By Robin Marshall, Director, Fixed Income
The sheer scale of the Great Lockdown impact is forecast to dwarf the GFC
The sheer scale of the economic contraction caused by the coronavirus shock and Great Lockdown is emerging (although much still depends on the length of the Lockdowns, unemployment levels, business survival rates and how far consumer behavior adjusts). For example, the IMF now projects the Great Lockdown contraction as the greatest since the 1930s depression, dwarfing the GFC recession, with an estimate of -3% global growth in 2020 vs only -0.1% in 2009 (IMF, April 2020).
Some central banks have implicitly conceded marginal changes to the QE programs used in the GFC are unlikely to restore acceptable levels of employment and inflation. Therefore, both the Fed and ECB have now broadened their QE asset purchases to include lower grade corporate credit. But these changes still remain modest given the IMF is forecasting an output loss of about $9 trillion in the global economy from Covid-19. At least central banks have balance-sheet room to expand QE programs substantially.
Central bank balance sheets as a % of GDP
Source: FTSE Russell / Refinitiv. Data as of April 2020.
…forcing policy makers to consider responses on a scale previously unimaginable
Given high debt/GDP ratios, alternatives to debt-financed fiscal stimulus, like helicopter money (fiscal stimulus financed by printing money), have been raised (see FTSE Russell blog post on Helicopter Money. Theoretically, central banks are not limited in the amount of extra reserves they can create, so this could be done on a huge scale to finance government stimulus.
For the EU, where the IMF is forecasting a contraction of 7.5% in 2020, but the impact of the shock is uneven, the urgency of the joint policy response is driven by the existential threat to the future of the Eurozone posed by the shock. ECB President Christine Lagarde has already proposed some form of coronavirus bonds be issued by Eurozone members, and the Spanish government has proposed a €1.5 trillion perpetual coronavirus bond in the Eurozone to finance economic recovery.
Helicopter money raises governance and moral hazard concerns
But moving beyond debt-financed fiscal stimulus and QE programs raises issues of governance and moral hazard*. Bank of England Governor Andrew Bailey has declared the BoE will not be financing central government through helicopter money because “Using monetary financing would damage credibility on controlling inflation by eroding operational independence” (Financial Times, April 5, 2020). But there is evidence from the UK central government’s Ways and Means Facility that it is already using money from the BoE to finance expenditures (just as it did during the GFC, on a modest scale).
But central banks could impose strict conditions on the money financing of government
The concern about governance and moral hazard with helicopter money is that without appropriate checks and balances, governments may use central bank money printing to finance reckless expenditures, jeopardising the economy and currency (as in Zimbabwe). Yet there is no reason why proper governance cannot be introduced, with the central bank controlling the process, just as central banks currently control QE programs.
Strict conditions could be imposed on how, and when this emergency central government account at the central bank could be used, including reference to the inflation target, and financial stability. Central banks already come very close to monetary finance of central government in QE programs, buying government bonds. The main difference being that this is designed to be temporary finance, to be unwound in future, as opposed to a permanent increase in the money stock in helicopter money. After a massive deflationary shock to global demand, it could be argued economic conditions for helicopter money, with appropriate governance controls, are appropriate.
Some moral hazard may be inevitable, if central banks are to do enough to meet the challenge
The scale of the global policy challenge means trade-offs for policy makers between adopting more radical policy, like helicopter money, to restore economic stability, and the risk of moral hazard, are becoming more acute. Already, extending QE purchases to corporate bonds, including sub-IG bonds, means central banks have accepted some deterioration in the asset quality of their purchases and an increase in moral hazard.
Buying equities as part of QE, and a move to full-blown helicopter money would extend these risks and the moral hazard. But erring on the side of doing too little and allowing economic conditions to spiral downwards in a self-feeding contraction, like the 1930s, might carry even higher risks.
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*Moral hazard is defined as a situation in which an individual has an incentive to increase their exposure to risk, because they do not bear the full cost of that exposure.
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