Playing the long game is the only game in town

The support programmes implemented by governments have barely got off the ground but already central banks are stepping in to lend their support. The US Federal Reserve plans to offer an extra $2.3 trillion of credit and support the market for high-yield corporate debt in a bid to ensure that small and medium-sized businesses can access the central bank’s largesse. Meanwhile the UK government will borrow from the Bank of England to meet its financing needs via its long-established Ways and Means facility. This will allow the government to sidestep the bond market in order to ensure it has access to its funding needs. Since the amount borrowed is due to be repaid by the end of the year it does not constitute monetary deficit financing. But given the current strong demand for safe haven securities – a gilt auction this week had a bid-to-cover ratio of more than 3 – we have opened the floodgates to such unconventional financing measures much earlier than I expected.

In the BoE’s case, the irony is that the latest announcement came just a few days after the new Governor wrote a column in the FT making it clear that the BoE is not and will not be engaged in monetary financing. Andrew Bailey emphasised that “the UK’s institutional safeguards rule out this approach … [and] the MPC remains in full control” of the policy instruments designed to increase the central bank balance sheet. Simply put, if the BoE buys financial assets this is purely in line with the BoE’s inflation remit. But the element that is often overlooked is that the remit is “to maintain price stability; and subject to that, to support the economic policy” of the government, where the government’s policy objectives include a “credible fiscal policy, returning the public finances to health, while providing the flexibility to support the economy.” The BoE’s policy remit is about far more than simply controlling inflation – whatever it says in public.

But what is monetary deficit financing and why is it so “bad”? In simple terms, it amounts to central banks creating money to pay off the government’s creditors. The conventional argument is that it results in excessive liquidity creation that eventually results in higher inflation (too much money chasing too few goods). The textbook example of such a policy is the action of the Weimar government in Germany following World War I which chose to inflate away its debt by printing money but which instead resulted in the great hyperinflation of 1923. Admittedly it was successful as a debt reduction strategy but disastrous in terms of its other economic side effects. A century on from this experience, Germany remains scarred by the memory and was instrumental in writing the provision into the Maastricht Treaty that prohibits monetary deficit financing in the euro zone. More recently, it was practiced by Zimbabwe and the policy was only stopped when the currency became so devalued that the government was reputedly unable to pay for the ink required to print more banknotes.

It is thus generally accepted that allowing governments to control the monetary printing press is a bad idea for it may encourage them to over-expand the money supply. The conventional narrative is that allowing central banks to enjoy a degree of autonomy over monetary policy in the last two decades is one of the key factors helping to curb inflation. I have argued before that this is far from the whole story but it has certainly played a role. However, over the past decade central banks have bought huge amounts of government debt which has led to a massive rise in central bank reserves (i.e. liquidity creation) but not resulted in higher inflation. Indeed, the BoJ and ECB have struggled to push inflation towards their target goal of 2% despite a balance sheet worth 100% and 40% of GDP respectively (see chart, taken from the St Louis Fed). This is in part because the institutions which sold their securities to the central bank have simply gone out and bought other assets, notably equities, thus pushing up their price. There may not have been too much money chasing too few goods but there was a lot of it chasing a dwindling pool of high yielding assets. I have little doubt that liquidity creation will be inflationary in some form. It will surely push up asset prices although whether it inflates consumer prices remains to be seen.

The actions of the Fed and BoE in recent days confirm my suspicion that we will be engaged in financial repression for a long time to come (i.e. central banks will do everything in their power to keep interest rates low). They are likely to go further: The BoJ has been buying assets on an industrial scale for almost 20 years and both the Fed and BoE have a lot of headroom to ramp up their balance sheets without necessarily sparking CPI inflation if the Japanese experience is anything to go by. As it currently stands, central banks buy debt in the secondary market (i.e. not directly from the issuer) and for the foreseeable future they are going to be buying a lot of assets. Past experience suggests that at some point they will call a halt to the process. At that point, they can sit on their bond holdings indefinitely. As bonds mature, they can roll over the debt by cashing in the proceeds and use them to buy an equivalent amount of additional securities. In this way, the central bank balance sheet remains unchanged and it continues to hold the same amount of government debt.

