With economic policy and solutions changing rapidly around the world, our Chief Strategist John Johnston breaks down what is going on and what we should be thinking about (updated as of March 22, 2020).
- Covid-19 is a massive economic and financial shock that has caused a deep recession to begin. It is likely to last six-to-twelve months.
- Policymakers across the globe are taking aggressive actions on multiple fronts – government spending and tax policy, monetary policy (short-term interest rates and liquidity provision), regulatory policy, and health policy.
- Actions by Canadian policy makers in reaction to developments related to Covid-19 are a very important step in supporting Canadian households and businesses and will help them weather this difficult period.
- While governments are struggling to keep up with a rapidly changing situation, they are doing a lot. They are certainly doing more than they did at the equivalent point in the global financial crisis of 2008-2009.
- More policy actions are likely going to be required, but governments are committed to doing as much as is required – “whatever it takes”.
- The policy actions from global policymakers over the past two weeks are likely to be the beginning of the end of the current crisis. Not the end, but the beginning of the end.
- Once global financial markets see the potential for an end to the economic and financial dislocation, they will rebound. This has always been the case in the past and will be this time as well.
Economic and Financial Background
- In January of this year, there was significant evidence that the global economic slowdown was ending and that 2020 would be a year of better economic news. In the last issue of The Quarterly, we noted that it would take a major shock to push us into recession.
- Covid-19 has turned out to be that shock. The global, U.S., and Canadian economies slipped into recession in March, 2020.
- The downturn has hit hard and fast, much like turning the lights off in a building. The closest episode we can find in history is the shutdown of military production in Canada, the U.K. and the U.S. in 1919 and 1946. Canadian gross domestic product (GDP) fell 7% in 1919 in volume (or inflation-adjusted) terms and U.S. GDP shrank 12% in 1946. Note that the shift from wartime to peacetime production after WWI was complicated by the so-called Spanish flu, which killed an estimated 50-100 million people.
- We are likely to see some dreadful economic reports over the next few months, notably surging unemployment and sinking incomes for businesses and households.
- The current situation is certainly challenging, but it is not as disruptive as these shifts from war to peace. In those instances, the challenge of resuscitating peacetime economies was like turning the lights back on but getting an extended period of flickering. Today, we will flick the switch and the lights will come back on relatively quickly. The same industries will exist as before the virus hit, though there will likely be fewer firms in many industries and fewer jobs in the first part of the economic recovery.
- The modern-day challenge is that the virus hit economies with a lot of debt and with very frothy asset prices. With economic activity declining sharply, incomes will follow suit. With many households and private businesses facing stretched finances, many could face insolvency. With asset prices down sharply, many individuals and businesses might be forced to liquidate their diminished portfolio of assets to satisfy creditors, in absence of government intervention.
- Effective policy actions are the difference between a recession and a depression. Bad policies in 1929 and 1930 turned an economic contraction into the Great Depression.
- In the 2008-09 global financial crisis, policy makers floundered through most of 2008. However, the failure of Lehman Brothers in September 2008 galvanized opinion and led to very aggressive policy actions in late 2008/early 2009. It is critical to remember that asset prices and the economy bottomed very soon after the aggressive policy actions. Equity prices hit their lows in early March, 2009 and the global, U.S. and Canadian recessions ended in June-July 2009. This is consistent with our latest market forecast.
- While policy makers are struggling to catch up after being slow off the mark in the early days of the virus appearing, they are catching up quickly. Notably, they are way ahead of where they were in 2008.
- Health policy is focused on dampening down the virus’ spread and helping the stricken survive. The sooner the spread is contained, the quicker the lights go back on (and more households and businesses avoid serious financial damage). Enforcing social distancing and rapid testing will go a long way to slow things down, as we have seen in South Korea, Singapore, and (seemingly) China.
- Actions by Canadian governments on this front look constructive.
- Announcements by the Federal and some Provincial governments on Friday, March 20 that there is increasing cooperation with industry to get more medical equipment into the health care system are also encouraging.
- Monetary policy and financial regulatory policy are pumping liquidity into the financial system so that financial firms have funds available to meet the needs of businesses and households, many of whom need to access credit to help them weather the economic disruption. The Bank of Canada’s cuts in short-term interest rates and its facilities for providing liquidity go a long way to supporting the financial system. The overnight interest rate has been reduced by 100 basis points so far in March from 1.75% to 0.75% and there is plenty of room to cut it further.
- Canada Mortgage and Housing Corporation (CMHC) has revived its insured mortgage purchase program where it will temporarily buy mortgages from the chartered banks and provide them with significant (up to $50 billion) liquidity. CMHC did this amidst the 2008-09 crisis to great effect.
- The Office of the Superintendent of Financial Institutions (OSFI) has reduced the Domestic Stability Buffer from 2.25% of risk-weighted assets to 1.00% for Canada’s systemically important financial institutions. This will free up approximately $300 billion in additional lending capacity.
- OSFI has made clear that these newly available funds are to be used to support households and businesses rather than used to return capital to shareholders.
- One final monetary policy point: Bank of Canada Governor Poloz is retiring in June 2020 when his seven-year term ends. His term should be extended, and he should be asked to stay on until this crisis eases significantly. This is not the time to lose an important and experienced policymaker.
- Fiscal policy shifted dramatically on March 18 when the Federal government announced a support package for the economy. It is a big package, amounting to $82 billion, or 3.5% of full-year, or annual GDP. Given that these measures are being implemented over a much shorter period than a year – likely 3-6 months – the impact with be much larger than 3.5%.
- There are two components to this: $27 billion (1.2% of GDP) in direct assistance to businesses and households, and $55 billion (2.3% of GDP) in tax payments deferred until after August 31. The Finance Minister has indicated that this is phase one of the response, so the size of the fiscal actions could increase considerably further. These are important actions to help ease the financial pressures in Canada’s private sector. This package may not be enough, but it is a good start.
- Moreover, we are seeing provincial governments announce complementary measures that boosts the size and potential effectiveness of the fiscal actions.
- U.S. policy is also shifting dramatically, with fiscal policy poised to inject roughly $2 trillion (or 10% of GDP) into the economy. This comes on top of the Fed cutting the Fed funds rate to 0-0.25% and injecting massive amounts of liquidity into the financial system, and many states and municipalities forcing broad shutdowns of their economies to try and stop the spread of the virus.
- There is talk that the government will support full employment income replacement. This is a potential bazooka solution whereby the government injects liquidity into the system via the payroll system of business. Effectively paying the wages of those who might have lost their job. Implementation of this and other measures will need to be ironed out in a political process ensuring that bankers and bad corporate actors don’t walk away with all the money.
- The policy actions from global policymakers over the past two weeks are likely to be the beginning of the end of the current crisis. Not the end, but the beginning of the end. There is bad news to come and additional policy actions are likely to be needed and will be forthcoming. However, the actions taken thus far should prompt us to start considering when the crisis will start to ease.
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Image Credit: Ottawa Tourism