Triggering a Global Financial Crisis: Covid-19 as the Last Straw

Yves here. I hope readers won’t get sidetracked from this post’s discussion of how to implement a debt jubilee by quibbling with its set-up. Some (in particular Lambert) take issue with the notion that COVID-19 is a black swan, since epidemiologists had been warning of the risk of a pandemic for well over a decade. But economists live in a bubble and are unwilling to incorporate the findings of other social sciences into their work, so a discipline like public health is barely on their radar. Or to put it another way, despite a pretty popular movie, Contagion, showing how a pandemic would lead authorities to require people to shelter at home, outcomes like that were treated as fiction by too many politicians and policy makers. Hence the risk of a global sudden shock was something to wild-eyed even to consider.

I don’t think Öncü fully comes to grips with who “lenders” are. For instance, debt investments are important parts of the assets of pension fund, endowments and foundations. Öncü seems to think that they are held significantly by wealthy individuals, when in the US, that isn’t the case.

He finesses the core problem that was dodged in 2008: how to apportion losses on bad loans. Öncü seems to think they can be redistributed. But instead, the priority then was on preserving institutions and existing power structures, and no one cared much if that meant throwing borrowers under the bus. After all, they must have been profligate to have gotten themselves in this mess.

By T. Sabri Öncü (sabri.oncu@gmail.com), an economist based in İstanbul, Turkey. This article was written on 8 March 2020 and first published in the Indian journal Economic and Political Weekly on 14 March 2020

Whether a black swan or a scapegoat, Covid-19 is an extraordinary event. Declared by the WHO as a pandemic, Covid-19 has given birth to the concept of the economic “sudden stop.” We need extraordinary measures to contain it.

Initially referred to as the novel coronavirus 2019, the coronavirus disease (Covid-19) originated late in 2019 in Wuhan, China and was first reported to the World Health Organization (WHO) Country Office in China on 31 December 2019. Rapidly becoming an endemic, it was declared by the WHO a “Public Health Emergency of International Concern” on 30 January 2020.

Covid-19, now present in more than 100 countries, has been declared a pandemic by the WHO. However, the global financial markets had declared it a pandemic in the week that started on Monday, 24 February 2020, by overwhelmingly vouching for pandemic. They did this through the fastest equity market correction of all time that took place in about six to seven days, where a correction is defined as at least a 10% drop from the peak. There remains a second question which still is debated, and it is about whether Covid-19 is a swan or a goat.

Swan, Goat or Both?

While the origin of the concept of goat (specifically, scapegoat) is Chapter 16 of Leviticus, one of the early books of the Bible, the origin of the concept of swan in the current context is from Black Swan. There is also the white swan, which originated in Crisis Economics: A Crash Course in the Future of Finance. A scapegoat is a person or an event blamed for the wrongdoings, mistakes, or faults of others, especially for reasons of expediency. As for the two swans, a black swan, as defined by Taleb (2007), is an unpredictable outlier event with an extreme impact, and a white swan, as defined by Roubini and Mihm (2010), is the same as a black swan except that it is predictable.

Although, in a recent essay, Roubini (2020) identified several white swans for 2020 that “could trigger severe economic, financial, political, and geopolitical disturbances,” such as the escalation of the ongoing cold war between the United States (US) and China to a near hot war, and the potentially catastrophic effects of climate change, even he did not refer to Covid-19 as a white swan as it was an undeniably unpredictable event. So the real debate is whether Covid-19 is a black swan or a scapegoat.

Although we could not have predicted it, Covid-19 was not the reason, but just the trigger for the ongoing financial crash as all we needed was the proverbial straw to break the finance sector’s back (Öncü 2015). With asset price bubbles everywhere and the total global debt over 322% of the world gross domestic product in the third quarter of 2019 (IIF 2020), something had to trigger what is happening now.

‘Economic Sudden Stop’

But Covid-19 was not just any trigger as it gave birth to the concept of the economic “sudden stop.” When the global equity markets dropped on 31 January 2020 following the WHO declaration of the Public Health Emergency of International Concern, El-Erian (2020) warned the investors on 2 February 2020 that they should snap out of the “buy the dip” mentality. Pointing out two vulnerabilities, namely structurally weak global growth and less effective central banks, he introduced the concept of “sudden stop” economic dynamics.

