This crisis is different–it resembles the famous collapse of 1973. First of all, as for now, it’s the supply-side crisis, stupid. Hence, “traditional” neo-Keynesian measures, together with QE, LTRO, TARP, interest rate cuts, etc. are not appropriate and will not be effective at the moment.
Monday, March 9, will go down in the world's economic history as a symbolic date for the start of the present economic crisis, as I called it one of the first economists in the world. Oil prices fell by 30% and stock markets dived by 6%. There has not been such a combination of dramatic circumstances for years. As I predicted, the following days brought continuation.
What we see is the birth of the biggest crisis for over 40 years. It will affect many countries, not only those that have the highest rates of coronavirus infections. The whole world will suffer, no matter how much particular countries will be infected by a virus because COVID-19 fill is followed by another virus–the economic one.
This is a modified version of the article written on March 12, 2020, and published by Forbes Poland on March 19, 2020, translated into English with the permission of the publisher.
Background of the crisis
Something has been hanging in the air for several months when it comes to the global economic situation. Tensions have been felt: the US-China trade war, a slowdown in the economy (e.g. in Germany), and increased tensions in the financial markets. The largest investors began to accumulate cash.
The policy of pumping the economy with money (not accompanied by a sufficiently large increase in labor productivity) and liquidity (see QEs) has led to an overvaluation of companies and stock markets. Record low-interest rates maintained at this level by record-breaking time—in the world's economic history—led to the rise of many speculative bubbles (which I have been warning for several years). In addition, the wide-spread money flow from China fuelled asset price increases around the world. Now, the world a global correction awaits, e.g. real estate prices will fall by 20-30%, many start-ups whose model was based on a constant inflow of capital (from VC funds) will not survive.
In the previous decade, China has become the undisputed factory of the world—it has taken over some of the low-skilled jobs from the developed countries, replacing them with cheaper labor. Richer countries have left the most profitable part of the value chain: management, design, research&development. When China began to lead some high-tech markets (see 5G technology), this caused numerous tensions. It turned out that the Middle Kingdom–not so long time ago a third world country—began to aspire to the first league of innovators. Now, with the reduction of production and transport, international value chains have (temporarily) broken.
Financial Eldorado has loosened prudential standards. While the situation in banks after the world financial crisis of 2008-09 is relatively healthy, companies (e.g. S&P500) have become very indebted. Anticipating a positive scenario and the continuation of the longest bull market in history, they borrowed for further investments and purchase their own shares. Now they will have problems with paying off debts, and together with them also the holders of corporate bonds will see the consequences.
In the background, the conflict over what will be the world's dominant currency began to sprout. About 130 years ago, the United States took precedence in international trade, and as a result of the destruction of World War II and the Bretton Woods agreement, the dollar replaced pound sterling as a world reserve currency. Digital money disputes: Libra vs digital renminbi is a discussion about maintaining the monopoly of central banks for the creation of money and about a challenge that some digital currencies may dominate international settlements. It is a pity that Poland did not start pushing between the powers and did not propose its own solution (at the beginning of 2018, the central bank has blocked my project aimed at creation of the digital version of Polish zloty, dPLN), once having a strong position in the digital currency markets (3rd place in the world in 2012-14).
Forecast
The coronavirus has become a pin that triggered the crisis and breaks through many speculative bubbles blown with easily accessible money. Its direct effects may expire in a few weeks (let’s hope so), but by this time some of the industries may ruin. First of all, those related to the movement of people will suffer transport, automotive, hotel, entertainment, gastronomy, etc. However, these will be temporary effects. They are dramatic, as seen from recent stock market declines—but this is "just" panic.
The more serious problem that I think may cause even the global economic crisis (not just a slowdown or a recession) will be the inter-industry domino effect in the global economy. Domino effect is a concept known in the banking sector, where the collapse of one financial institution leads to bankruptcy of others—when the population loses confidence in them. The current situation may be similar but on a larger scale. Panic may result in the loss of faith in the possibility of further growth of many industries, especially when we will observe the collapse of well-known large companies (e.g. Boeing, Tesla). Then the collapse of one industry will translate into others. This, in turn, may lead to the slowdown of the development of large parts of many economies in the world.
