The death of liquidity
What is the greatest economic danger from the new coronavirus? Liquidity.
As country after country goes into full lockdown, business transactions cease. Streets empty. Businesses stop. Social events cancel.
When this happens, business liquidity dries up overnight. In economic speak, the system faces both supply and demand shocks. No one buys; no one sells. The velocity of money falls to the floor. Revenue plunges to zero.
This crisis is different to that of the 2008 GFC. In 2008, the financial system was the first to freeze as banks scramble to deleverage their foolishly leveraged balance sheet. This then spilled over to the real economy. In just two lines:
2008 GFC CBs <-> Financial System/Banks (Liquidity crisis) <=> Real Economy
2020 Coronavirus CBs <-> Financial System/Banks <=> Real Economy (Liquidity crisis)
What are the ramifications?
Three aspects worth noting:
One. The epicentre of the economic crisis originates from the real economy due to the curtailment of the covid-19 pandemic. When transactions at the street level grind to a halt, it spills over to the corporate sector quickly – and then ripple across the financial system. Sectors that depend on the service industry goes into a tailspin as the movement of people is drastically restricted. For example, the transportation industry, entertainment, and tourism.
Two. Quantitative Easing (QE) will not be as effective as it was back in 2008. Currently, the economy is jammed by the virus, not confidence in banks, although some aspects of QE can alleviate burden on household and corporates.
Three. When corporate distress increases sharply, the only way to survive is to cut cost, deeply and swiftly. Everything is a cost in a zero-revenue world. Companies will defer capital expenditure and investments, stock buybacks and dividends, execute mass layoffs (or unpaid leave), and defer payments to suppliers via the activation of force majeure clauses. Firms that tipped over due to a lack of cash and revenue will probably declare bankrupt, one way or another.
Remedies
So what can the government and central banks do?
For central banks, the first thing is to lower interest rates to lessen the burden of debt. Second, ensure the monetary liquidity is ample throughout the crisis. QE may be revived – on a huge scale. Third, be prepared to re-capitalise TBTF banks. This is because banks will be hurt when many corporations fail to repay their debt simultaneously or when mortgagees are in distress. The balance sheets of weaker banks will fall through their minimum required capital ratios. The standard procedure of ring fencing banks and buying bad debt from financial institutions must be resurrected once again.
For government, ensuring adequate food and medical supplies and treating those infected from covid-19 is the first priority. Yes a significant number of people will be infected. Those who escaped from covid-19 still need to eat. Given that the 2008 monetary recipe will be largely ineffective, the government should step up this time.
- Ensure no mass layoffs during the crisis. How? By providing capital lifelines to companies in financial distress. Allowing companies to shed workers unrestricted will compound the crisis quickly because of the knock-on effect to the rest of the economy.
- Government should consider taking stakes in big companies to recapitalise their balance sheets.
- Government should also prepare a one-off, time limited tax write-offs for many sectors, such as travel sectors.
- VAT should either halve or drop drastically to encourage spending
- Ensure household are receiving basic income since many are unable to earn from home, such as those in the gig economy, due to nationwide quarantine. Higher unemployment benefits, in-work absence pay, and other forms of insurance payment could be made to household in distress. If there is a good reason for *helicopter money*, this is it.
- Setup dedicated lending unit for small and medium enterprises, with capital injection from the gov and central bank. This is to provide liquidity specifically for small businesses.
All these steps are to ensure the economy has sufficient liquidity to last at least until a full recovery from the pandemic. Of course, government debt will increase as tax revenue slumps while public health spending increases sharply to fight the virus and to support the economy. But this is essential. Doing nothing is not an option because in a ‘sudden stop’ scenario, a deflation spiral has been created. Hence the possibility of another Great Depression grows if no concerted action is enacted.
We can not allow an epidemic ‘sudden stop’ to destroy all the progress we have made so far.