The unique circumstances of the 2020 coronavirus crisis mean that giving banks access to cheap credit is largely ineffective; instead, central banks must lend directly to normal businesses, or risk economic collapse. Thus, Main Street – and not Wall Street – must be the main target of quantitative easing.
This is the main conclusion of a new paper by University of Notre Dame (USA) economists Eric Sims and Jing Wu, based on the similarities and differences between the current crisis and the 2008 Great Recession.
On the surface, the two economic contractions have much in common: collapsing asset prices, sharp declines in consumer spending, and surging unemployment. Consequently, central banks, such as the US Federal Reserve, have introduced quantitative easing packages, including lending to financial organizations at zero or near-zero interest rates, large-scale asset purchase programs, and the relaxation of strict reserve requirements.
The goal of such policies is to ensure that banks do not go bankrupt, and that they have access to the liquidity necessary to keep lending to the private sector, so that businesses can pay each other and the wages of their employees.
In 2008, this was a sensible response, since the root of the problem was a sudden and unexpected deterioration in the balance sheets of banks. Banks had irresponsibly granted housing loans to people who were almost certainly unable to pay them back, and investment companies created complex financial derivatives based on these loans that obscured their inherent riskiness. The result was that financial organizations assumed that the assets that they were holding were worth a lot more than they actually were.
When this large-scale error was uncovered, it triggered a massive contraction in financial activity as banks sought to stabilize their finances. The ensuing collapse in asset prices and credit crunch caused unemployment to rise sharply, igniting a vicious cycle. The quick and easy response, as central banks surmised, was to print lots of money and give it to the banks, interrupting the vicious cycle, and putting the economy back on an upward path.
It may have required unprecedented levels of money printing, but it basically worked; and to stop it from happening again, new regulations were imposed on banks, diminishing the likelihood of irresponsible lending and risky leveraging.
In 2020, unlike 2008, the root of the crisis is not financial; it is the “real” economy: people can’t go to work to produce things, and people can’t go to shops to buy things. The resulting contraction in economic activity, including falling asset prices, has precipitated a financial crisis, too; but as a corollary rather as an ignition point.
To avert a catastrophic economic collapse, governments have realized that they need to focus on the cash flow of normal businesses: their revenues have sharply declined, and without a cash injection, they will lay people off, and default on their loans, exacerbating the financial crisis. Then, once the health crisis is dealt with and people can interact normally again, the economy can commence a conventional recovery.
Prof. Sims and Prof. Wu show that repeating the 2008 strategy will be ineffective, for two reasons. First, the problem isn’t with banks; it’s with normal businesses, and so helping banks only works if banks help normal businesses. Second, giving banks access to cheap credit will not convince them to help normal businesses by lending to them; the banks will predictably be afraid to lend to businesses with acute and unprecedented cash flow problems, meaning that the cheap credit will just sit idly in Wall Street while Main Street goes under.
Fortunately for the US economy, the Federal Reserve anticipated this, and so they took the unprecedented step of lending directly to Main Street. This has been especially important because the US government has not paid the wages of workers in the same way that other governments have, including those in the Gulf states and the European Union.
Yet not all central banks have been so prescient, underscoring the importance of reading and disseminating this research paper. Instead, many financial authorities have largely replicated their 2008 playbook, potentially impeding their economic recoveries.
This speaks to a deeper problem in many countries, which is the lack of communication between those who are able to help – the government – and those who need help – people and businesses. Technocrats are often skeptical of the value of consulting directly with stakeholders, either because they think it needlessly slows them down, or because they think that they understand the issues better than the affected parties.
While such presumptions may be acceptable during generic recessions, they are potentially disastrous during unprecedented crises, such as COVID-19. Consequently, it is critical for all governments to engage the people they are trying to help, as they have information that is critical to determining the effectiveness of countermeasures.
Omar Al-Ubaydli (@omareconomics) is a researcher at Derasat, Bahrain.
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