All over the world governments and central banks are addressing the pandemic crisis with three main sets of measures:
However, as well-intentioned as these measures may be, they may cause deeper problems than what they aim to solve. When governments try to artificially boost debt and demand in a supply shock, the risk is to create a massive deflationary spiral driven by debt saturation that is followed by stagflation when supply chains start to be insufficiently flexible.
This is a health crisis and a supply shock added to the forced shutdown of the economy. As such, policies aimed at boosting demand have very little effect because whatever demand is artificially created will not be followed by supply, as long as the economy remains shut. Considering that the opening of the economy will be gradual and subject to changes, it may be safe to say that the risk of achieving very little positive impact with these stimulus packages is very high.
Governments make two important mistakes in a lockdown as severe as this one: Thinking that the impact is similar in all sectors and believing that a nationwide shutdown will be recovered swiftly.
There are sectors that will take years to recover: Travel and Leisure, Autos, Retail, Fashion, Music, Cinema, Tourism and Energy all face years of weak demand, balance sheet reparation and survival-mode strategies.
The collapse in earnings and cash flow followed by the more-than-likely tax hikes that we will likely see are also going to create an enormous burden on Research and Development, innovation and technology.
The financial sector was already weak in 2019, suffering with negative rates, high non-performing loans and weak return on tangible assets. The impact of the crisis will be severe on exisiting assets, with rising non-performing loans and downgrades of earnings. If we add to this that most governments’ stimulus packages are based on approving massive loans for companies that face years of difficulties, the strain on banks is going to be very significant, and may lead to a financial crisis after a supply shock.
The key measures to take in a supply shock with a forced lockdown need to be supply-side measures, eliminating taxes throughout the lockdown, reducing unnecessary expenditure to accommodate for higher healthcare costs, and providing non-recourse liquidity lines to preserve the business fabric as well as giving sanitary equipment and protocols for businesses to manage the supply chains.
Some governments, like the United States administration, are combining both demand and supply-side measures. Others, like most of the large eurozone economies except maybe Germany, are only focused on policies driven to provide credit relief and increased spending.
With these measures in mind, and considering the slump in economic activity, corporate profits, wages and tax revenues that will be generated, global debt is likely to soar above 350% of GDP. This means that the vast majority of the stimulus packages will be aimed at financing higher debt created by government non-economic-return current spending and hibernating large companies, while small and medium enterprises, which have little access to debt and maybe no assets to leverage, simply disappear. Start-ups and small businesses may face a double negative of zero access to equity as well as collapse in sales.
When governments and central banks announce massive stimulus packages at the very beginning of a crisis they bet on a speedy recovery and a return t normal as if nothing had happened. This is far from the case. Debt-fueled stimulus into a lengthy and painful recovery may generate a deflationary spiral short-term that will likely be addressed with more monetary and fiscal stimulus and, then, create stagflation.
The evidence shows that the global economy has recovered in a much slower and indebted way from each of the past crises. However, none of the crises of the past 50 years have been remotely similar to this one. We have never witnessed a global shutdown of the entire economy, and policymakers have no idea about the mid and long-term ramifications, so doubling-down on debt and liquidity is, at least, dangerous.
How do we go from crisis to deflation and then to stagflation?
The process would be the following:
I genuinely hope that this will not happen. I will be delighted to be wrong.
The pandemic lockdown is showing us the importance of having open supply chains, diversified, global and efficient companies, as well as competitive services. It also shows the importance of collaboration.
The solution to this crisis must be global and local at the same time. A global answer that ensures that cooperation and trade are preserved and that liquidity policies are also aimed at emerging, not just developed economies. The local answer must be aimed at ensuring a rapid recovery of the lost jobs by preserving the business fabric and ensuring that companies have the equipment and protocols to come out stronger.
Interventionism will only lead to stagflation.
A version of this article first appeared here.
Daniel Lacalle is one the most influential economists in the world. He is Chief Economist at Tressis SV, Fund Manager at Adriza International Opportunities, Member of the advisory board of the Rafael del Pino foundation, Commissioner of the Community of Madrid in London, President of Instituto Mises Hispano and Professor at IE Business School, London School of Economics, IEB and UNED. Mr. Lacalle has presented and given keynote speeches at the most prestigious forums globally including the Federal Reserve in Houston, the Heritage Foundation in Washington, London School of Economics, Funds Society Forum in Miami, World Economic Forum, Forecast Summit in Peru, Mining Show in Dubai, Our Crowd in Jerusalem, Nordea Investor Summit in Oslo, and many others. Mr Lacalle has more than 24 years of experience in the energy and finance sectors, including experience in North Africa, Latin America and the Middle East. He is currently a fund manager overseeing equities, bonds and commodities. He was voted Top 3 Generalist and Number 1 Pan-European Buyside Individual in Oil & Gas in Thomson Reuters’ Extel Survey in 2011, the leading survey among companies and financial institutions. He is also author of the best-selling books: “Life In The Financial Markets” (Wiley, 2014), translated to Portuguese and Spanish ; “The Energy World Is Flat” (Wiley, 2014, with Diego Parrilla), translated to Portuguese and Chinese ; “Escape from the Central Bank Trap” (2017, BEP), translated to Spanish. Mr Lacalle also contributes at CNBC, World Economic Forum, Epoch Times, Mises Institute, Hedgeye, Zero Hedge, Focus Economics, Seeking Alpha, El Español, The Commentator, and The Wall Street Journal. He holds a PhD in Economics, CIIA financial analyst title, with a post graduate degree in IESE and a master’s degree in economic investigation (UCV).