine of the world. Global investors view U.S. dollars as the 

safest store of value available for their savings, creating continued strong demand for U.S. Government debt.  For as long as this remains the case, there is virtually no limit to how much the U.S. can borrow.  

The Consequences:

Just because the U.S. can continue to borrow does not mean that it should. The years following the 2008-2009  financial crisis marked the slowest post-recession recovery ever. Although the unemployment rate hit a post war trough, the quality of the jobs created by the economy were mainly low-skill and low-pay, not the sign of a  balanced and healthy economy. With each successive recession, the recovery becomes weaker as we see the  diminishing returns of deficit spending.  

The solution to this cycle is painful. In terms of the federal debt, there is only one option; pay it off. The  problem here is obvious. If more tax dollars are being used to pay down the debt, there are fewer dollars for  everything else. This would lead to an increase in tax rates or a reduction in government spending. Would any  configuration of the U.S. Congress support this approach? Has any politician in recent memory, from either  party, suggested anything other than increased spending?  

There is a “stealth tax” that some economists believe will materialize at some point: inflation. Inflation is too  many dollars chasing too few goods. The US Government and Federal Reserve have made sure that there are  plenty of dollars in the economy through stimulus spending and asset purchases. So far, those dollars are  sitting in bank savings accounts, not chasing goods and services.  

U.S. Treasuries are mostly fixed rate (not variable rate) securities. If the Federal Reserve allows inflation to  increase, it becomes easier for the government to find the dollars to pay debt. Again, a brief pause to explain  why. Inflation is an increase in prices. Increasing prices are eventually followed by increased wages. With  increased wages, the government collects more tax from employers and employees that it can use to pay  down debt. With inflation, the government wins, and holders of U.S. Treasury securities lose, as the buying  power of the interest payment on those securities is eroded. Finding the inflection point where inflation is  supportive without being oppressive is difficult to do. The Federal Reserve has been trying for a decade to get  the inflation rate over 2%, without much success. Market-based indicators of inflation expectations are  currently at all-time lows.  

The more formal way of measuring how quickly capital flows through the economic system is called “money  velocity.” When economic activity is strong, money velocity is high as dollars move from employers to  employees and to providers of goods and services. At present, there is not much velocity at all. Banks have  record levels of cash in deposit accounts. Until the COVID-19 situation is resolved, confidence is restored, and  consumers and business have time to repair their balance sheets, money velocity will remain low, as will  inflation.  

The Federal Reserve will likely keep interest rates low for a very long time to stimulate the growth of the  economy. Federal Reserve Chairman Powell said as much on Wednesday of this week. Low interest rates for  long periods, in theory, lead to inflation. But the Fed’s low rates have not produced sustained inflation above  their target in more than a decade. The most likely outcome over the next few years will be more of what we  experienced after the ’08-09 financial crisis. That era was characterized by a fair bit of market volatility,  growing federal deficits, modest real economic growth and strong investment asset prices.  

After another sluggish recovery, somewhere down the road, this will happen again. When it does, those best  positioned to weather the storm, whether private persons, corporations, or governments, will be those with  reasonable, responsible levels of debt. Will any of these stakeholders heed the lessons of today and past  recessions? Surely some will. The more, the better. 

This conclusion may seem unsatisfying for many. It is a common for market observers to speculate that the  crisis will be a major turning point for the economy, either for the better or worse. If the policy response from  the Federal Reserve and US Government to this crisis, and those to follow, does not change, then we should  not expect the results to be much different.  

Closing Remarks: 

Our objective today is not to instill a sense of hopelessness. It is to discuss, to inform. These are big, complex  problems. Fair-minded, informed people can disagree about the extent to which government intervention into  the economy is appropriate. In a crisis, nearly everyone agrees that we must pull out all the stops. The  question is, will we do anything different afterwards. We will find out.  

If you have questions or comments about this, or anything else, please be in touch. From all of us at PIM, to all  of you, your families and friends, be well, stay safe and look forward.  

Personal Investment Management, Inc.

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