Extreme Economic Times require Extreme Measures.
Conventional economic thinking is inadequate in the current crisis. This situation is too extreme and sudden. It's a time for practical immediate solutions to ensure people can meet their basic needs and the economic system can tick over in some form.
If viable businesses collapse because of short term liquidity issues our economy could be munted for a very long period. "Munted" is a technical economic term. It will take a long time to re establish these businesses once this crisis passes. The costs to our society in jobs, incomes and confidence will be huge. Not to mention the personal costs. These businesses in areas such as tourism, farming, forestry, entertainment and retail are key parts of our economy. No business owner could have foreseen the current situation. If these businesses are allowed to fail due to a lack of liquidity it will be horrendous for our economy.
What is evident is that in financial terms, people and businesses with substantial debt will be hit the worst in the short term. They face an immediate liquidity crisis . They need to keep servicing their debt regardless of their income levels. They are under enormous pressure as events rapidly unfold. If good businesses are allowed to fold due to a Liquidity crisis it will take a very long time for our economy to recover.
A liquidity crisis means a business is unable to generate short term cash flows to meet its immediate payments. It does not mean the business is not viable in the long term. It just means current inflows of cash are not sufficient to meet current outgoings.
The main tool for fighting recession in recent decades has been monetary policy. During downturns such as the GFC, the Reserve bank slashed interest rates. This encourages people and businesses to borrow and spend more. This can pump up economic activity leading to more demand and jobs and incomes which creates a ripple effect throughout the economy. This ripple effect is known as the multiplier.
But this multiplier can work in reverse when things turn bad. An external shock like this virus cuts incomes and spending leading to job losses and a loss of confidence and further falls in incomes and spending. A nasty negative feedback loop.
The current situation is unique due to its speed and immediate impact on cash flow for businesses and the wider public. The GFC was about a liquidity crisis in the financial sector. This is a liquidity crisis in the broader economy. It's nastier in implications. Cutting interest rates is unlikely to have much immediate effect. Nor is an increase in government spending on infrastructure. They are too long term and uncertain in their effects. This crisis is here and now.
There are two options during a liquidity crunch in the wider private sector. Either the private banking sector provides support to debtors to allow them to keep afloat, or the central bank steps in.
Don't hold your breathe for the latter. Banking shares have taken a big hit in anticipation of bad debts. The banks are generous lenders during boom times but hard task masters during slumps. This slump is unprecedented in modern times in its immediacy and wider impact on the economy.
That leaves the Reserve bank as lender of last resort for the wider community. We are very fortunate that we have our own currency, unlike countries in the European Union. . Our Reserve bank can create this currency at the click of a mouse. These days it doesn't have to resort to the printing press. Most modern money is digital. It's debits and credits in bank accounts .
This crisis is very immediate and broad based throughout our economy. The Reserve bank could establish a short term lending window for businesses facing immediate liquidity issues. It could work through the banking sector to provide mortgage holidays to those whose jobs and incomes have suddenly disappeared. It could provide a life raft to allow them to stay afloat in extreme times.
A core Lesson of the GFC suggests that such policy does not create rampant inflation. Quantitative easing by the Federal reserve in the United States did not lead to rampant inflation, despite dire predictions. It likely prevented another Great Depression. People aren't going to go on a huge borrow and spending spree during a time of such uncertainty. Providing an immediate debt holiday to those affected allows the economic engine to tick over during an extreme time. The alternative is a nasty debt implosion that could cripple our economy. The last thing we need is a housing market collapse if people are unable to service their mortgages and viable firms are allowed to collapse. In such a scenario we will find that deflation is a much nastier curse than potential inflation.
Extreme times require extreme measures.
Peter Lyons (M.Comm) teaches scholarship-level Economics and has authored several New Zealand curriculum economic texts. His inspiration often comes after a dram of whiskey. Just one mind you. So if you're ever stuck in a room full of economists, grab the seat next to him. For a conversation peppered with wit, wisdom and weirdness.
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