Daniel McDowell
In 1873, Walter Bagehot, a prominent businessman in British high society and a journalist who served for 16 years as editor-in-chief of The Economist, wrote a treatise on banking and finance in which he left his most enduring mark on the world. In “Lombard Street: A Description of the Money Market,” he laid out a playbook for policymakers facing an unfolding economic and financial crisis. When up against such a challenge, Bagehot asserted, leaders must enact a policy response that is both swift and large. “By that policy,” he argued, “they allay the panic; by every other policy they intensify it.”
Economic policymakers around the world today find themselves facing an incredible challenge. As the novel coronavirus spreads, governments are swiftly implementing drastic measures to limit the scope of the pandemic, including banning public gatherings, closing national borders and shuttering all non-essential businesses.
These emergency measures are unquestionably justified, as millions of lives hang in the balance. But they have hit economies with a shocking intensity that seems to get worse by the day. Entire economic sectors have been shuttered and seemingly carved out of society in less than a week. The wrenching effects of these unprecedented events hit hardest at the individual level in the form of wage cuts and job losses.
Viewing the crisis from a higher altitude, however, financial markets are responding to widespread fears about the pandemic’s aggregate economic impact. Global equity markets are volatile. In the United States, stocks have lost three years of gains in less than a month. In Europe and Asia, equity and bond markets have been hammered.
Now, governments that have shut down economies in order to contain the virus are working furiously to implement countermeasures that they hope will limit the long-term damage of those actions. They are using all levers available to them: monetary policy and fiscal measures, national interventions and international cooperation. Will any of it work?
Bagehot’s ideas suggest that two things are key to maximizing the chances that policy interventions have their intended effect: speed and size. The economic policy response must come swiftly in order to calm market fears before irreparable damage is done. What good is a fire truck if it arrives after the house has burned to the ground? The response must also be sizeable. In times of panic, half-measures are rendered useless. Indeed, they may even be counterproductive by sending ominous signals that governments are either unwilling or unable to muster the kind of response that is needed. What good is a fire truck if it runs out of water?
So far, policymakers have hewed closely to Bagehot’s playbook. In comparison to the 2008 global financial crisis—a proximate, if imperfect, analog to the coronavirus crisis—governments and central banks have moved quickly and appear to understand that historically large programs will be needed. Yet more can and should be done, especially at the international level. There is still time to move, but the clock is ticking.
Economic responses to the coronavirus need to be structured with a view toward sustainability. The longer the pandemic lasts, the more difficult things will get.
Beyond that pressure, the unique character of today’s crisis raises an additional element of the response that policymakers must weigh, one that is outside of Bagehot’s prescription of size and speed. That is the matter of sustainability.
Our present crisis is, first and foremost, a health crisis. The bans on travel and public gatherings are not truly optional, and must be sustained until the worst of the pandemic passes—yet it is not clear how long that will take. How long will COVID-19 force governments to limit international and domestic travel? How long must restaurants, coffee shops, hair salons, boutiques and the like remain shuttered? How long before schools and universities can once again begin educating pupils? We don’t know the answer to these questions today. This is the greatest uncertainty among a large pile of uncertainties.
Policymakers can act swiftly. They can even act boldly by implementing historically large rescue programs. But their policies also need to be structured with a view toward sustainability. The longer the pandemic lasts, the more difficult things will get. Swift, large and sustainable—this is what our present moment demands. Can policymakers deliver?
Central Banks Swing Into Action
As largely independent, technocratic institutions, central banks have a significant advantage when it comes to dealing with an unfolding financial crisis: their ability to respond quickly. The former chair of the Federal Reserve, William McChesney Martin, once noted that America’s central banking system was uniquely empowered to “undertake the task without new legislation and the inevitable horse-trading that went with it.”
The autonomy and agility of monetary authorities like the Fed have been on immediate display as the pandemic has spread across the globe. In addition, central banks’ recent experience with the 2008 global financial crisis has aided their understanding of the steps that need to be taken to stabilize the system.
In this pandemic, as with previous economic crises, the first salvo by central banks has been to ensure that there is enough liquidity in domestic credit markets. As economic activity has ground to a halt, hard-hit businesses have watched their revenue streams dry up, forcing them to look to the banking system for credit lifelines. Yet when many businesses rush for aid together, financial systems can find themselves under strain. Moreover, economic uncertainty can cause banks to hoard cash, gumming up functioning of the banking system. Such reactions push the cost of credit higher at precisely the time when it needs to be falling.