Currency, banking, financial and debt crises - all of them can have serious consequences for the entire economy. But because they occur relatively often in many countries, the policymakers have already been taught to fight them, e.g. with the support of the central banks and in emergency situations with the help of the International Monetary Fund. The current crisis is of a different nature. Unlike most crises over the past two centuries, it is not primarily associated with financial markets. It concerns directly the real economy, i.e. the population flows.
The business cycle theory indicates that the channels of economic impulse transmission are: 1. labour, 2. trade (of goods and services), 3. capital, 4. technology and information (e.g. on prices) and 5. sentiment (trust). It is believed that the first of them was significant in the nineteenth century, and throughout the twentieth century played a marginal role (but not the European migrant crisis in 2015). The current crisis, however, began with the disruption of migration processes in the global economy (e.g. many international flights have been canceled) or within the countries (domestic travels have been limited), after which this impulse quickly spread through other channels.
The sentiment channel is particularly important, and it is hardly recognized. Trust management is particularly difficult, especially for economists or politicians, because it does not mainly concern monetary, financial and fiscal issues to which they are accustomed and have a number of instruments. This can be seen even after the unsuccessful interventions so far (e.g. first interest rate cuts of the Fed did not have an influence on the markets)—even information about the Fed pumping up to USD 1.5 trillion in the US economy (i.e. about 40% of the entire quantitative easing program—QE) did not stop the panic (and it was decided to pump even more funds, as much as $6 trillion).
Trust management requires good communication with the public and credibility. In economic policy theory, moral suasion (i.e. influence through persuasion) has been pointed out for years. This policy instrument is particularly important in the first phase of the crisis (e.g. in the Czech Republic in 1994 it helped the central bank with stopping the currency crisis). However, to be able to convince markets to your arguments, you need a good reputation.
It is important for key people to implement an anti-crisis policy to be trusted. In this respect, it would be ideal if both the head of the central bank and the head of the finance ministry (state treasury) had a high reputation, e.g. they would be professors of economics specializing in crises or heads of major economic institutions. It was the luck of the United States before the previous crisis when the governor of the Fed was the outstanding professor of economics Ben Bernanke (his research specialization was the Great Depression of the 1930s) and the head of the treasury department was Henry Paulson (former CEO of Goldman Sachs, one of the most important investment banks on the world). The talents of these two persons have helped not only the U.S. only but also the whole world. If the reputation is weaker, then the possibilities of using moral suasion as an effective instrument of anti-crisis policy are limited. Such weaknesses increase the risk of making mistakes in designing an anti-crisis policy.
How Poland is prepared for the crisis?
During the crisis, macroeconomists should conduct economic policy. The skills of officials, even of the good ones, may not be enough. In Poland, this role was taken over by the Minister of Development. In the whole government (consisting of over 100 people, counting deputy ministers) there is only one macroeconomist (and one financier). Prime Minister Morawiecki, although a historian by education, was the CEO of one of the largest banks in Poland. It's a good half of the duo (see Bernanke-Paulson). We can mention here the macroeconomic inconsistency in his economic strategy, which included plans for investment rate growth, but without raising savings rate. Such macro-weaknesses may be problems for conducting successful macroeconomic polities in the troublesome times.
Poland has for many years had one of the lowest savings rates in Europe (and in terms of national gross savings / GDP it was only about 60th in the world). Negative real interest rates in recent years did not stimulate them. This is a big problem because about half of the Polish households have savings sufficient for only three months. It's not enough—too little for such a big crisis.
For almost 30 years, the Polish economy has been growing steadily (with the exception of a short, mild slowdown) and Poles we have gained the false confidence that it will continue. Most of the transition countries have had some crises or recession since they finished the first stage of system transition (e.g. banking crises, currency crises). Poland did not have them. Many people have forgotten that after fat years they must come lean; that in every business cycle after a period of prosperity - there must be a slowdown or even recession. In a situation, where the economy almost stopped, economic activity is frozen—it immediately has serious consequences. The collapse of companies, or even entire industries, and wealth effects in the form of shrinking assets (declines in stock exchanges, soon also on the real estate markets), will impoverish society and reduce consumer spending. The consequence will be reducing the scale of operations of companies and their bankruptcies. The unemployment rate will also rise.