Although El-Erian is yet to define what exactly an “economic sudden stop” is, I take it as an abrupt onset of a deep recession. In the case of Covid-19, it is a sudden stop of economic activity resulting in supply and demand shocks to the global economy as major cities in infected countries, more than 100 and counting, are put on lockdown. And, add to that the deepening oil price war between Russia and Saudi Arabia.

Shortly after 6 pm on 8 March 2020 in New York, the futures markets opened and oil futures (both Brent and WTI) are trading about 21% down, gold is above $1,700 per ounce, and all United States (US) equity index futures are trading about 4% down. What is worse is that with the long-term US Treasury yields at their historical lows (10-year yield below 0.5% and 30-year yield below 1% as I write), the capital markets are frozen (not to mention many oil projects that will go bust at these prices).

Disorderly Deleveraging

All this means that what I claimed inevitable in my column (Öncü 2019) has already started: a disorderly global non-financial private sector debt deleveraging, which is likely to lead to deep global debt deflation, followed by a recession (and possibly a depression), thereby creating financial and economic instabilities, and further tensions in international relations with dire consequences for emerging and developing countries, not to mention developed countries.

As mentioned in Öncü (2019), while in developed and high-income developing countries, the non-financial private sector is more over-indebted, in middle-income and low-income developing countries, the public sector is more over-indebted. Given that the global non-financial private sector debt deleveraging has already started, the analysis in Öncü (2019) indicates that the public sector debts of the developed and high-income developing countries will also go up and the governments’ ability to rescue their economies will also decline in these countries. Furthermore, this will severely constrain the governments’ ability to spend on climate change-related projects to address the potentially catastrophic effects of climate change for many years to come, diminishing our hopes to make the necessary investments and innovations to address the now existential climate crisis on time. Last, but not least, the measures we have to take to control the spread of Covid-19 before a cure is found will further challenge the financial system, as people stop earning an income and businesses go bankrupt (Keen 2020b).

Orderly Deleveraging

In this column last year, I looked at the German Currency Reform (GCR) of 1948 as a modern example of debt restructuring to see if it could be adapted for use now (Öncü 2019). Recall that the original plan of the GCR consisted of (i) conversion of currency and debts at a ratio of 10 reichsmarks for one deutschemark, and (ii) a fund built with a capital levy for the equalisation of burdens (Lastenausgleich) to correct part of the inequity between owners of debt, and owners of real assets and shares of corporations. As the actual GCR deviated from the planned GCR in that it required all financial institutions to remove from their balance sheets any securities of the Reich and cancel all accounts and currency holdings of the Reich, it impaired the balance sheets of nearly all of the financial institutions. The equalisation claims were the solution, which were interest-bearing government bonds of a then non-existing government and had no set amortisation schedules. They later became bonds of the Federal Republic of Germany, established on 23 May 1949.

In his two Patreon posts, Keen (2020a, 2020b) proposed several extraordinary measures including the “Modern Debt Jubilee” (MDJ) of Keen (2017) that the governments, central banks and financial regulators should take now to stop the health effects of Covid-19 triggering a financial crisis that could in turn make Covid-19 worse. Supporting these immediate measures wholeheartedly, I add a globally coordinated deleveraging framework to be considered later that Ahmet Öncü and I have proposed in Öncü and Öncü (2020a, 2020b). Our proposal is a blend of the MDJ and the GCR.

In our framework, there would be three authorities to maintain a deposit account at the central bank in each country: a deleveraging authority for leverage reduction, Lastenausgleich authority for capital levies, and a climate authority for financing needs in developing national climate plans. These national authorities should be globally coordinated through the appropriate United Nations agencies.

The Lastenausgleich authority would be under the finance ministry, whereas the deleveraging and climate authorities would be not-for-profit corporations promoted by the government. The government would capitalise the deleveraging and climate authorities by the Treasury-issued zero-coupon perpetual bonds, that is, our proposed equalisation claims. The deleveraging authority would then sell its equalisation claims to the central bank in exchange for an increased balance in its deposit account at the bank, while the climate authority would wait until the deleveraging concludes. Further, the climate authority would not be allowed to open deposit accounts to its borrowers to ensure that it would be a pure financial intermediary, not a bank.

