The guest commentary below was written by written by Daniel Lacalle
All over the world governments and central banks are addressing the pandemic crisis with three main sets of measures:
- Massive liquidity injections and rate cuts to support markets and credit.
- Unprecedented fiscal programs aimed at providing loans and grants for the real economy.
- Large public spending programs, fundamentally in current spending and relief 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:
- The crisis is created by the pandemic and the subsequent closing of entire economies in a domino effect, causing strains on supply chains as well as a domino of credit events in highly indebted sectors.
- Governments bail out the large and strategic sectors as well as citizens with massive loans and grants and fiscal measures but leave behind the preservation of supply chains at a global level. As the crisis deepens and lasts longer, governments decide to take protectionist and interventionist measures that further erode supply chains. This period is deflationary because money velocity collapses, investment stops, consumption is weaker and citizens try to hold on to the little savings they have.
- The deflationary and indebted spiral is addressed wit more liquidity and more debt, but by now the supply chains have been irreparably damaged and interventionist measures add to rising inflation in essential goods and services. The economy remains in stagnation but prices creep up.
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.
This is a Hedgeye Guest Contributor note by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the most recent Escape from the Central Bank Trap. This piece does not necessarily reflect the opinions of Hedgeye.