Before the previous global crisis, the Polish government had a lot of time to prepare for it. We were the first country in Europe that was warned of the "American Crisis" (i.e. as early as in August 2007)—more than a year before the collapse of Lehman Brothers. Now we don't have such a luxury to have so much time to prepare. The next weeks will be key. It will be important because first of all the government needs to introduce effective trust management—convince society and business that the Polish economy will not suffer too much, that the banking sector will survive, that there will be no tax on bank deposits, that people do not need to withdraw cash from ATMs, etc. The usual ways information is spreading has changed—for a large part of society trustworthy are no longer TV news (esp. of state-owned channels who are told to be a propaganda of a ruling coalition), but the internet; so the government also have to fight the fake news, conspiracy theories, etc.
In a situation of quarantines, the possible sanitary cordons, shortages of goods, further reduction of population flows, limited use of services—this will increase tensions and nervous behavior. This is already visible on the store shelves—they were so empty in Poland as far as more than 30 years ago. During the previous crisis of 2008-09, the minister of finance in Poland was a professor of economics with international experience (in London), whose head of political cabinet was a Ph.D. holder in economics specializing in crises (by the way, my former student). They did not succumb to panic imported from abroad; they aptly diagnosed the sources of the crisis and did not fight with them, but introduced timely proven protective tools (including significantly increasing the budget deficit).
This time it different – it is a supply-side crisis
This time it will not be enough.
"The National Bank of Poland and the entire Financial Stability Committee will use all the possibilities at their disposal to ensure stability", the NBP governor said.
But it is not enough. Such instruments are sufficient remedies for typical crises: banking, stock market, or financial ones. This crisis is different. More like the first oil crisis than the other ones. As a result of the embargo imposed by OPEC on the U.S. and other countries (1973), transport and international trade suffered significantly. We have a similar situation now, but without raising oil prices (they go down). At present, the world is more globalized, more closely interconnected than half a century ago, so the consequences may be larger. Hence, international cooperation is required to protect international trade and the flow of goods. Otherwise, we may suffer the consequences seen during the Great Depression of the 1930s. Protectionism is a big threat, given strict controls on borders introduced so far.
Just like in the 1970s, now we have, first and foremost, a supply-side crisis and not the typical lack of aggregated demand is not an issue, now. Therefore, the neo-Keynesian instruments will not be appropriate to use. If the supply is not sufficient, stimulating demand will drive price increases! The effect of the oil crises was stagflation—a simultaneous stagnation and inflation. We have already seen the beginnings of such a situation—even before the coronavirus, there was a worsening economic situation and in some countries, rising prices were visible, especially of food. I was the first economist in Poland that described this threat; it was at the beginning of May 2019. But the central bank has ignored it and in February 2020 Poland had 4th highest inflation rate among 60 countries reported by BIS. I warned of the threat of rising inflation, on time! The inflation can now be exacerbated by other factors, not just in the food sector (caused partly by the swine fever in China). That is also why it is important to stimulate international trade.
Fortunately, the starting situation in Poland is not bad. And it's not only about the later appearance of the virus in Poland compared to other countries. One of the main successes of the five years of the economic policy of Prime Minister Morawiecki was to diagnose and counteract one of the most important crises risk factors, as it was indicated in his strategy. This is the concept of net international investment position, i.e. the difference between a country's external financial assets and liabilities. A year before the current prime minister took over the office of the Minister of Finance, i.e. in 2014, this indicator was almost 70% of GDP in Poland, and in this respect, we were in a group close to the so-called PIGS countries (in 2008 it ranged there from 76% to 98%). At the end of 2019, I estimate that it was slightly over 50%, only. This means that our country is financially less dependent on foreign countries' investment. In addition, approx. 80% of foreign liabilities are stable capital (FDI and long-term debt instruments) and the Polish zloty dominates (approx. 60%). This means a low risk of transferring crisis impulses from abroad to Poland (at least through the financial channel). It is important if we assume that the U.S. or some west European countries will to into severe recession.
Before the 2008 crisis, Poland was very lucky. The Law and Justice government in 2006 reduced the personal income tax and disability pension contributions. Aggregate demand has increased on time due to this fiscal stimulation and the economy was already stimulated while entering the crisis. We now have a similar coincidence. The 500+ program (thanks to which parents receive a tax-free benefit of PLN 500 (about EUR 120) per month for a child until they reach the age of 18) will alleviate part of the consequences of the crisis, especially in the poorest families. In addition, there were substantial increases in minimum wages and 13th (in a year) retirement social transfers. Therefore, Poland has quite a good entry into the crisis.
