A CO.VI.D.-19 Recession is Imminent, Inevitable, and Impossible to Gauge
A few months ago, I wrote an article forecasting the next recession. Of all the things to spark the next economic downturn, though, I honestly did not expect a global pandemic to be one of them. Unfortunately for us, this outbreak likely will start a recession; how bad it will be is the only remaining question on economists’ minds.
The tragic deaths of thousands and the disruptions to daily life around the world are terrible enough, but now the CO.VI.D.-19 coronavirus is threatening the state of our economy—including millions of people's jobs and livelihoods. The fact that coronavirus is starting a downturn is widely accepted by now. The traditional measure of a recession is two quarters of consecutive negative G.D.P. growth, and forecasters across the spectrum see that scenario playing out. CNBC contributor James Pethokoukis reports that JP Morgan is forecasting negative G.D.P. growth of negative two percent in the first quarter and negative three percent in the second quarter this year. He also reports Barclays predicts negative growth through the second and possibly third quarter depending on the government response to the downturn. Capital Economics predicts a negative four change in G.D.P. for the second quarter and total stagnation in the third. These forecasts vary from bad to worse, but they all foresee a recession under the traditional definition. Why is coronavirus causing such a severe impact? The reason is the dependence of the U.S. economy on consumer spending. According to statistics from the end of 2019, approximately 69 percent of G.D.P. is consumer spending: buying groceries, getting haircuts, eating out, etc. When companies and events across the country close down and people stay home because of coronavirus, consumer spending collapses.
The stock market has taken an increasingly severe beating over the last few weeks. We are officially in a bear market, meaning at least a 20 percent drop from recent highs and negative investor outlooks. On Thursday, the Dow Jones and S&P 500 had their biggest one-day drops since 1987. I watched live on television as, just minutes after the opening bell, the stock exchanges shut down because of the activation of “circuit breakers” (an automatic shutoff of trading due to a huge drop in prices). These circuit breakers also activated a few days prior. Stocks have seen upswings every few days, but the general trend has been a dramatic downturn.
Treasury bond yields have also suffered. During most of February, we saw an inverted yield curve (a consistent indicator of an oncoming recession). In the last few weeks, however, we saw the yield curve not so much invert but completely crash. For the first time in history, the yields for all treasury bonds fell below one percent. Business Insider explains that investors are “worried… about a global slowdown and a wide sell-off of higher-risk assets.” They are scrambling to buy up any asset that can be deemed safe, such as treasury bonds, because the underlying economy is failing.
The headline domination of coronavirus also obscured the oil war between O.P.E.C. and Russia. Saudi Arabia, who leads the Organization of Petroleum Exporting Countries, asked Russia to cut back oil production to keep prices stable, but Russia refused. In retaliation, Saudi Arabia promised to overproduce and lower prices—starting a race to the bottom of oil prices worldwide. This war led to the biggest crash in crude oil prices in decades, and the downturn could continue further. The crash has already plagued the stock market, but more dangers lie ahead. Many countries around the world rely on oil sales to sustain their economy; if prices fall, those economies could follow suit.
Despite the widespread acceptance of recession, forecasters expect a quick turnaround by the end of the year. I am not as optimistic. I fear that these predictions put too much faith in the underlying economy and see coronavirus as a passing problem instead of the spark of something worse.
The repo market, which I brought up in my previous article, is back in the news. The Fed announced $1.5 trillion in new repo market operations to keep it afloat. This dramatic expansion further proves how volatile and dangerous the repo market is becoming. While repo market rates have remained stable for now, the stability is entirely subsidized by the Fed. The risk of a repo crash and subsequent crackdown on new credit remains strong. Such a crunch could tank the economy further and for much longer.
This recession will also imperil millions of working people. Up to 80 percent of Americans work paycheck-to-paycheck; if layoffs start, people will start to miss rent and utility bills and lack funds for enough groceries. Additionally, school closures nationwide could leave millions of children without the free or reduced lunches that families rely on and force parents to stay home or shell out for daycare for their children. Both of these problems will put even more stress on household finances. The stock market crash only compounds this issue. To quickly rebound stock prices, corporations will be eager to shrink labor costs, which means layoffs or pay cuts. This tendency could create a second round of unemployment and add to the problem.
The consequences could go beyond even the terrible, months-long hardship imposed on these families. With fewer paychecks to go around, those paycheck-to-paycheck households may end up skipping payments. People could lack the funds for their credit card payments. Or their auto loan payments. Or their student loan payments. Or any other payments towards the $14 trillion in household debt in the U.S. This debt, the highest nominal level ever recorded, equals 76 percent of our G.D.P. If the recession lasts long enough or the government response is weak enough, we could see delinquency rates and possibly default rates spike. In normal times, this could lead to a crackdown on new loans, but Fed rate cuts might solve this problem. The real issue is how increased delinquency and defaults could affect the derivatives market. The byzantine world of shadow banking builds loans and debts into derivatives, which themselves are spun into more and more derivatives. The 2007 Financial Crisis started because mortgages started to default, leading to the endless chains of dependent assets to fail. If loans across the board start to suffer, derivatives today could enter a similar chain of collapse. The derivatives market is already an unregulated house of cards; what happens when it starts to fall over?
