Coronavirus Economics: Dealing with the Conflict Between Anchored Expenses and Unanchored Income

  By Richard Kasmin, NJEDA Chief Economist

Modern economies are nothing short of miraculous. They’re also incredibly complex. Globally, billions of people trade their labor and output with one another, valued by the International Monetary Fund at upwards of $90 trillion in annual production (GDP). This output is supported by global debt valued in 2018 at $188 trillion. That’s more than $2 in public (government) and private debt for every $1 of output.

For advanced economies (e.g.: North America, Europe, China, Japan), public debt as a ratio to GDP rose from around 70% just ahead of the great financial crisis (2008-2009) to around 100% in 2018 (see chart below). Most of this approximately 30 percentage point increase happened in the immediate aftermath of the great financial crisis. Why did this happen? What was the purpose of these governments incurring all this debt? And what does that increase in public debt tell us about how to deal with the economic impact of the Coronavirus crisis?

Advanced Economy Public Debt % of GDP

Before addressing these questions, we must first get a grasp of the nature of the current economic problem. What’s going on right now? When diagnosing issues in the economy, I often find it helpful to imagine the economy as if it were a play with these four roles:

• Private businesses
• Households
• Financial markets
• Government

Understanding these roles and how they interact with one-another helps explain how any shock to the economy differentially impacts actors in the economy and how to address the impacts of the shock.

So, imagine the economy is humming along. People are going to work, companies are producing goods and services, taxes are being paid, financial markets are easily directing flows of capital, and so on. Then the Coronavirus hits and the economy is forced to freeze – something that has no parallel in post-WWII history. What happens?
 
Act 1 – An Economic Freeze      
                                                                 
When the freeze hits, the actors in our play do the following:

  ​1. Private businesses and households are forced to face the tension between anchored expenses and 
      unanchored income:

       a. Their debts and many of their expenses are fixed, while
       b. Their income isn’t.

  2. To preserve financial capital given the loss of income, private businesses shed expenses. Their main
      expense is labor, so businesses fire or “furlough” workers.

  3. Households are the suppliers of labor, and the decline in demand for their services leads to a drastic drop in
      household income, which in turn causes sharp declines in consumer demand.

  4. This decline in demand forces private businesses to shed more labor, which then leads to more household
       income loss. Thus, a vicious cycle between private business and households is in play.

  5. The government then faces a crisis as tax income drops while the need for government assistance rises.

Simultaneously, financial asset prices drop due to:

  1. Increased default risk – that tension between anchored expenses and unanchored income;

  2. Lower GDP, which leads to lower asset valuations;

  3. A scramble for cash due to liquidity constraints from the decline in income and asset valuations (financial
      firms and households sell assets, and it’s tough to find buyers for these financial assets);

  4. And there are capital calls – investors are forced to pledge more capital (cash) when the value of their   
      assets drop – which leads to needs for even more cash, which causes more sales of assets and further
      drops in valuation, and so on. This is another vicious cycle.

The drop in financial asset valuation obviously has a negative impact on private business and households. Feeling less wealthy and panicked about financial market stability, businesses and households further curtail consumption and investment, creating another reason for a downward vicious cycle.

Thus, Act One ends with an economy in freefall. There are downward spirals in business and household income. Financial asset prices are dropping as valuations erode and investors are forced to sell into an illiquid market in a scramble for cash. Confidence in the economy has been shattered. If left to its own devices, this downward economic spiral will continue until the economy hits some version of rock bottom. What to do?
 
Act 2 – Fill the Hole and Stabilize the Financial System

What’s been done is attack the economic freefall on two fronts: attempt to fill the income hole and attempt to stabilize financial markets. This is done so the economy can hopefully avoid what Federal Reserve Chairman Powell described as “unnecessary insolvencies,” or business failures caused by the virus to otherwise sound companies. Unnecessary insolvencies cause destruction of the economy’s productive capacity and dampening the prospects for economic recovery. The attacks are fueled by two sources — US Treasury debt and Federal Reserve funds (otherwise known as reserves).

To date, the United States government has pledged more than $3 trillion, generated by debt creation. The US economy generates around $20 trillion in GDP per year, and some estimates have US economic output declining around 10-15% before rebounding during the summer. Thus, one way to think of the $3 trillion created by the federal government is as filling the economic hole created by the virus.

The Federal Reserve can create funds, or reserves, virtually out of thin air. It has used this power to intervene in financial markets to lend funds and buy assets where the market is not functioning adequately.

What follows explains the dynamics involved.

  1. Because the federal government can:

     a. (theoretically) create an unlimited amount of debt to supplement lost income;
     b. essentially ‘team up’ with its central bank – the Federal Reserve — to create unlimited currency to
         purchase debt and provide a financial backstop;
     c. tax people and businesses to generate income and receive payment for those taxes in the currency the
         federal government creates;

  2. The US Treasury issues debt to:

     a. provide funds for businesses so they can retain employees, pay debts, and hopefully enable them to
         survive the crisis;
     b. provide funds to households via enhanced unemployment insurance and one-time checks so they can
         keep up with living expenses and debt payments;
     c. provide funds to the medical care industry;
     d. and provide funds to state and local governments so they can supplement revenue loss and keep up with
         the rise in expenses incurred by the economic downturn;

  3. And the Federal Reserve utilizes its ability to create money to:

     a. become “the lender of last resort,” lending dollars to households, businesses, state and local
         governments, and even other countries;
     b. buy (or simply rely on the threat to buy) US Treasury debt to keep long-end interest rates low;
     c. and lower the short-term Federal funds interest rates in the hopes of stimulating economic activity.

All this said, the federal government cannot do this all on its own. The private banking system and other financial firms are necessary partners in utilizing their capital, funds created by the Federal Reserve (otherwise known as reserves) and institutional knowledge to provide loans and liquidity.

Act 3 – To be continued…

As of now, we can’t write Act 3. However, there are some things we can be sure it will contain:

  1. Assuming the government’s funds get to where they’re needed and quickly, they will help stabilize the
      economy so private businesses and households can stabilize, survive the freeze, and bridge the gap
      between anchored costs and unanchored income.

  2. Still, we will likely need more funds to stabilize the economy as the coronavirus impact drags on.
 
Epilogue

There is the potential for financial and economic damage from all the debt that’s been created. It could be in the form of higher future inflation. It could mean the federal government has to significantly change tax and spending policy to lower future deficits and debt. It could lead to depressed financial asset prices, weaker business investment growth, and damped consumer spending plans.

In other words, there is likely to be some form of payback for creating all this money today. But that’s another day’s problem. For now, it’s all about getting through the current crisis so that, when the time comes to take the economy out of the freezer, it can thaw without suffering significant structural damage.

Another question not addressed here is, if it’s so easy to create money, why don’t we just do it to pay for everything we want, like medical care for all? That’s potentially a topic for another Economist’s Corner.