Assuming that a globally agreed-upon debt reduction percentage that would bring the global non-financial sector leverage well under 100% is determined, and that all countries agree to act simultaneously, the framework is as follows (i) the financial institutions comprising the banks and non-bank financial institutions (NBFIs) write down all the loans and debt securities on both sides of their balance sheets by the required percentage; (ii) the deleveraging authority compensates the banks and NBFIs for the loss if any; and (iii) the deleveraging authority pays each qualified resident their allocated amount less than the debt relief if any. If an NBFI gains after the above debt reduction, it should owe equalisation liabilities to the deleveraging authority of its jurisdiction. Note that as all debts mean all debts, public sector debts will also be written down by the same percentage except the official debts of the sovereigns that fall out of the scope of our proposed framework and should be handled by other means.

After Deleveraging

After deleveraging, the balance of the deleveraging authority account at the central bank goes down whereas the total balance of the bank accounts (reserves) at the central bank go up by the total payment made by the deleveraging authority. Hence, the base money goes up by the total payment of the deleveraging authority. Since NBFIs and residents cannot maintain deposit accounts at the central bank, they have to be paid through a bank which creates deposits for the NBFIs and residents against reserves. Hence, the broad money goes up by the amount of the payment to the NBFIs and residents.

One issue is that in many countries, the bank and NBFI balance sheets are multi-currency balance sheets. However, the deleveraging authority payments are in domestic currency, which may create currency risk for some banks and NBFIs. Backed by the central banks, the globally coordinated national deleveraging authorities should stand ready to intervene to avoid potential crises.

The authorities would require their domestic banks and other financial institutions to spend an internationally agreed-upon percentage of their newly found money, if any, after the deleveraging on the interest-bearing, finite-maturity bonds the national climate authorities would issue. Since the promoter of the climate authority is the government, the bonds of the climate authority would have the same credit with the government bonds, and the central bank would accept the climate authority bonds in its open market operations. Therefore, the climate authority bonds would be the main tool to manage the reserves and deposits created through the equalisation claims. In addition, the climate authority bonds could be used for the greening of the financial system through the investment of foreign exchange reserves of the central banks proposed by the Bank of International Settlements (BIS 2019).

Lastly, equipped with a “globally coordinated wealth registry” (Stiglitz et al 2019), the Lastenausgleich authorities would collect progressive wealth taxes from the owners of real and non-debt financial assets for the equalisation of burdens. While a part of these taxes could be used to retire some of the equalisation claims and the corresponding reserves and deposits created in the deleveraging process, another part could be transferred to the climate authorities, and the rest could be spent in the interests of the society.

References

BIS (2019): Green Bonds: The Reserve Management Perspective, Bank of International Settlements, https://www.bis.org/publ/qtrpdf/r_qt1909f.htm, viewed on 18 December 2019.

El-Erian, M (2020): “Coronavirus Should Snap Investors Out of ‘Buy the Dip’ Mentality,” Financial Times, 2 February.

IIF (2020): Global Debt Monitor, International Institute of Finance, January, https://www.iif.com/Research/Capital-Flows-and-Debt/Global-Debt-Monitor.

Keen, S (2017): Can We Avoid Another Financial Crisis? Cambridge and Malden: Polity Press.

— (2020a): “A Modern Jubilee as a Cure to the Financial Ills of the Coronavirus,” 3 March, https://www.patreon.com/posts/modern-jubilee-34537282.

— (2020b): “Thinking Exponentially about Containing the Coronavirus (corrected),” 3 March, https://www.patreon.com/posts/thinking-about-34565061.

Öncü, T S (2015): “When Will the Next Financial Crisis Start?” Economic & Political Weekly, Vol 50, No 24, pp 10–11.

— (2019): “Non-financial Private Debt Overhang,” Economic & Political Weekly, Vol 54, No 45, pp 10–11.

Öncü, A and T S Öncü (2020a): “A New Framework for Global Debt Deleveraging: Globally Coordinated Deleveraging Authorities,” forthcoming.

— (2020b): “Debt, Wealth and Climate: Globally Coordinated Climate Authorities for Financing Green,” forthcoming.

Roubini, N and S Mihm (2010): Crisis Economics: A Crash Course in the Future of Finance, New York: Penguin.

