26 Mar 2020

This time is different


‘Generals fighting the last war’ also applies to policymakers in general. The memory of the financial crisis of 2008/9 is still very fresh. This is the reason why financial markets will not collapse this time. Policymakers at every level are using every lever at their disposal to avoid a repeat of the freezing of financial markets, which was so damaging ten years ago. Then, the reaction was somewhat delayed and initially confused, especially in Europe, because financial crisis and government defaults were not part of the lived experience of policymakers and the public. But the lesson was learned and is now being applied at a vast scale throughout Europe and the US.

There is a second lesson from military history: armies with actual combat experience are much stronger. It is this lack of experience that has been crucial to the delayed response on both sides of the Atlantic. Neither Europe nor the US have experienced a public health crisis of this type for over a hundred years – since the Spanish Flu of 1918. However, countries in Asia learned hard lessons from the SARS outbreak just under twenty years ago and reacted much more quickly with drastic containment measures.

The emerging narrative: “The example of China shows that dictatorships are better a fighting an epidemic” is thus wrong. What made the difference this time was that the society had had an experience with this type of problem. All the countries in Asia that had to deal with SARS (which fortunately did not become a pandemic) were able to flatten the curve of contagion fairly quickly. Democracies can fight against a virus as efficiently as a dictatorship. Open societies also have the advantage that unpleasant information cannot be suppressed as happened initially in China.

For Europe and the US, this outbreak constitutes a surprise attack by a hitherto unknown enemy. No wonder that the initial response has been disorganised and late. This botched initial response on the public health front is also the reason why financial markets are now reacting so violently. Initially, the market expected a sharp but short recession for China, followed by a ‘v’ shaped recovery- and, implicitly, that the virus would not spread much outside the country. However, as public authorities dithered throughout Europe and the US, the virus was able to take hold everywhere. Without intervention, cases seem to multiply by a factor of 4 to 5 in one week, 20 in two weeks and can rise more than 100-fold in a single month. The price of a few weeks of hesitation, denial and outright ignorance was thus huge.

What is different about this crisis is that it has not been caused by an internal build-up of imbalances, like excessive lending to house owners or weak peripheral states in Europe. It is now the spectre of a prolonged period of enforced inactivity with many potential bankruptcies from airlines to restaurants and hairdressers which is driving valuations down. Given the uncertainty about how the health crisis will evolve, investors are trying to sell all risky assets and hunker down until the uncertainty is resolved. This ‘mad dash for cash’ leads to a chain of fire-sales that disrupt normal relationships and threaten the very functioning of markets. Fortunately, central bankers have learned the lesson that they need to prevent this kind of doom loop. The Federal Reserve and the ECB have therefore initiated large programmes to buy everything scarred investors want to dump right now.

The hoarding of cash in a crisis has been compared to the panic buying of toilet paper one can observe almost everywhere now. There is one difference: the supply of toilet paper is limited; it takes time to increase production. By contrast, central banks can create unlimited amounts of money instantaneously. There can thus be little doubt that the central banks can ultimately calm markets.

However, restoring calm on the wider financial markets will not be sufficient. First of all, only larger companies depend for their financing on the financial markets. Small and medium-sized enterprises employ over 4/5th of the entire workforce, even in the US. This crucial sector is not much affected by the gyrations in the commercial paper or other securities markets, as it relies on banks and the continuous cash flow from sales. While central banks ensure that markets and the plumbing of finance continues to work, they cannot do much to help millions of small businesses to survive a prolonged period of zero cash flow. This means governments have to step in with generous loan and other support programmes to prevent widespread bankruptcies. But as they have the experience of 2008/9 still fresh in their memory this is being done on a grand scale, albeit in very different ways from country to country.

Ultimately the world economy will restart since all the capital, technology and the work force are still there. Experience suggests that consumers will resume their spending pattern much as before. The same happened even after the Spanish Flu of 1918 which led to an estimated 20-50 million deaths. Public health measures at the time (at the end of a long war) were patchy, allowing the virus to return more than once. But despite all this, the recession lasted less than a year.

If the combined effort of central bankers and governments can keep financial markets working and prevent mass bankruptcies, there is a good chance that the now unavoidable recession can be followed by a vigorous recovery once the virus has been contained. It is on this front, how to protect public health, that Western societies have to learn and adapt quickly.