Those who compare the 2020 situation to let’s say the Great Recession, in our opinion at least, oftentimes fail to understand the fundamental difference between an economic crisis that affects industry after industry in a meaningful manner and a financial crisis which came as a result of Wall Street recklessness correlated with consumer greed and ignorance.
A textbook example of the latter is represented, of course, by the Mortgage-Backed Security fiasco which led to the Great Recession, which at its very core had to do with:
- Wall Street greed, with commercial banks offering mortgages to pretty much anyone with a pulse, then selling those loans to investment banks that packaged these mortgages so as to create so-called Mortgage-Backed Securities, which were then sold to investors
- The greed of the various entities which were involved in the process, from credit rating agencies which were excessively generous to insurance companies that didn’t plan for systemic shocks which would lead to average consumers defaulting on their mortgages en masse
- The greed of the average consumer, who took advantage (or so they thought) of the fact that obtaining loans was ridiculously easy and bought homes they couldn’t realistically afford, took out additional loans to live above their means so as to impress the Joneses and the list could go on and on
As can be seen, we are looking at a financial crisis generated by greed, primarily the greed of the financial sector, with all it encompasses.
Is the 2020 situation similar?
When it comes to certain manifestations, yes.
For example, the fact that asset prices have crashed represents a common denominator which makes many observers wrongfully believe that we are dealing with the exact same phenomenon, when in fact… we are not.
What we have now, in China as well as elsewhere, is a downright economic crisis brought about by the fact that in the aftermath of the Covid-19 panic, the worldwide economy essentially froze when it comes to many key industries. Tourism took a devastating blow, transportation was also hit incredibly hard and shocks were felt across the system, with for example February 2020 auto sales falling by a whopping 92.5 over in China and similar trends manifesting themselves in other countries.
Think of it as the difference between a financial crisis brought about by financial sector greed and which ultimately led to a recession and a full-scale economic crisis brought about by a white/black swan (a pandemic, in our case), which led to economic activity grinding to a halt in many cases and among other things, risks generating a financial crisis as well.
Needless to say, we are dealing with more than just differences pertaining to nuance.
By understanding these differences, observers will ultimately realize that gone are the days when central banking “superheroes” such as Alan Greenspan and Ben Bernanke could step in and proverbially save the day through aggressive monetary policy choices alone. At this point and beyond, the market demands a correlation between even more aggressive monetary policy than before and, very importantly, unprecedented fiscal policy.
In a “primarily monetary policy” paradigm, central banks can lower interest rates and flood the financial system with liquidity, liquidity various economic actors can take advantage of in one way or another. Companies can access cheaper financing and among other things even buy back their own shares, individuals can take out loans at “bargain basement” interest rates and the list could go on and on. In a nutshell, the name of the game is making financing more and more affordable, with the private sector hopefully stepping in and taking it from there.
But in situations such as the one we find ourselves in, the private sector has been paralyzed by fear as well as current losses/uncertainty and as such, even if central banks make financing more accessible than before (with an important caveat being that financing had already been more than accessible, for reasons covered in a wide range of ChinaFund.com articles), there will be no demand from the private sector. As such, a powerful “monetary + fiscal policy” duo is required, with the government stepping in decisively through measures which range from directly helping affected industries such as airline travel with various forms of aid to stepping in through public spending (infrastructure spending, for example) so as to fill the demand gap left by a frightened private sector.
How do countries respond?
In China, things are actually fairly straightforward and as such, the authorities are far more likely to respond in a strong “fiscal + monetary stimulus” fashion decisively due to the far more centralized and undemocratic nature of the political system compared to the West. As strange as it may sound, increased centralization and even the absence of democracy, despite representing major issues in other areas, can sometimes work in favor of the country in question. To put it differently, it is not at all difficult in China for Xi Jinping to decide on a course of action and then swiftly implement said plan.
On the other end of the spectrum, we have the European Union as a textbook counter-example. There, in light of the fact that we are dealing with several countries with in some cases completely different cultures as well as political systems, finding a common denominator when it comes to both monetary and especially fiscal policy represents a Herculean task. This became apparent in the European sovereign debt aftermath of the Great Recession, with EU leaders frustrating markets repeatedly through what was perceived as depressing inaction (with Northern European creditor nations being less than thrilled about the prospect of having to provide assistance to poorer Southern European debtor nations).
It remains to be seen what happens next but this much is certain: markets demand strong action on both the monetary and this time also fiscal stimulus front. Should this monetary and fiscal stimulus not be provided or be perceived as inadequate, we have more than valid reasons to believe that little mercy will be shown in terms of asset price action. As such, the price that is being paid for let’s say the current US share price action needn’t be underestimated.