Roubini, N (2020): “The White Swans of 2020, Project Syndicate,” 17 February, https://www.project-syndicate.org/commentary/white-swan-risks-2020-by-nouriel-roubini-2020-02.

Stiglitz, J E, T N Tucker and G Zucman (2019): “The Starving State: Why Capitalism’s Salvation Depends on Taxation,” https://www.foreignaffairs.com/articles/united-states/2019-12-10/starving-state.

Taleb, N (2007): The Black Swan: The Impact of the Highly Improbable, New York: Penguin.

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26 comments

  1. PlutoniumKun

    This month certainly has the feeling of a genuine inflection point in history. Even the most sober grey commentators are talking about a massive reversal of globalisation and potentially mass bail-outs (most can’t bring themselves to say the words ‘privatisation’, but that is indeed what is going to happen to vast swathes of the world economy). When Republicans in the US are openly talking about UBI solutions (opposed of course by corporate Democrats), you know something big is up.

    In the last crash, the broader left was caught completely on the wrong foot and unprepared to take advantage. So banks and key industries were bailed out and let go to wreck even more havoc. I’m not optimistic that we are more prepared with ideas this time. Ironically, it seems to me that much of the right (especially in the US and UK) is fully prepared to take the best ideas from the left and use them for their own aims.

    This will be a battle of ideas – I can only urge everyone to circulate MMT and Debt Jubilee and Jobs Guarantee articles as widely as possible so we don’t see a re-run of 2009.

    Reply
    1. teacup

      Agreed – I have a faint hope that MMT goes mainstream. This is a great teaching moment to inverse the bs of trickle down theory, as well as differentiating between good vs bad debt. Euthanize the rentiers!

      Reply
      1. Amfortas the hippie

        i’ve been a-wandering on the net, in places i usually ignore…specifically Zerohedge.
        MMT is mentioned all over the place.
        and Mnuchin(sp-2) is apparently channeling Bald Hank in Senate circles and talking about depression era unemployment…like 30%.
        I’m making another run to the feed store today to obtain oat and wheat seed left over from fall, before anyone else begins to think along those lines.
        for me, “all stores within 50 miles out of bread/flour/cornmeal/etc”=” get ready to add bulk carbs to gardens”

        Reply
  2. Sabri Oncu

    Yves,

    I am in agreement with Lambert. Although the onset of Covid-19 was an unpredictable event, it is endogenous. I have kept calling it a goat rather than a swan since the beginning. Indeed, everything I have written here and elsewhere since 2015 had been warnings of what was coming and it came. Covid-19 was just the trigger.

    As for that debt investments are important parts of the assets of pension fund, endowments and foundations, and I don’t fully come to grips with who “lenders” are, this cannot be correct as I happen to be a former fixed income quant on the buy-side. These institutions will get compensated for their loss. Therefore, pensioners are protected, for example.

    Reply
    1. OpenThePodBayDoorsHAL

      Covid-19 may have been an “unpredictable event” but the incredible “dis-health” of the financial system, rendering it so incredibly vulnerable is not. Let’s recall:

      #1:First comes Productivity; then #2 Profit; then #3 Savings; then and only then comes #4: Investment. Trying to fast forward to #4 by extending credit to any and all cash flows and against any and all collateral turns that sound system on its head.

      Greenspan-Bernanke-Yellen, and now the hapless Powell is left trying to push on a string, just when we need some actual strings to pull.

      Everybody thought it was so great when we had such obvious signs of froth atop froth atop froth: WeWork “valued” at $47 billion dollars. We laughed as Boeing bought back $35 billion of their own shares (this is legal why, again?)

      And with no possibility of capitalism anywhere in sight: now Boeing, hat in hand, demanding a multi-billion bailout. Hello? Unbelievable private gain financed by completely socialized loss?

      We gave private financiers every last opportunity to create our money, against all evidence and against our Constitution. Time and time and time again they demonstrated they would radically abuse that exorbitant privilege to their own private advantage.

      The analogy that works for me is an engine. You give it more gas in order to go but you cannot over-rev it. Our engine redlines at 3,000 RPM, but the banking geniuses enabled by our CB geniuses have been running it at 5,000 RPM for a decade or more. An incredible amount of torque! It’s amazing! We’re all going to be rich! Little did they notice the temperature gauge climbing up to 11… of course it finally blew a gasket and threw a rod, now smashed in pieces at our feet.

