Summer was supposed to be the season that helped deliver a knock-out blow to covid-19, and pave the way to returning the economy, and people’s lives, to normal. Instead, we are faced with not just a surge in new cases, but record-setting numbers of infections. California has now surpassed New York in total covid cases at over 400,000. Moreover, each state is seeing its caseload rise as they try to reopen, forcing many states to partially reverse their shutdown policies. Relapses are not limited to the America, either, as India, Hong Kong, Japan, and Brazil are seeing very high numbers of new cases.
As covid rampaged across the globe--in three months it was found on every continent except Antarctica--scientists were baffled by its virulence. They soon realized that early attempts to contain the virus were being stymied by the fact that covid can be spread by seemingly healthy people. “Social proof” has played a large part in our current predicament, as uncertainty about this invisible enemy has prompted us to look to others for behavioral cues. Believing that you are safe not wearing a mask is easy to accept when you are surrounded by other mask-avoidant healthy people and are not yourself getting sick. Reassured by their lack of symptoms, confident partygoers over the big holiday weekends of Memorial Day and July 4th have unwittingly spread covid in a most insidious way. Now, as workers return to offices, children prepare for the new school year, and all of us pine for our favorite restaurants and entertainments, the asymptomatic possibility of virus transmission points to a sobering reality—if people who appear healthy can transmit the illness, it may be impossible to fully contain it.
Policymakers are struggling to understand how much of the economic fallout can be contained. The dramatic rebounds in numerous economic indicators off the very depressed March-April readings gave hope to Wall Street’s cheerleading squad that maybe a V-shaped recovery was possible. But covid’s spread has upended reopening plans and cast a pall over expectations of a strong rebound in economic growth.
A central plank of the economic recovery plan is a massive increase in unemployment benefits at the state and federal level. It is needed by many. New weekly initial claims for unemployment have consistently held above one million people since March, and the total receiving continuing benefits is now about 32 million. This includes those getting state benefits (18 million) and gig workers able to claim under Federal pandemic assistance programs (14 million).
Many of these income support programs are set to expire as of this writing in late July, and Congress is now wrestling with the structure of another stimulus package. Unlike the initial programs, however, rival Democratic and Republican proposals are far apart on their terms. Key differences between now and then are the reduction in the Federal unemployment benefits (currently $600/week) and the expiration of the eviction moratoriums in place since March. Another big source of tension is Democrats’ call for more than $900 billion in aid to state and local governments; Republican proposals call for none. The loss of unemployment benefits, the potential for evictions, and continued municipal cutbacks will certainly dampen spending and would likely reverse the gains of the last two months.
We are already seeing that effect as covid cases rise, and households again revert to their hunkering down state. Consumer confidence dropped in July following a large gain in June. Consumers have grown more pessimistic about the outlook for the economy and labor market and remain subdued about their financial prospects. This uncertainty about the future does not bode well for the recovery, nor for consumer spending.
The net effect of aid packages to Main Street and, via the Federal Reserve, to Wall Street, is that debt issuance is exploding. The Fed is monetizing the US Treasury’s debt in order to finance these emergency programs. In other words, Congress appropriates the money, the Treasury issues the debt, and the Fed buys the debt with cash that they can create out of thin air. The result has been an increase of about $3 trillion in the Fed’s balance sheet since March. Total federal public debt now stands at 107% of gross domestic product (GDP), a level not seen since WW II. The Federal budget deficit, at the end of 2019, was almost $1 trillion, and is sure to have crossed the trillion-dollar mark when 2020’s blowout spending is accounted for.
Global debt surged to a record $258 trillion in the first quarter of 2020 as economies shut down to contain the covid pandemic. The Institute of International Finance (IIF) reported that the global debt-to-GDP ratio jumped to a record 331%, with overall debt issuance hitting an “eye watering” pace of $12.5 trillion in the second quarter. The IIF noted that 60% of those issues came from governments who are substituting debt for income lost by the unemployed.
