[Below is a note written early March, updated in the third week of that month, in thrall of the emerging COVID-19 Crisis, while trying to understand the global implications, expanding on my other thoughts at that time. Some errors, of course. But was a fun exercise.]
The challenge
The impact of the Coronavirus is as if “emerging market crisis” happening simultaneously across the private sector of every major economy.
Consider each economy in isolation before piecing together the global economy. The requirement to quarantine to halt the spread of the virus is equivalent to a discrete fall in income across many households and businesses; meanwhile regular outgoings on rent, utilities, consumption and sometimes investment continue. As such, large parts of the private sector are being forced into a (further) deficit as incomes fall more than spending—either due to falling profits, wages, or unemployment.
At the same time as becoming deficit agents, a greater risk of delinquency and default is emerging—meaning there is a sudden stop or withdrawal of financing. Thus, credit risk is growing across many private agents.
The result of these two forces—growing deficits and financing withdrawal—is that the private sector faces an “external” financing gap. This is similar to an emerging market facing a sudden stop of financing with an external deficit.
To offset these forces, it becomes necessary for private agents to draw on pre-arranged financing or overdrafts—or to draw down deposits or other liquid claims. However, other things equal, the private sector as a whole cannot achieve their desired move into deficit.
The problem is, while each individual can run down their claims on the bank and—by proxy—the government in the belief that will allow them to fund their personal deficit, the community as a whole cannot. There is a fallacy of composition. As each individual moves into deficit, selling liquid assets or seeking funding from the central bank, this doesn’t provide resources for the community as a whole—instead asset prices fall, interest rates increase, and markets fall into a tailspin.
The only way the community as a whole can draw upon external resources, given the risk of in private markets—is if these are intermediated by the consolidated government—through non-resident purchases of government debt, growing fiscal deficits, the depletion of international reserves by central banks, drawing upon swap lines or IMF funding, or—in the particular case of the euro area—drawing upon the TARGET2 system.
The policy response
The correct policy response is therefore some combination of fiscal expansion, central bank action, and balance of payments support in each case—though the details will depend upon the particular circumstances of each economy. Ultimately, USD remains the fulcrum of global finance, and the US plays a central role in terms of managing global liquidity and underpinning the global fiscal response.
United States. While many other countries will find external financing being withdrawn, this financing will be flowing into the US at this time. This means the external constraint is not binding (hence DXY strength) and US residents can indeed in the aggregate sell their domestic claims to non-residents to manage their cash flow challenge. However, this might not be enough. Growing credit risk means there will still be financing problems domestically, and the unwinding of leverage. To support private incomes—and avoid impulse into deficit—Federal and State governments can provide transfers and income support by going further into deficit themselves. This will lower private credit risk but requires a potentially large increase in the general government deficit. So far, the proposed fiscal package in the US is far too small.
As well as supporting private credit and incomes, the larger the US government support will sustain overall private demand in the US which will prevent a sharp import compression. The US current account deficit is a key source of dollars globally. The smaller is US government action, the larger the import contraction, and the greater the global dollar shortage.
Meanwhile, Fed swap lines de facto serve to recycle dollars that are being lost on current account and financial account by providing dollars directly to non-resident central banks to intermediate towards the private sector abroad. How large these have to be depends on the overall shock in the United States, which remains uncertain.
China. Being the key bilateral counterparty to the US deficit, China serves as a crucial intermediary for dollars globally. Absent sufficient US fiscal support, a reduction in imports will drive the US towards external balance and—other things equal—China into smaller surplus or external deficit. As in 2010/11, China will likely choose an expansion in credit and spending to offset the negative impact on the domestic economy. However, credit is already elevated there, and the possibility is real that the external constraint will bind as China’s surplus has been depleted substantially since 2010. Absent sufficient non-resident inflows into RMB assets, it seems unlikely China will allow international reserves to be depleted substantially. So, the counter-cyclical response might not be sufficient to save the world as in 2010—and as corollary, China will not recycle dollars globally to offset any missing US stimulus.
Germany and euro area. The monetary-fiscal response in the euro area is taking shape into a substantial package of measures. The ECB’s APP expansion and PEPP imply about 10% of GDP purchases this year of government and private assets. This supports bond prices and (at least temporarily) removes the balance of payments constraint from the periphery. Meanwhile, Germany is expected to announce on Monday a substantial fiscal expansion and state support for corporates (via KfW), which will increase assets the ECB can buy and remove the issuer limit.
For Germany, however, the impact of a contraction of trade driven by the US and a less aggressive China will be to lower the external current account surplus. Together with a strong fiscal expansion, it is possible that individual countries (Spain, Italy, Portugal?) and maybe the euro area as a whole will run current account deficits Germany’s surplus is probably too large to turn to deficit but should fall sharply.
In a sense, except for the current account, Germany plays the role within the euro area that the US plays for the world as a whole. In period of risk off, euros flow from the periphery to Germany, and Germany is the recipient of capital inflows. In this sense, Germany needs to recycle these euros in support of the periphery. This could happen through sufficient fiscal expansion which supports German demand and peripheral exports. Absent this, ECB APP and the TARGET2 system serves to provide the external support to prevent the periphery’s external financing constraint binding. This is equivalent to the Fed’s swap lines in the global context.
United Kingdom. The UK’s main weakness is an already large external deficit—about 4.5% of GDP—meaning the private sector was already in deficit before the Crisis hit. Being pushed even further into deficit while trade flows are contracting makes the UK uniquely exposed. Access to the US swap lines are useful, but these are small compared to the total external financing need. And while the fiscal response has correctly been aggressive, the UK requires non-resident buyers to gilts to hold things together. This will happen, but only at the right price.
Emerging markets. Meanwhile emerging markets are caught between these shifting tides of global trade and dollar flows. While many have large reserve assets, some do not. Others are exposed to the commodity squeeze. Others still have large dollar liabilities. Those without reserves or a USD swap facility have to rely on weaker currencies, IMF support, or hope for an SDR allocation.
END.
The General Theorist 