Technically, this is not monetary deficit financing because the presumption is that at some point the central bank will sell its debt holdings back to the private sector. A small complication arises from the fact that in the UK, the BoE hands over the interest it earns from its bond holdings back to the Treasury so it is in effect monetising the interest payments, but that is small beer. A bigger issue is whether at some point the central bank will simply write off its government debt holdings. It is not going to happen anytime soon, so we can rest easy on that score. But they may surreptitiously be able to do so in the longer term. The BoE plans to hold £645 bn of bonds, which amounts to around 30% of annual GDP. Suppose that in the long-term nominal GDP growth averages 3.5% per year and that the BoE rolls over its debt holdings ad infinitum. After 25 years, the bond holdings are worth 13% of GDP and in 50 years just 5% of GDP.

Is anyone going to complain if in 50 years’ time, the BoE writes off (say) half of these holdings? The current generation of central bankers will be long gone and I certainly won’t be around to do so! Therefore, the issue of whether central banks are likely to monetise the debt holdings built up over the last decade is something we will only be able to judge long after the current crisis is past. Sometimes playing the long game really is the only game in town.

Rising to the challenge

After another week of market drama, with big price corrections and a drying up of market liquidity, central banks and governments are stepping up to the plate to provide the biggest support package in modern times. We should not be under any illusions about the nature of the economic shock that is unfolding before us and as a response risk is being socialised to an unprecedented degree. This is a recognition that the coming shock is likely to be significantly worse than Lehman’s for the simple reason that COVID-19 is affecting everybody’s daily lives, not just a small section of the community. 

The market position 

From a market perspective, the wild movements we have seen in recent days represent attempts to find an equilibrium based on a complete absence of information. Precisely because we have no idea of how bad the COVID-19 infection rate will be nor how badly the economy will be impacted, investors cannot make even the roughest of guesses as to where the bottom is. We hear lots of reports from investors keen to put their funds to work, arguing that there are bargains to be had. But whilst this is understandable, it may be totally wide of the mark. What appear to be solid businesses today might suffer significant knock-on effects in future as they emerge from the other side in worse shape than we thought. 

Take airlines as an example. Admittedly they were operating on thin margins anyway, so they were always going to be badly affected by the collapse in international travel. But the risk is that people will change their post-crisis behaviour, perhaps because they are less willing to travel or because they start to pay more heed to the environmental implications of air travel. As a result, investors looking for bargains today may be disappointed if they back the wrong horse.

This underpins my view that we should be wary of accepting the consensus view that there will be a V-shaped economic recovery. In a sense, a lot of displaced activity in the coming months will be “permanently” lost. After all, people will not visit restaurants or bars twice as frequently in future to make up for the activity that they will be forced to forego during the spring. And in the early stages of any recovery, the crisis mentality is likely to persist with the result that the rebound may be much slower than supposed. Thus, rather than taking a year to recoup lost output it may take up to two (or even more). Suggestions that this may mark the start of a second Great Depression may sound alarmist, but the idea that we are about to return to business as usual strikes me as overly sanguine. Without wishing to sound trite, recall that 10 years after the crash of 1929, the world was hit by another shock in the form of World War II which resulted in the biggest expansion of the state in history. Dark times indeed! 

Monetary policy has acted with what limited scope it had left 

The policy response was a little bit slow to get off the mark at first but the authorities have reacted decisively in recent days to do “whatever it takes” to provide support. Central banks have committed to pumping in huge amounts of liquidity, in the form of direct asset purchases to ensure markets can continue to function and in the form of loan guarantees for businesses to ensure their continued operation during the worst of the crisis period. The renewed bond buying is an easy way to provide liquidity to banks but this is a blunt instrument to support the overall economy. However, it will support the bond market following a period last week when it wobbled following concerns at the sheer amount of debt that governments will be forced to issue. 

Whilst loan guarantees are a positive step, they are still loans, which means that many companies operating with already-stretched margins will have to take on additional debt in order to survive. Many small businesses are going to take a major hit as their income flows dry up and there will inevitably be staff layoffs which will hit people particularly hard at the lower end of the income scale. Governments have increasingly realised this and have moved quickly to adopt unconventional fiscal solutions. 

