A lot is happening very quickly.
And the extraordinary scale, scope, and speed of the monetary and fiscal responses carry a slew of long-term consequences — some known, some unknown; some intended, some not so much.
It’s all quite fluid and the barrage of headlines makes it difficult to turn one’s attention from the immediate to the long term … triply so when schools are closed.
But here are six thoughts I’ve been pondering about the world we may enter after the pandemic subsides and we’re allowed to leave our houses again.
1. The Debt Trap
I don’t think rates will normalize in my lifetime.*
There is too much debt and there is not enough growth. (These two things are related).
Companies — whether investment grade or junk — can’t afford to pay higher rates, and bondholders can’t absorb downgrades (e.g., pension mandates that require disposals of non-investment grade credit).
It’s a pickle. The Federal Reserve’s response to crises (expanding the assets on its balance sheet) entails the creation of more debt.
The system cannot function with higher rates.
Companies can’t roll over their debts. The country is going into a deficit, bigly. There is no escape from zero.
* In theory we should see inflation and thus higher rates — particularly if we’re going to monetize government (and potentially commercial) debt. We’ll see …
2. Farewell to Market Pricing
The volume of leverage in the economy inevitably leads to systemic risks. The Fed stepped in with alacrity last month to create markets where no participants were willing to transact, and to establish a floor on pricing.
As the Fed’s actions in the markets become more pervasive and inclusive of more financial instruments (e.g., Treasurys, corporate bonds, MBS, money markets, bridge loans), what happens to price signals?
I think price signals become irrelevant.
The main thing that matters is price stability … as in the price stability of financial assets.
The Fed is putting a floor on pricing because it has to — too much is at stake for market participants and / or market infrastructure to dictate outcomes. The Minsky Moment is on hold … possibly indefinitely.
I think we’re moving away from the era of markets playing a leading role in the flow of funds, to one where the state plays a bigger role.
Beyond the Fed, consider the ~$350B in SBA loans for small businesses that are part of the $2T CARES package. The U.S. Treasury says these loans will be offered at 0.5% interest with a variety of attractive provisions.
Food for thought:
- Once the infrastructure is in place for the government to underwrite commercial loans, what role will the private banking system play?
- Will the SBA turn into something like Brazil’s BNDES (with all the implications that would have)?
3. The Intertwining of Corporate and National Interests
In a world where markets play less of a role in the flow of funds and states play a greater role, corporate managements are likely to decrease their focus on shareholder interests and increase their focus on national interests. (In some cases, the government may be a shareholder).
In turn, the state is likely to champion chosen corporate objectives.
We’re seeing a clamor to produce PPE, medical equipment, and pharmaceuticals domestically.
But as more people wake up to the diffusion of supply chains for the defense industrial base, I wonder whether aerospace and defense companies’ investment decisions will place less emphasis on NPVs and ROICs, and more on self-sufficiency, resilience, and security of supply.
Or consider the shale complex. There is a confluence of interests amongst the state, producers, labor, and investors to keep shale producers alive. However, the credit intensity of shale injects risks to all parties when oil prices fall below breakeven. Why wouldn’t the Fed or U.S. government backstop shale producers by rolling over their (high yield) debt at concessionary rates, or act as a buyer of last resort to establish a floor on prices?
Food for thought:
- How will the state use its expanded control over the flow of funds to influence corporate decisions?
- How will corporations use their ties to the state to shape the markets for labor and capital?
- Which industries will become “strategic sectors” and / or too big to fail?
- Is this environment conducive for entrepreneurship, or does it entrench the market position of incumbents?
- How pervasive would patronage become under this kind of system?
4. Goodbye Globalization, It’s Everyone for Themselves
The financial system is currently organized for globalization and the integration of markets. The dollar is the global currency, and the Fed has become the de facto central bank for the world.
In a world where the United States brings more of its supply chain onshore — and I suspect other countries will do the same — and where the state has greater influence on the flow of funds, does the current system make sense?
I think not.
A shift from specialized production to self-sufficiency would lead to reductions in international trade, FDI, and potentially portfolio capital flows.
Food for thought:
- Is global dependence on the dollar likely to last in this scenario?
- What type of financial system will emerge if the world is carved up into trading blocs?
- How likely are the imposition capital controls and / or tighter restrictions on foreign direct / portfolio investment?
5. Autarky under Anarchy: The Prospects for Peace
The United States can pursue autarky given its resource endowments and scale, but few other countries can. History suggests countries tend to compete for market access and embrace protectionist measures under this scenario.
Food for thought:
- In recent decades, has the United States supported international institutions or undermined them?
- Are the relative power positions of large states conducive to peace or conflict?
- Do the institutions we have for international cooperation — such as the UN — help us to transition from an age of globalization under American leadership to an era of autarky under anarchy?
- Do the institutions we have for adjudicating trade conflicts — such as the WTO — give us confidence that the world will fairly and / or equitably resolve competitions for market access?
6. The Moment of Maximum Risk
If the casualty projections that the White House shared last night are accurate, then the United States is about to enter the moment of maximum risk.
Many people seem to assume that the United States will have the luxury of dealing with one emergency at a time.
That seems foolish, but it may still be right.
Food for thought:
- What are the odds of a miscalculation between U.S. and Chinese leadership?
- What are the odds that a country conducts a cyberattack on U.S. critical infrastructure to hamper Americans’ ability to respond to the disease?
- How likely is it that a country will use this opportunity to launch an international adventure?
(There are several hotspots; use your imagination).
What have you been thinking the world might look like after quarantine? I’d love to hear your views. Maybe we could chat over beers on the Zoom? Hit me up.
Regardless, we’re all in this together.
We’re going to need a reservoir of goodwill, and a willingness to find principles of unity on the other side of this.
Stay safe everyone. Peace and health be with you.