      This is a financial disease as much as it is a biological disease, if we don’t wake TF up and have a clear discussion about what happened and why we will just rinse and repeat.

      Reply
      1. drumlin woodchuckles

        A President Newer Deal might “bail out” Boeing the right way. A leaner tougher meaner version of the GM “bailout”. All the stock will go to zero. All the executives who were “aboard ship” starting from the moving of the headquarters to Chicago will be investigated for tryable crimes. All the non-union shops and facilities will be liquidated in the most hostile and savage way.

        Boeing will be divided into ” bad boeing” and “good boeing”. “Good boeing” will be strictly the 100% unionised facilities in and around Washington State. The Engineers will decide which of themselves will be sent to “bussiness and management schools” for Engineerial managing. Etc.

        Reply
    1. Carla

      I, too, thought that PlutoniumKun in the excellent comment above probably meant “nationalization” and not “privatization.” Perhaps PK will weigh in and let us know.

      Reply
        1. Carla

          See, PK, even when you switch words around, we can figure out what you’re saying — that’s how good you are!

          Reply
      1. CoryP

        I think if you read it differently maybe the train of thought was “reversal of… (…privatization)”.

        Took me a few seconds to figure out as well.

        Reply
  3. Michael

    “”the core problem that was dodged in 2008: how to apportion losses on bad loans.””

    I think this is only part of the problem this time. Cash flow problems and the unwinding of levered positions bound together by complex financial arrangements may be geater. I believe many LTCM’s are lurking today.

    Will tenant’s claims of price gouging over the years by landlords be reversed when jobs are lost and income shrinks and rent isn’t paid and govt gets involved (no evictions for 60 days). Landlords may grudgingly accept delayed payments as long as they are paid in full (after all they have a mortgage to pay) and they get a payment pass for a period of time. But will rents be paid in full??

    Will social media be a force this coming April Fool’s Day to halt rent payments? It played a large part in convincing borrowers to not pay their loans in the GFC. Its already a hot topic on the few sites I read (not FB).

    Reply
  4. John A

    The black swan/white swan analogy had nothing to do with unpredictability originally. All swans in the northern hemisphere, then the only known world, are white. The assumption was that all swans are white. However, the far away country/continent Australia, for some reason, has black swans. This discovery effectively overthrew the then ‘known fact’ that “all swans are white”. The discovery of black swans was a shock to the system, nothing to do with unpredictability.

    Reply
    1. BlakeFelix

      It was unpredictable because previously all evidence pointed to all swans being white. Black swans were a never observed phenomenon, that suddenly appeared and instantly changed the definition of a swan. An unpredictable shock to the system is a black swan. A predictable system shock isn’t. Although people can argue whether shocks were predictable. I would argue that both a bad virus showing up someday and the whole debt funded service economy being fragile were easily predictable, but no one could predict this exact virus right now, so it’s black swandom is debatable but I would say it isn’t one. If the dead came back as flesh eating zombies it would be one, because all our evidence indicates that is impossible. Although I guess that gets predicted all the time, so it’s by definition not unpredictable lol. Black swans are kind of like porn in that they clearly exist but edge cases can be hard to call, to my understanding.

      Reply
  5. Ignacio

    My mind is quite opaque to debt structures these days so I didn’t try to rationalize the technicalities of the deleveraging process proposed here. My guess the problem is how to proceed without destroying the savings of the many but more importantly to avoid that most assets end in the hands of the very few. The latest would be the nail in the coffin for post-WWII social democracies turned into oligarchic regimes.

    Many corrosive policies are starting to show their ugly faces: economic sanctions, beggar-thy-neighbour, austerity, monopolies, tax avoidance… apart from debt restructuring these should also be confronted.

    Reply
  6. rtah100

    This seems needlessly complicated and involves the climate fairy to boot.
    We should just dust down the Chicago Plan instead.
    https://blogs.lse.ac.uk/usappblog/2013/11/25/chicago-plan-revisited/

    There is clearly an immediate need for government to replace lost demand. For the long term though, it needs to buy out the rentiers – buy the stock of mortgages off the banks in exchange for bonds and then cram down the price of land with a land tax (annual percentage payment for use value) and write down the mortgages by the price fall. The accounting loss to government is a wash because the future value if the land tax receipts is a balancing asset.