First policy actions against the crisis
The first economic policy actions taken against the coming recession were not particularly successful, because they were based on the incorrect diagnosis that the current crisis is primarily of a demanding nature. Hence, the usually recommended (Keynesian) tools would be inappropriate. For example, lowering interest rates—the most popular mean of combating the recession for almost 90 years - may not work this time. In Poland, this causes also the risk of accelerating inflation or deteriorating banks (because of their lower profits).
Furthermore, the government announced the so-called anti-crisis shield. It, however, was based mostly on microeconomic solutions and hundreds of micro-regulations. In my opinion, they will not be enough in a situation, where not individual companies and industries will go bankrupt, but there will be a recession in the entire economy. Macroeconomic measures will be necessary. However, there are almost no announcements or discussions on this topic yet.
Next policy actions
What is needed is not monetary instruments, as we are not dealing with a financial crisis (the recent stock market plunge is an effect, not a cause of problems), but an appropriate policy mix, including regulatory changes. Monetary policy tools will be useful when banks go bankrupt (several of them in Poland may be at risk, esp. those with a higher share of mortgage loans denominated in Swiss francs). However, now, the most important thing is to protect companies from bankruptcy and as many families as possible from poverty. Actions such as the following may be considered:
- helicopter drop, targeting especially families with the lowest savings and incomes (vide 500+ program in Poland);
temporary nationalization of some parts of the economy—as was done in the US banking sector at the end of 2008; - price control and rationing of some goods (which is already being done on the market of surgical masks or disinfectants) and intervention purchases (e.g. accommodation in hotels or delivery of food from restaurants for the needs of people in quarantine, purchases of some securities);
- widespread extension of mortgage repayment dates (abolishing the bank tax and suspending the interest tax—which should have been done a few years ago to raise the savings rate) and fiscal and pension system liabilities (e.g. contributions of self-employed people);
- accelerating the spending of EU funds (maximum simplification of procedures; acceleration, and not delay—as it was done—of calls for proposals) especially for innovative projects (this type of company is easier to go through crises), e.g. online services.
These are examples of activities. More detailed should be developed, which would be possible is one has the right staff to do so and make the right diagnosis of economic problems.
Social consequences of the crisis
During crises, mortality rates increase - especially among the most vulnerable: children, seniors, and the poorest families. This can indirectly bring more casualties than coronavirus directly. This will not be noticeable (by the media), because such estimates are made by scientists years after the crisis. But this does not mean that it should be underestimated. Action should be taken to prevent long-term unemployment, because it is more difficult to pull people out of it, and in addition—passive attitudes may become permanent (hysteresis effect).
Among the social consequences, one should also pay attention to the possible increase in mental disorders or even suicides, especially among children (parents will be exposed to post-traumatic stress as a result of the crisis, the divorce rate will increase, and thus the scale of children's problems) and among men (as a result of losing their jobs or companies). The researchers have estimated that the last economic recession caused more than 10,000 suicides between 2008 and 2010 across the U.S., Canada, and Europe. Therefore, shielding measures should be introduced (the minimum is an online psychological consultation, e.g. for people on quarantine), not to mention the improvement of the terrible condition of Polish psychiatry, especially child psychiatry.
Integrity
On the one hand, so should society and entrepreneurs be reassured. Not to cheat it with the vision of only slowing the economic growth, but to help prepare for difficult times without, however, boosting negative self-fulfilling prophecies. Otherwise, the government is exposed to the risk of losing credibility, which can be useful when the situation is really hot. It's like a fairy tale about a shepherd who lied to his colleagues several times crying that the wolf had kidnapped his sheep. When it really happened - nobody believed him in the next alarm. That is why the credibility of people who govern the economy, their good understanding of the nature of crises, having macroeconomic knowledge and the ability to calm the situation without losing their reputation, are needed. Because the worst is yet to come.
prof. Krzysztof Piech, PhD
specialist in the field of crises, economic policy and innovation;
from August 2007 he warned against the financial crisis of 2008-2009