Is the COVID-19 recession a prelude to a major economic collapse?
But the coronavirus is not the only source of uncertainty about our economic future. Doubts about the underlying health of the economy raise another concern that the COVID-19 recession could cause deeper financial problems.
Last week I dusted off two hypotheses of economic pessimism put forward in the aftermath of the Great Recession: William Robinson’s argument in 2010 that capitalism, now truly global, had entered a new period of “structural crisis”; and Larry Summers’ diagnosis in 2013 that the weak recovery from the 2008 financial crisis reflected chronic illness of “secular stagnation. “But this was all eons ago in 21st century political terms. How do these ideas hold up in 2020?
At first glance, these notions seemed to be contradicted by fairly steady, albeit still rather slow, growth in the United States and around the world in recent years. In mid-2018, our nation was enjoying the longest economic expansion in its history. In 2019, by some measures, the economy had never been better. The stock market has hit all-time highs; in many states, including Washington, official unemployment has hit lowest ever.
But a closer look reveals signs that all was not well. On the one hand, the Federal Reserve has not increase interest rates above virtually zero until the end of 2015, then only gradually, to a peak of around 2.5% in 2019. It was less than half the 2007 peak, which in turn was lower than the peak before the 2001 recession. A lowest federal funds interest rate is the monetary equivalent of keeping one foot on the accelerator. It is the government saying to the private sector: please borrow! Thank you for investing!
It was not only the continuation of monetary stimulus that reinforced the apparent recovery. With Trump’s election, after years of painful austerity, Republicans in Congress were suddenly prepared to resume fiscal stimulus as well. Together, the Tax Cuts and Jobs Act and the bipartisan budget law of 2018 increased the federal budget deficit by about 1.4% of GDP that year. The New Yorker John Cassidy reports that, although rarely discussed as such, this two-shot of tax cuts (albeit mostly for businesses and the wealthy) and increased government spending were “the biggest stimulus an administration has introduced. apart from a recession since World War II, “according to economists at Deutsche Bank Securities.
In other words, it took an aggressive government to achieve a simply acceptable turmoil in economic activity. In addition, long-term global growth projections – almost always overly optimistic – had become downright slow. By mid-2019, some have seen the justification for Summers that the economy was suffering from a long-term slowdown in investment.
Was growth again, as before the Great Recession, supported by speculation that would eventually collapse? Were today’s profits only sustained by the peddling of illusory hopes for tomorrow’s profits? At the end of 2019, some observers began to warn against climbing a mountain of corporate debt. Much of this debt was high risk, corresponding to “leveraged loans” or loans to distressed companies. More worryingly still, it was cut up, repackaged and sold in titles called secured loan obligations (CLO). If this sounded a lot like the secured debt securities, made up of subprime mortgages, which played a leading role in the housing bubble that burst in 2008, it was no coincidence.
Why would someone buy bad debt? Or, more specifically, how did low-rated debt get transfigured into AAA-rated CLOs, considered safe enough for the big banks to keep on their balance sheets? The reasoning was the same as for subprime mortgages. The risk of a possible default on a given loan can be significant, but mix them all up and it becomes highly unlikely that many of them will fail at the same time, at least under normal circumstances.
Enter the coronavirus.
The pandemic is creating precisely the conditions under which a massive wave of defaults on leveraged loans is possible. In one recent room in AtlanticBerkeley law professor Frank Partnoy presented a disturbing catastrophic scenario: Over the next year or so, as the impacts of the pandemic really sink, corporate failures will multiply and the prices of CLOs will drop. suddenly, turning into bank failures. From there, we will fall into a real financial collapse with no obvious way out.
No one can say for sure whether this grim series of events will happen, and not everyone shares The meaning of Partnoy’s alarm. But whatever the details, there are good reasons to take the “secular stagnation” and “structural crisis” theses seriously. Extreme financial risk-taking has continued in various forms since the Great Recession, and this is not only due to the failure of governments to impose adequate regulations; it is also the product of more fundamental problems, including persistent lackluster real economy growth.
All of this begs the question: what can be done?
Among thinkers who see today’s economy as somehow deeply out of step, even if they don’t quite agree on the diagnosis, there is quite a bit of overlap when it comes to the remedy prescribed. In 2010, Robinson spoke of the prospects for a “New New Deal” and a radical redistribution of wealth. In 2013, Summers called for a new era of massive public investment, creating good jobs and spurring growth by rebuilding the country’s infrastructure. Then there is Thomas Piketty, whose book 2013 The capital in the 21st century analyzed the ever-increasing global concentration and inequality of wealth in our time. Among other things, Piketty calls for a progressive global wealth tax.
This all sounds great to the progressive left ear. But is it realistic? And who will get there? That’s our topic for next week.