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Depression or recovery? The risk of time

Policymakers are beginning to worry about a depression. In a recent CNBC interview, St. Louis Federal Reserve President James Bullard put it bluntly:

"The shutdown can’t go on forever because if it does … you risk getting into a financial crisis or even a depression … and if you get into that I think even health outcomes would be way worse.”

There are no easy decisions for policymakers and politicians, particularly with public opinion so polarised on the policy choices. 

Time is the biggest economic risk

Bullard’s comment clarifies that the biggest economic risk is time. The economy will not breathe again before the lockdowns are phased out. What mattered most during the Great Depression and does again today is the duration of the contraction in incomes and spending. The hit to current economic activity has been so fast and deep that the longer it stays below normal, the greater the potential for irreversible deflationary feedback effects.

Personally, I agree with Bullard and think that a calculated unwind of the lockdowns is the right thing to do.

From 1929 to 1933, the unemployment rate surged to 25% while real gross domestic product (GDP) fell 26%, based on annual data, or roughly 10% on average a year. The Congressional Budget Office expects real GDP to drop by as much as 10% in the current quarter alone. Bullard’s staff projected in March that the pandemic’s unemployment rate might rise above levels of the 1930s. However, the data are biased by the sharp drop in the participation rate and by government programmes aimed at encouraging businesses to sustain employment. 

What many omit in their comparisons of current events with the 1930s is the behaviour of prices. Deflation was systemic in the 1930s; most assume that will not be the case currently. That is also what most thought about real estate in 2007 just before the biggest bust in 80 years.

It's worth noting that:

  • In the early years of the Great Depression, the GDP deflator fell roughly 20%, contributing nearly half of the 45% contraction in nominal GDP that took place. There are plenty of theories about why this drop in price levels happened, but macro policy did not help. The dollar was handcuffed to the gold standard, and Treasury Secretary Andrew Mellon famously advised President Hoover to allow the liquidation to run.
  • The deflation stopped in 1933-1934 after FDR revalued the dollar against the gold standard, the 1930s version of quantitative easing. By then, it was too late. A massive hole in nominal incomes and spending had been created relative to the economy’s nominal potential.
  • The level of real GDP rebounded briskly at a 10% annualised growth pace and returned to 1929 levels by 1936. But nominal GDP took seven years, close to a 9% annualised growth rate, and the start of a war before it returned to 1929 levels. It took even longer, until the end of the war, for both the GDP price deflator and the unemployment rate to fully renormalise.

The destruction of wealth and the toll on human suffering from the Great Depression is well documented. What is not as widely discussed or agreed upon is the lingering influence of falling price levels. Deflation inflicts irreversible economic damage by depressing nominal incomes and spending, which in turn triggers systemic liquidation. Sustained illiquidity turns into insolvency: unemployment surges, wages retreat, and nominal spending stays below its high-water mark for years.

There was a whiff of liquidation during March 2020. But Treasury Secretary Mnuchin is no Mellon and President Trump is no Hoover. The Federal Reserve fully comprehends the policy blunders of the Great Depression and has intervened aggressively, so far. Policymakers in many countries around the world have adopted similar measures.

For the time being, the macro policy measures have been enough to fend off the signs of systemic deflation, but barely. Breakeven inflation rates are off their bottoms but below levels that prevailed before investment sentiment cratered in February. The dollar has retreated from its March surge but is still firm. Corporate bond spreads have retreated to levels more normally associated with recession. US stocks have rallied but on narrow breadth. The macro policy measures have been epic, but defensive.

Bankruptcies and disappearing jobs 

Bullard’s comments coincide with a more general shift in policy sentiment toward reopening. The catalyst for the shift is the wreckage unfolding in the economy. Get ready. The free fall in employment offers a glimpse of what is coming: a gusher of bankruptcies and potentially permanent job losses. These data are no surprise but still shocking, which explains why various states are relaxing restrictions.

What will determine the beginning of the coming recovery is timing the end of the lockdowns and gauging when people feel safe. That is partly a bet on winning the war against this disease, which seems inevitable. The entire world is in this fight and the firepower is incredible. It is only a question of time.

But time is the crucial factor that the economy does not have. Waiting for a vaccine therapy with all its attendant uncertainties is not a practical course of action, at least for the next year or so.

How does it all play out?

Abraham Lincoln reportedly once said, “I am an optimist because I don’t see the point in being anything else.” That is probably my perspective at the moment as well.

The depression tail risk grows bigger the longer the economy is kept in its public health-induced coma. Policymakers seem to be realising this trade-off quickly. What is the point of erring on the side of too long a lockdown if the risks attached to that strategy are the same or worse than a pivot back to reopening?

Time is of the essence. The restrictions need to end in days and weeks, not months, for the chance of a meaningful rebound in the second half of this year.

I think there is a good case for a faster-than-expected recovery in the latter half of the year - if the lockdowns phase out rapidly and even if scientists do not immediately find a silver bullet for the disease.

That may seem like woolly-headed optimism given the high risk of a resurgence in the disease, which seems the norm for pandemics.

But cabin fever is beginning to overwhelm virus fear. People want out. They want to reconnect with family and friends. Fear is starting to shift to a more practical focus on figuring out how to live with this disease and minimise the personal risks of infection as we strive for a return to some semblance of normalcy.

I do not know what the specific solutions will be. But a sustainable policy for coexisting with this disease, in addition to the obvious response of disciplined hygiene, probably includes:

  • widespread testing and monitoring
  • follow-up tracing
  • technology
  • better data and understanding.

It is always easier to see the challenges and risks while underestimating ingenuity and positive possibilities. I suspect that will be the case this time, too.

 

Francis A. Scotland is a Director of Global Macro Research at Brandywine Global, an independent affiliate of Legg Mason. This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827), a sponsor of Firstlinks. The information in this article is of a general nature only. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person. Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

For more articles and papers from Legg Mason, please click here.

 

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