Households are not the only entities that could pop these bubbles. Corporations hold a record-breaking $9 trillion in debt, with little cash-on-hand to cover it in an emergency. During the recession, we could see another wave of delinquency and defaults as corporations lack the revenue to pay off their debts. In 2019, 40 percent of first-time corporate bond-issuers in North America were rated BBB, which is double the rate of the last recession. The BBB rating is the lowest that can still be considered “investment grade,” which implies stability and a low chance of default. If, during the recession, credit rating agencies start to downgrade corporations’ ratings, the market for bonds could dry up. Investors would be spooked and even high-rated corporations will find it hard to access new lines of credit in the bond market—completely paralyzing corporate America. The derivatives market is also at risk here. If corporations get their credit ratings downgraded en masse, derivatives lose their value overnight. The assets’ prices will crash as their root sources become less valuable. Corporate default and credit downgrades could, therefore, collapse the derivatives market and create another financial crisis.
The widespread downgrade of corporate credit ratings will also cripple banks. A wave of downgrades would force banks to improve their capital ratios, usually through issuing more stock. Such measures will crash the stock prices of banks further, deepening the market plunge. Financial institutions will also have to sell the downgraded assets if they are internally or legally required to only own investment-grade assets; this selloff would crash financial markets further. Mass downgrades also undermine our entire regulatory framework for preventing another financial crisis. Maintaining capital requirements is one of the key protections in post-Financial Crisis regulations, but banks could see their capital become insufficient overnight. This shock forces banks to issue ever more stock and, if the crisis is really, really bad, puts them at risk for needing bailouts.
The government's response to the economic crisis has already been exhausted. The Fed has slashed rates to zero, removed reserve requirements entirely, and started a process called quantitative easing. These are policies straight out of the Great Recession, and we have just begun. It took months after the start of the last recession for the rates to hit zero. These measures have a chance of working, but if they do not the Fed is out of options. There's simply nothing left for the Fed to do outside of setting a never-before-seen negative interest rate. In terms of fiscal policy, a stimulus plan is in the works, but we have already been at Great Recession levels of deficit spending because of Trump’s budgets. There is, again, not much more that can be done. None of these measures even account for the fact that businesses are shutting down no matter what. Restaurants, amusement parks, sports stadiums—everything is going to close for the foreseeable future no matter what the Fed does or how much money Congress appropriates. None of the conventional recession tools will do anything if we enter a lockdown due to coronavirus. Among the only measures possible are the government writing checks to people so they can pay their bills or enacting a payment holiday for all debts and utilities. With a Republican White House and Senate, those policies seem unlikely.
The dangers of a credit crunch, derivatives crash, repo collapse, and bank crisis make the coronavirus recession much more perilous. I foresee three possible scenarios for the coronavirus recession. The best-case scenario assumes, like most of the forecasters I listed at the beginning of the article, that the pandemic and economic downturn are quickly turned around. In this scenario, the government successfully contains the outbreak and mitigates the recession. We would suffer through a few months of recession, but the economy would rebound by the end of the year and unemployment would go back to normal. In addition to lessening the hardship of laid-off workers and their families, the best-case recession corrects the overinflated stock market. The government might also bail out some debt in the economy—deflating that crisis, as well.
The medium-case scenario assumes that the pandemic sticks around longer or the government response is weaker. G.D.P. growth does return, but it returns only at the end of the fourth quarter or in 2021. The recovery is sluggish and above-normal unemployment persists longer. Overall, the economy rebounds but much weaker than before. Important to note here is that the coronavirus might return for the next winter, even if we contain it now. If the outbreak repeats itself, this scenario is more likely.
The worst-case scenario assumes that the repo market, debt bubble, derivatives bubble, banks, or some combination of those four collapses (and that the government fails to mitigate the fallout). This scenario is a full-on financial crisis that repeats the events of the late 2000s. Another Great Recession explodes unemployment, crashes G.D.P., and drags on the economy for years. Banks need to be bailed out, bankruptcies increase, and millions of households see their finances ruined. An economic catastrophe, to put it plainly.
There is no certain way to tell which scenario is most likely or which one will eventually occur. I would, however, refrain from dismissing the worst-case one so easily. Almost no one saw the Great Recession coming, yet it came anyway. Pundits on cable news and spokespeople from financial institutions consistently place way too much faith in our economy and overlook problems. In many ways, our economy is weaker now than it was 12 years ago. The fact that the government has exhausted so many of its options before the recession has even begun is worrisome. Tens of millions of people in this country could see their lives ruined, and another generation of young people could see their futures crippled. The risks of the coronavirus recession necessitate the government containing this pandemic and downturn quickly and efficiently. Whether the Trump administration and current Congress can accomplish this feat is, unfortunately, debatable.
Katharine Sciackitano is a first-year C.L.E.G. major in the School of Public Affairs. She is the Deputy Editor for Economics for the Agora.
Image courtesy Shealah Craighead, Creative Commons