In the United States, the Fed has slashed its baseline interest rate by more than 1.5 percentage points since early March, bringing rates near zero, as it did in 2008. During the global financial crisis, the Fed responded more incrementally. It began cutting rates in the fall of 2008, but they did not reach the levels that they are today until mid-December of that year—a full three months after the collapse of Lehman Brothers, the central inflection point of that crisis. In comparison, the response today has been decisive and swift.
The Fed has also resumed large-scale asset purchases—or what is often called quantitative easing—buying up hundreds of billions of dollars of Treasury bonds from private banks. The effect is to pump cash directly into the banking system, increasing the money supply by easing credit conditions and, hopefully, raising aggregate demand in the process. The Fed’s asset purchases have already increased at a faster clip than they did during the worst period of the 2008 financial crisis.
Finally, in a notable move, the Fed announced on Monday that it would be buying high-quality corporate bonds for the first time. This is an unprecedented move to pump cash into the economy.
In contrast, the European Central Bank and Bank of Japan have limited room to maneuver with conventional monetary policy responses, as their interest rates are already below zero. Still, they have quickly implemented massive asset purchase programs to provide their respective economies with a jolt. Japan’s central bank is buying up bonds and stocks while also offering one year, interest-free loans to cash-strapped firms. Last week, the European Central Bank rolled out the aptly named “Pandemic Emergency Purchase Program,” a commitment to spend more than $800 billion, buying up bonds, including Italian and Greek government debt.
Treasury Secretary Steven Mnuchin, center, during negotiations on the stimulus package on Capitol Hill, Washington, March 23, 2020 (AP photo by Andrew Harnik).
In China, where the coronavirus outbreak began and where its economic effects were first felt, the People’s Bank of China began to intervene in Chinese financial markets as early as Feb. 1 by pumping the equivalent of $174 billion into the banking system. It has maintained its liquidity operations in the intervening weeks as necessary. China’s central bank has also slashed lending rates to their lowest levels in nearly four years, though many observers feel it has not eased enough.
There has also been an encouraging level of international cooperation between central banks as market conditions have deteriorated, with the Fed and its partners acting with great speed and size to ease access to dollars in financial markets outside of the United States. The dollar is central to the world economy; it is the most widely used currency in trade settlement, trade finance, debt issuance and cross-border payments. Yet dollars have become increasingly scarce as demand for the currency has surged in recent weeks. Financial indicators revealed that banks are charging each other more for dollar credit. One such measure, the TED Spread, has reached levels not seen in over a decade, indicating dollar credit markets are tightening up.
Without access to the greenback, foreign firms or financial institutions could run into problems servicing their dollar-based debts, and firms involved in trade could find it difficult to secure the dollar financing they need to complete their deals. Foreign governments and firms would likewise struggle to pay back dollar-denominated debt as dollar appreciation increases debt repayment burdens, threatening a wave of international defaults.
In response, the Fed has resuscitated the “currency swap lines” that it first opened during the 2008 financial crisis. These deals effectively operate as credit lines to select foreign central banks, which can use the dollars they borrow to provide liquidity to banks in their jurisdictions. The Fed first announced in mid-March that it was taking steps to increase the effectiveness of its five existing swap lines with the Bank of Canada, Bank of England, Bank of Japan, European Central Bank and Swiss National Bank. These arrangements have no limit on the amount of dollars a partner can acquire. Then, just days later, it announced that nine more central banks were being added to the program, bringing the total number of participants up to 14—the same number of participants the Fed partnered with between 2008 and 2010.
Back then, though, it took 45 days after Lehman’s bankruptcy to fully implement that program. Today, the swap network has been revived at a breakneck pace. Moreover, the 2020 swap program is larger, making an additional $225 billion available to participants. Early signs indicate the Fed’s generous provision of dollars to the world economy has helped to stem the currency’s appreciation, somewhat alleviating concerns about debt burdens. The move also appears to have eased dollar-funding strains in interbank markets.
Central banks have carefully followed Bagehot’s crisis playbook. Their responses so far have been swift and sizeable, and have done much to prevent the unfolding economic crisis from turning into a full-blown financial crisis. But monetary policy alone cannot save the world economy. It is, as is often said of it, a blunt instrument. It cannot put money directly into people’s pockets, nor can it target sectors hit hardest by the crisis. As Powell said last week, “fiscal responses are critical,” too.