    The banks are solvent and 100% backed in bonds, land is cheap, debt is reduced, interest to rentiers is replaced with land tax upon them.

    Obviously there is a lot more to do to build a new jerusalem: jubilees of student debt, increased pension provision, taking money and payments away from the banks entirely….

    Reply
  7. notabanktoadie

    Given that the global non-financial private sector debt deleveraging has already started, the analysis in Öncü (2019) indicates that the public sector debts of the developed and high-income developing countries will also go up and the governments’ ability to rescue their economies will also decline in these countries. Furthermore, this will severely constrain the governments’ ability to spend on climate change-related projects to address the potentially catastrophic effects of climate change for many years to come, diminishing our hopes to make the necessary investments and innovations to address the now existential climate crisis on time T. Sabri Öncü [bold added]

    But what about monetary sovereigns like the US? Or has the author never heard of MMT?

    Reply
  8. notabanktoadie

    the framework is as follows (i) the financial institutions comprising the banks and non-bank financial institutions (NBFIs) write down all the loans and debt securities on both sides of their balance sheets by the required percentage; (ii) the deleveraging authority compensates the banks and NBFIs for the loss if any; and (iii) the deleveraging authority pays each qualified resident their allocated amount less than the debt relief if any. T. Sabri Öncü

    Why not just simply pay every citizen an equal amount(s) and let the benefits “trickle up” to the banks and NBFIs?

    Why the additional complexity?

    Reply
    1. Susan the other

      Maybe to eliminate the old corrupt economy, as in the German Currency Reform example (didn’t Wukchumni mention this a while back?). We can’t have both systems – one based on financialization of presently accepted assets, creating debt securities that support those worn out financial practices – and one based on the Green New Deal side by side at the same time. So GND it is. And a clean slate for all debt replaced by equalization securities – new government bonds for a new economy. And all securities and equities will be exchanged for new ones. I didn’t follow how we keep this new system from corruption and greed. Maybe implied in this reform is the idea that we no longer value money/financialization/debt ownership, but instead value the real world and paying directly into society and the environment. But we are still dealing with financial instruments (green ones) which serve as the collateral for all new money as “a medium of exchange, a store of value and a unit of account” so there’s no way to protect a system of money/credit from the same corruption. Hoarding, speculation, skimming, etc. I don’t really get it.

      Reply
  9. Tim

    “But instead, the priority then was on preserving institutions and existing power structures, and no one cared much if that meant throwing borrowers under the bus. After all, they must have been profligate to have gotten themselves in this mess. ”

    Excellent point. Perhaps the idea of being forced to stay home and not be able to pay your bills is clear enough to have the “everything is your own fault” crowd give them a pass this time.

    Reply
    1. notabanktoadie

      “After all, they must have been profligate to have gotten themselves in this mess. ” via Tim

      Except government privileges for usurers simultaneously cheat savers and drive the population into debt.

      Reply
  10. robert L goodwin

    Abandoning debt is periodically necessary. That is why countries periodically walk away from their national debt. It is in their interest. That is why we have bankruptcy laws.

    What confuses me is why we are so much more protective of bond holders equity then we are of stock holders or home owners equity. Yves makes the case that not all bond holders are rich. Are we establishing that only the rich should experience losses? We cannot have such a thing as a risk free asset or we are distorting natural systems for the benefit of one class.

    We have zero interest rates. That does help raise capital for the economy, but it also has severe downside risk. Can there truly be zero interest rates without near zero risk? Isn’t the protection of bond holders part of the problem?

    When it becomes in the national interest to deleverage, why would we want to continue the error? Only when bond assets are properly priced can we expect rational behavior. And only bond losses can accomplish the good.

    Reply
    1. drumlin woodchuckles

      Large-amount bondholding may be where a lot of the Old Money of the Old Money classes is kept. The people that George ” Opium Poppy” Bush called the “investing classes”. So to sacrifice bonds is to sacrifice much of the money of those particular ” Old Money” families. They may have the power to insulate themselves from that particular sacrifice.

      Reply

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