But fiscal policy is where the action is

The UK acted swiftly on Friday to unveil its Coronavirus Job Retention Scheme (CJRS), in which the government has committed to pay up to 80% of the wages of furloughed workers, up to a limit of £2,500 per worker each month. This will cover the period March to May and will be extended if necessary. It will not be cheap. Some back of the envelope calculations suggest that if 10% of employees are laid off, this could cost up to £8bn per month if all workers are paid the maximum amount. This will obviously vary according to the average payout and the proportion of furloughed workers and the table below shows some illustrative monthly fiscal costs.

In addition to these measures, the UK government has announced a deferment of business VAT payments due between now and the end of June and has extended the period of interest free loans to small businesses from 6 to 12 months. It has also raised the standard rate of Universal credit and Tax Credits for one year from 6 April, with the result that claimants will be up to £1040 per year better off, and has committed to providing an additional £1bn of support to renters. As one who has called for many years for greater use of fiscal instruments to support the economy, it is gratifying to see the government act decisively in this way. There are those who have pointed out the irony that it is a Conservative government which has acted to leverage up the UK national balance sheet, having criticised Labour governments for doing just that. But in truth, this is the right thing to do. People are being asked to make sacrifices and need support to help them do so.

A question which has been put to me by non-economists is who is going to pay for all this largesse. In truth, we are – maybe not immediately, but in the longer run. The UK government will have to significantly raise borrowing – it is too early to determine by how much – and if other governments around the world follow suit, there is going to be a lot of competition for bond investors’ attention. Under normal circumstances, bond yields would be expected to rise sharply in anticipation of big increases in national debt, which would in turn imply a rising proportion of tax revenue being used to service debt. Governments would thus be expected to respond with fiscal tightening. After a decade of austerity, this will clearly not be a vote winner. However, we can expect central banks to continue bond buying in an effort to keep interest rates low as we enter a period of intense financial repression. Low interest rates appear set to stay in place for years to come.

Future historians will likely look back at this week in 2020 as the point at which the world changed. Hopes that we would resume our march towards pre-2008 normality appear to have been dashed for good. We are now on a different economic and social path, and nobody knows where it will lead.

The storm before the tsunami

To say it has been a wild market ride today would be an understatement. Based on daily data back to 1985 (a total of 9179 observations) the 7.7% decline in the FTSE100 is the fifth largest correction in recent history, beaten only by double digit declines in the wake of Black Monday in 1987 and two days of correction in October 2008 as the Lehman’s fallout continued to reverberate. The 7.9% decline in the DAX was also the fifth largest correction in the German equity market although the US correction did not even make the top 10.

I have been through a few market corrections in my time, and each of them was triggered by a unique set of circumstances. Today’s moves, however, were only partly initially related to equities. They were triggered by the 30% collapse in the oil price following Saudi Arabia’s decision to launch an oil price war and were exacerbated by coronavirus concerns. The Saudi decision came after Russia refused to join OPEC countries in extending existing production curbs in a bid to drive oil prices higher and the Saudis are clearly trying to force the Russians back to the negotiating table. This is bold and risky strategy. Whether or not it works, the shock decline in oil prices put initial pressure on the oil majors and triggered a broader market selloff at a time when sentiment was already extremely nervous. Momentum effects then took hold as equities competed to go ever lower.

Faced with this kind of environment, there is nothing anyone can do but stand back and watch the carnage unfold. Interest rate cuts will be of no real help, even though the Fed, ECB and BoE are likely to deliver additional monetary easing before the month is out. Policymakers can perhaps impose bans on short-selling or impose circuit breakers on the market which will temporarily limit the downside but they are on the whole powerless. The flip side of the equity selloff has been the surge into safer havens such as government bonds and gold, with the US 10-year Treasury yield falling to a new all-time low of 0.5% and the 10-year German Bund trading at -0.86%, implying that investors are so keen to preserve their capital that they will accept a negative return on their holdings of sovereign German debt because the expected loss of principal is greater than the negative yield on Bunds. Without wishing to be too gloomy, a lot of countries are now apparently at much greater risk of recession than perhaps we thought a week ago.