The Slower Government Response
Unlike central banks, governments lack the kind of agility often needed in times of crisis. This can be especially true in democracies, where partisan politics can get in the way of the policymaking process.
Recall that during the global financial crisis, the United States was slow to implement the fiscal stimulus that was so direly needed. Part of the delay had to do with the timing of the crisis, which happened to overlap with the 2008 elections. Yet even after President Barack Obama took office in January 2009, politics delayed a fiscal response. The American Recovery and Reinvestment Act, first introduced just days after Obama’s inauguration, was contentious. No Republican in the House of Representatives and only three in the Senate voted to support the $800 billion stimulus bill, opposing it largely due to concerns about its effects on the budget deficit. Ultimately, the bill passed into law on Feb. 17, 2009—a full five months after Lehman’s collapse. In retrospect, many experts have panned the bill as too little, too late.
Monetary policy alone cannot save the world economy. It cannot put money directly into people’s pockets, nor can it target sectors hit hardest by the crisis.
Today, there appears to be a greater sense of urgency in Washington regarding the need for swift, decisive and major fiscal action. U.S. lawmakers are currently hashing out the details of a bill that will likely involve direct cash payments to all Americans, extended unemployment insurance and direct aid to industries hardest hit by the COVID-19 pandemic, such as airlines. Policymakers have signaled the eventual deal will have a price tag somewhere between $1.3 trillion and $2 trillion, or between 5 and 10 percent of America’s GDP. While partisan squabbling continues to delay agreement, expectations remain high that the two sides will reach a deal this week.
In Europe, Germany responded late to the 2008 financial crisis with a $63-billion stimulus plan that was only enacted in February 2009. In a signal of how seriously it is taking the present crisis, Chancellor Angela Merkel’s government is already poised to introduce the most ambitious fiscal stimulus plan in modern Germany history: a massive $160-billion intervention in the economy. The United Kingdom and France are working on their own historically large spending plans.
Europe and the United States, in this way, have adopted something of a united fiscal front. Though the final packages are still being hammered out, the initial efforts have been both fast and large, even in comparison to their responses to the last major global economic crisis.
The story is a bit different in Asia, where the two leading economies, China and Japan, have yet to employ fiscal measures on par with their Western counterparts. Japan has committed to a modest $4.1 billion stimulus plan, though it appears to be weighing a much larger one.
For its part, Beijing is prepared to go forward with a plan to increase spending on infrastructure to the tune of $394 billion. But this is smaller than the government’s response to the 2008 crisis, which amounted to $580 billion. For now, at least, Beijing appears reluctant to implement a more aggressive fiscal response that would quickly boost Chinese consumption.
This reluctance points to a possible snag facing the global economic response to the coronavirus. U.S.-China relations have declined substantially over the past decade, and especially since President Donald Trump took office. Years of escalating trade tensions and other concerns about China’s rise have now mixed with verbal attacks since the coronavirus outbreak, with Trump insisting on calling COVID-19 the “Chinese virus,” and Chinese government officials suggesting that the U.S. military planted the virus in Wuhan. Meanwhile, many key figures in the Trump administration are using the pandemic as evidence of the risks of overdependence on China, and pushing for policies that would further sever economic ties between the two countries.
The 2008 financial crisis resulted in the elevation of the G-20 from a somewhat obscure meeting of finance ministers to the world’s premier forum for global economic cooperation. It played an important role in coordinating fiscal policy around the world in 2009. Can it do the same in response to this pandemic? The G-20 is set to hold a “virtual” summit this Thursday. But what are the chances that the United States and China will play nice with each other in the current climate? What incentive does Beijing have to coordinate with Washington if the Trump administration is bent on pursuing a hard decoupling of the two economies?
A more aggressive fiscal stimulus in China—particularly one centered less on infrastructure and more on increasing Chinese consumption—could do a lot to help revive global growth. Its effects would be amplified if it were enacted alongside the massive interventions underway in the United States and Europe. But, for now, politics seems poised to get in the way of such an outcome.
‘Allay the Panic’
The collective response to the coronavirus pandemic, so far at least, appears to be following Bagehot’s guidelines. But how long can governments and central banks sustain their unprecedented interventions? Can they really “allay the panic”?