Since opening the Pandora’s box of “quantitative easing” (QE) in 2008, central banks have discovered what they thought was the magic elixir of growth by combining near-zero-percent interest rates and massive expansions in the money supply. This once radical approach has now become standard policy for central banks, who have become mired in their own trap of keeping interest rates near zero for too long. They have had to shift to creating inflation in asset prices, via QE, since already low interest rates had lost their power to stimulate growth. This is clearly shown below by the Minneapolis Fed, which charts the change in output during recoveries from various post-war recessions. Even with near-zero interest rates, the 2008-20 economic expansion was the most anemic on record, save for 2001’s effort. This flies in the face of classical economics, which says lower interest rates will stimulate borrowing and therefore economic activity.
The reality of the last ten years is that record low interest rates have not turbocharged the economy, but only kept it muddling along. The outcome seems to have been that the tremendous rise in debt over the last decade has not been put to productive use, but rather channeled into paper assets (Wall Street, hedge fund leverage, and stock buybacks). Only a small portion of these benefits have trickled down to Main Street, who are now needing financial life-support to keep from being kicked into the streets.
How long can the debt carousel continue spinning around? Is there a limit to the absolute amount of debt investors are willing to buy at such low yields? Or are we in a cycle of perpetual refinancings facilitated by central banks, who are effectively nationalizing the debt markets? Insight into the answer may be gleaned from Reinhart and Rogoff’s 2009 book “This Time Is Different: Eight Centuries of Financial Folly.”
Certainly the “this-time-is-different” mindset has taken hold, even before covid hit, as investors have embraced the idea that the Fed will always bail out Wall Street with more QE. Indeed, the Fed has reinforced that belief with repeated injections of QE cash, turning what looked like major bear markets into brief, V-shaped affairs. This has fostered the buy-the-dip mentality that now pervades Wall Street and provides an outlet for the gambling urges of growing numbers of day traders.
Bureaucrats have also succumbed to the seductive allure of this-time-is-different thinking, as they issue debt with reckless abandon. The Fed’s QE policy appears to have created a perpetual money machine, where considerations of repayment or the burden on future generations can be ignored through some sort of magical thinking. For instance, there is no discussion of raising taxes in some form (a “war on covid” tax) to help finance the spending taking place. Instead, the belief in QE as the pain-free solution to our money needs has become an article of faith among monetary authorities.
But Reinhart and Rogoff’s book reveal that similar belief systems have come and gone over the centuries. In the 1920s, conventional wisdom held that large-scale wars were a thing of the past, and that political and economic stability would replace the volatility of the pre-WW I years. In the 1980s, economists believed that high commodity prices, reinvested oil profits, and falling interest rates would banish the business cycle. More recently, by 2008, popular belief was that globalization, amazing technology, and sophisticated monetary policy would prevent any severe economic setbacks.
It is hard to expect that two things can be avoided in the wake of this debt binge, which may prove to be the greatest credit bubble of all time. The first is the avoidance of broad-based inflation. This is the one economic outcome that nobody is talking about. Inflation (as “officially” calculated) has been so mild we have become conditioned to its absence. But anyone who buys food, maintains a car, or rents an apartment knows the real inflation rate to be much higher. It seems reasonable to expect that soaring money supply growth, coupled with covid-caused shortages, and now a falling US dollar, provide the tinder to fuel a significant inflationary shock. No one will be more shocked than central bankers, who, with their this-time-is-different groupthink, thought they had inflation whipped. When this may happen is anyone’s guess, but it is the one thing that investors are least expecting.
Second, can we really expect that lenders will not come knocking for repayment of their loans? Debt is creating the illusion of wealth, but with a catch: debt payments never disappear, but revenues and profits can easily slide to zero. At the corporate level, it is easy to visualize that air and cruise lines, restaurant chains and retailers will eventually run out of rope. Many already have. Lenders have only so much patience before they withhold funds, not wanting to throw good money after bad. Even with the Fed backstopping corporate debt of all qualities, another round of covid-related closures could cause a broad withdrawal of lenders from the market.
Wall Street seems very complacent that the Fed will make good on all this debt. But what the Fed creates with their QE programs is liquidity; it cannot create customers. Without a comprehensive, cohesive, and nationwide plan to control covid’s spread and bring customers back to American businesses, today’s debt binge may turn out to be money for nothing.