In the face of an equity correction of today’s magnitude, it is easy to extrapolate into the future and make the case for further huge declines. But much depends on the nature of today’s shock. If it merely represented a kneejerk reaction to the oil collapse which got out of hand, markets could easily rebound a little in the near-term. But if it reflects concerns about the impact of the coronavirus on the wider economy, which is more likely, I would expect a lot more downside before we reach the bottom. I noted in this post that the US market had the potential for another 10-20% downside. The market is already 7% below where it was when I wrote that, and as the number of non-Chinese virus cases continues to increase, the potential for economic disruption continues to grow.

The fiscal response

With monetary policy all but exhausted, governments will have to step up to the plate to deliver measures to support the economy. We will have a great chance to see what the UK government is made of when it delivers its post-election Budget on Wednesday. Much of the very good pre-Budget analysis prepared by NIESR or the IFS has now been overtaken by events. It was originally planned that this would be a Budget which attempts to deliver more spending, particularly for those regions which have been left behind by austerity. This was to be a reset of policy – the so-called “levelling up”. But now it will be dominated by efforts to limit the impact of COVID-19.

There are essentially three areas that the government will have to address: (i) ensuring liquidity-constrained businesses can continue to operate; (ii) providing support for individuals who lose income and (iii) maintain the delivery of public services. There are various things the government can do: In the case of (i) more generous payment terms in areas such as employer social security contributions would help to limit the burden (e.g. a payments holiday whereby firms do not have to pay contributions for those workers who are sick with the coronavirus). To tackle issue (ii), the government could reduce the time it takes to get access to Universal Credit payments (as I argued here) and addressing (iii) might involve significant increases in the budget for the National Health Service.

As the IFS points out, in fiscal years 2008-09 and 2009-10, the government’s fiscal expansion package was equivalent to 0.6% and 1.5% of GDP respectively. That is a high benchmark but the UK does have the fiscal headroom to try something similar today. Other governments across Europe will have to follow suit. The German government, for example, has previously dragged its feet but there are indications that it is now prepared to boost spending to support companies which apply for aid to offset wage costs during labour layoffs. As the UK examples cited above show, fiscal policy does not necessarily have to take the form of big infrastructure spending programmes: tweaks to the tax and benefit system can provide much more targeted help.

The time for waiting is over with action required to at least prepare the economy for the worst case outcomes. There is after all, no point in the likes of Germany continuing to run surpluses for the sake of it. We should welcome any moves towards fiscal easing. For too long, governments have been absent from the fiscal policy fray and have left it to central banks to manage the economy. Whether it will mark the start of a more targeted approach, or whether we will soon revert to a period of retrenchment remains to be seen. But whatever else governments do, they must act soon. If nothing else, markets will ultimately punish them for failing to act.

Accounting for tail risks

Today’s announcement by the Fed of a 50 bps rate cut – the first intra-meeting rate cut since 2008 – is an indication of the extent to which it is taking seriously the potential for corona virus-related economic disruption. The die was cast yesterday when the OECD reduced its outlook for global growth in 2020 from 2.9% to 2.4% (chart) – just below the 2.5% rate which is considered to be consistent with global recession. There is little doubt that COVID-19 has left an impression on the Chinese economy during Q1, with the OECD cutting the 2020 growth projection from 6.1% to 4.9%, which would be the third slowest growth rate since 1980. 

It might yet turn out worse: As the OECD noted, “a longer lasting and more intensive coronavirus outbreak, spreading widely throughout the Asia-Pacific region, Europe and North America, would weaken prospects considerably. In this event, global growth could drop to 1½ per cent in 2020, half the rate projected prior to the virus outbreak.” Markets are certainly looking to the downside, with US equities down almost 3% following the Fed’s actions. So much for shoring up market confidence.

Just to put the coronavirus issue in perspective, the WHO’s latest Situation Report suggests that China has recorded 80304 cases out of a population of 1.428 billion. That’s an infection rate of 0.0056%. Based on the reported number of deaths (2946) this implies that (so far) the chance of an individual dying from the disease is 0.0002%. This is roughly a 1 in 490,000 chance which compares with a 1 in 10,000 chance of being involved in a fatal auto accident in China. Obviously the authorities have put in place some draconian measures to restrict movement which has significantly slowed the rate of new infections but which have had significant adverse consequences for the economy.