The sudden economic crisis brought on by this pandemic is unlike any other experienced in modern times. Its root cause is not found in the banking system, or in unbound global capital flows, or in economic policy. The cause is found in human lungs in the form of a microscopic pathogen. Economic policy responses—no matter how swift, no matter how heroic in size—cannot end this crisis. Defeating the virus is the only way to do that. And because scientists still know so little about this virus, it is not possible to predict how long the pandemic will last.
Optimists suggest that, perhaps, the virus will fade as warmer weather arrives in the northern hemisphere. With aggressive public health interventions now, like quarantines and social distancing, perhaps life could return to normal by the middle of the summer. However, more pessimistic models suggest that the extreme measures currently being taken may need to continue until a vaccine is developed and widely available. If true, this is just the beginning of an 18-month battle.
Streets and sidewalks are mostly empty near the New York Stock Exchange, March 16, 2020 (AP photo by Craig Ruttle).
Neither of these scenarios is encouraging to economic policymakers. However, if the more dire predictions are correct, then the current policy interventions are almost certainly too limited to have any meaningful long-term effect in stabilizing economies.
One-time cash payments will help those who have lost their jobs for one month, perhaps two. But what then? Landlords and banks can defer rent and mortgage payments for 90 days, or perhaps a bit longer, but not for 18 months—not without some unprecedented intervention, that is. The same goes for businesses, which, even with unparalleled government support, may fail to survive if the pandemic lasts as long as some fear. Will a bailout of the airline industry be enough to sustain aviation if international travel is seriously restricted well into next year?
If the public health pessimists are correct, swift and sizeable interventions today will not be enough. Yet sustaining the current economic measures will be difficult, especially for governments. First, politics may get in the way. While most Republicans appear to support fiscal stimulus today, there are elements of the party that remain ideologically resistant to it. If a second major stimulus is required in the fall to aid ailing workers and businesses, it is unlikely it will garner the same level of support that appears to exist today. As in 2009, debates about the spending bill’s effect on the budget deficit may delay and possibly derail such an effort.
More worrisome, the unprecedented policy responses to the current crisis may result in new crises of their own. Nowhere is this more apparent than in Europe. Italy, which has suffered the largest human cost of the pandemic to date, has responded with its own major fiscal stimulus package. The stimulus is necessary, but it raises concerns about Italian debt levels. Even before the coronavirus reached Italy, Italian debt totaled 120 percent of the country’s GDP. That number will balloon significantly over the next year as the Italian economy shrinks and its debt levels rise higher.
If the public health pessimists are correct, swift and sizeable interventions today will not be enough. Yet sustaining the current economic measures will be difficult.
Italian Prime Minister Giuseppe Conte’s government will have to find buyers for increasingly risky Italian debt. The European Central Bank is doing its part, pledging to purchase large amounts of Italian bonds. But that will not be enough. The European Stability Mechanism, created when the continent’s debt crisis began unfolding 10 years ago amid the Great Recession, may be called into action.
The longer this all drags on, the more likely things will not end well. Even optimists like Olivier Blanchard at the Peterson Institute for International Economics have warned that “Italy’s debt is sustainable unless the … crisis turns out to be even worse than we currently expect.” If extreme lockdowns must be maintained well into the fall, the economic damage will be unimaginable. In that case, Europe may find itself back where it was a decade ago: facing questions about the fate of the common currency and the broader European project itself.
Frankly, we just do not know how this will end. On the whole, though international cooperation needs to improve, central banks and governments have responded well. They have learned from the 2008 financial crisis, and have been quick to resurrect tools that have worked in the past. Governments have also moved quickly on historically large stimulus packages. Yet all of these actions will have questionable results because of the unknowns that distinguish a pandemic from a financial crisis. Without knowing how long the public health emergency will last, policymakers cannot be sure that their economic policy responses today will give the economy the boost it needs to make it through to tomorrow.
This is the hard truth. Policymakers may be doing all the right things by following Bagehot’s playbook, and yet they may still fail.
Daniel McDowell is an associate professor of political science in the Maxwell School at Syracuse University, specializing in international political economy. He is the author of “Brother, Can you Spare a Billion? The United States, the IMF, and the International Lender of Last Resort,” and a regular contributor to World Politics Review.
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