But without wishing to downplay the seriousness of the threat posed by the virus, it is important to keep the risks in proportion. Much of what the authorities are preparing for in Europe and the US represents the worst case outcomes and it is important to distinguish these tail risks from outcomes at the centre of the distribution. We have, of course, learned to our cost the failure to prepare for worst case outcomes. The failure to identify tail risks ahead of the Lehman’s bust arguably contributed to the severity of the downturn and on the basis of the old adage, “fail to prepare, prepare to fail” it makes sense to take precautions. If such measures save lives they are clearly worthwhile but we must be careful to avoid talking ourselves into a panic. 

The statement by G7 Finance Ministers and central bank governors early today suggested they would “use all appropriate policy tools to achieve strong, sustainable growth and safeguard against downside risks.” It was only a matter of hours later that the Fed decided to act. Whilst the G7 was correct to suggest that greater use of fiscal measures was appropriate, it is questionable how useful interest rate cuts will prove to be. This is not to say they are unwelcome but the fact is that many central banks, including the ECB and BoE, have very little scope to cut, unlike in 2008 when there was plenty of downside for rates. This highlights the point that many of us have been making for some years that failure to normalise interest rates as the emergency conditions of 2009 eased, has left many central banks with little policy space to counteract the next downturn.

Moreover, it is widely accepted that the virus will act as a supply shock, as people are unable to work, rather than a demand shock where interest rate cuts can have more of an impact. To the extent that people’s demand patterns are altered, this is more likely to reflect a conscious change in behaviour rather than a  response to financial conditions. Where monetary policy can be more effective is in ensuring that business cash flow is not affected by a short-term breakdown in activity. Thus central banks may be able to make more capital available to banks by cutting the countercyclical capital buffer, in a bid to maintain the supply of credit.

On the assumption that the virus effects are relatively short-lived, it is imperative that central banks quickly take back their emergency easing measures in order that they do not become permanent. Fed Chairman Powell sidestepped this question at his press conference today, and whilst it is understandable that he does not want to telegraph the future course of policy, it is equally important for the long-term health of the financial system that markets do not continue to live on the fresh air provided by an overly lax monetary policy. In the event that the ECB cuts rates again, which is a realistic possibility, removing the stimulus as soon as is practicable will help to alleviate some of the damage which negative rates are doing to the fabric of the euro zone banking system. 

On the fiscal front, health services will obviously need the resources to ensure that they can function properly and governments are making the right noises to ensure that this will be forthcoming. Another issue which has come to light in recent days is to ensure that there is an adequate form of employee insurance in place. One of the problems for workers, particularly at the low end of the income scale, is that they do not get paid if they do not turn up for work. But if infected people turn up for work in order to collect their pay cheque they run the risk of infecting others. The last thing that hospitals need is for infected porters or cleaning staff to be running around the place. In the UK, those who are self-employed, who account for 15% of total employment, are not entitled to sick pay. Some form of temporary scheme to compensate them for loss of earnings is certainly an option worth considering, even though the practicalities of such a scheme are quite daunting.

But when all is said and done, the best thing the authorities can do to minimise the economic impacts of COVID-19 is to ensure that infection rates are held down. So far as China is concerned, there are hopeful signs that things are improving. The rate at which infections are increasing has not exceeded 2% for the past 9 days as the draconian measures put in place start to take effect. Outside of Hubei Province, the epicentre of the outbreak, there are only 13,000 confirmed cases and just 112 deaths – less than in the rest of the world (166). Prevention is always better than cure but preparedness runs it a close second.

Advisers advise, ministers decide

The resignation of Sajid Javid as Chancellor of the Exchequer following the reshuffling of Boris Johnson’s government came as a major surprise since Javid had, by all accounts, been promised that he could continue in the job despite changes in ministerial responsibility elsewhere. It has emerged that Javid was offered the chance to stay in post, but only on condition he fired all his special advisers and replaced them with those appointed by the prime minister’s office (i.e. by Boris Johnson’s de facto chief of staff, Dominic Cummings). Javid had rather unkindly been labelled as CHINO (Chancellor In Name Only), and it is clear that he was not prepared to compromise any further in order to retain his position at the heart of government.

All this comes less than a month before Javid was due to present his first post-election budget to parliament which was (is?) expected to include tax breaks for low income earners and a boost to social spending, coupled with measures to claw back some revenue from higher earners. His replacement is the little-known MP Rishi Sunak who has 27 days to prepare himself for the budget presentation. Clearly this will not be his budget – it will be the one imposed upon him by Downing Street and will have the fingerprints of Dominic Cummings all over it. It does appear that the current government is a highly centralised administration, offering little scope for individual minsters to set the direction of policy. But particularly in the area of fiscal policy, there is a sense of conflict between what the Johnson government wants to deliver and the caution which the Treasury reserves towards big policy initiatives which involve spending money.

The first issue is whether the resignation will have any implications for the direction of policy. It almost certainly will not derail the government’s plan to take more low-paid earners out of the tax net. The Conservative election manifesto promised to raise the threshold for National Insurance Contributions to £9,500 (currently £8,632). Using HMRC data as a baseline, which suggests that an increase of £2 per week will cost £300m of revenue, this implies an annual revenue loss of around £5 billion (0.2% of GDP). I would be surprised if that was not one of the measures to be presented by the new Chancellor on 11 March. The Conservatives also expressed an “ultimate ambition … to ensure that the first £12,500 … is completely free of tax” which on current calculations would put a £22bn annual hole in public revenues (1% of GDP). Such largesse will have to be paid for and various trial balloons have been floated, including restrictions on pension tax relief where cutting the relief rate from 40% to 20% for workers earning more than £50,000 per year could claw back £10bn. Another option which has been mooted is the levying of a tax on properties above a certain (high) value threshold. The problem is that although such policies might play well with non-traditional Tory voters who lent their votes to Johnson in December, they will not go down well with voters in the Conservative heartlands in southern England.

The alternative to a big clawback is that the government simply runs a looser fiscal stance. Prior to the election campaign, Javid announced a set of fiscal rules in which the government would seek only to balance the current budget by the middle of the decade and borrowing to fund investment would be permitted to rise to 3% of GDP – around half as high again as the previous set of fiscal rules – whilst debt servicing costs would be limited to 6% of tax revenues. These are estimated to allow for fiscal expansion equivalent to 1% of GDP. However, it would be easy enough to tweak the limits to allow for a slightly larger expansion and to blur the distinction between current and capital spending by setting even more nebulous targets for balancing the budget.

But there is a bigger issue at stake than the nature of the fiscal stance and it goes to the heart of who runs government. The prime minister is primus inter pares – first amongst equals – but he (or she) cannot control everything. And it will raise further questions about the role of Cummings, for it is known that he and Javid did not see eye-to-eye on many issues. Margaret Thatcher once famously said that “advisers advise and ministers decide” but press reports over recent months suggest that the advisers are doing a little more advising than is good for government. Ironically Thatcher made this comment in the wake of the 1989 dispute between her economic adviser, Alan Walters, and the then-Chancellor Nigel Lawson. Lawson was an advocate of the UK joining the ERM but Walters was not, and what should have been an internal government matter got out of hand when Walters published an article outlining his position. Lawson subsequently resigned (as did Walters) but the damage to Thatcher’s position ran deep and she was forced out a year later.

The lesson from that episode was that when it comes to a showdown in which a prime minister has to choose between the advice of a minister and listening to an adviser, it is usually a mistake to choose the latter over the former. It smacks of authoritarianism and does nothing to foster good relations between the prime minister and other MPs on whom he ultimately depends. We should not over-dramatise today’s events. The budget will still be delivered and many of the ideas currently on the stocks will be put forward. But it should act as a warning to Boris Johnson that he will not always get his way and although he is currently flavour of the month he must beware alienating those who may have a different point of view. As a classics scholar, Johnson will be all too aware of the fate which befell Caligula – although in fairness Johnson has not yet appointed a horse as an adviser.