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Jeff Meli Christian Keller

Episode 23

Jeff Meli in conversation with Christian Keller

Navigating the virus economy: Will the global recovery be a quick bounce or slow grind?

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Many countries are now beginning to take steps towards re-opening gradually as social distancing measures lift and coronavirus infections decrease. However, the global economy is expected to shrink significantly more than during the 2008 global financial crisis, in what could become the worst economic downturn in generations. Monetary and fiscal policy responses to limit the damage have been extraordinary, but it is still unclear whether those actions will be enough to spur a robust recovery.

The latest episode of The Flip Side highlighting the effect of COVID-19 on businesses and markets features a debate between Barclays Head of Research Jeff Meli and Head of Economics Research Christian Keller about how long it may take for government interventions to be effective in restarting the global economic engine.

  • Jeff Meli:              Welcome to this episode of the Flip Side.  My name is Jeff Meli, I'm the Global Head of Research at Barclays.  I'm joined today by Christian Keller, our Global Head of Economics.  Thanks for joining me, Christian.

    Christian Keller:   Thanks for having me.

    Jeff Meli:              Today, we're going to talk about what kind of economic recovery we should expect once the global economic engine restarts.  So I know that might sound hopeful to those of us who are still in the middle of social distancing, but we are seeing some signs that economic activity will restart even though we haven't really fully come to terms with the damage done by COVID-19.

    Christian Keller:   Indeed.  We are seeing the first steps towards opening of European economies in May, it’s a gradual opening.  Italy will reopen its manufacturing construction sectors and wholesale trade.  France allows businesses to come back with the exception of cafes and restaurants.  Germany has already allowed smaller-sized commercial spaces to reopen, they're not opening gyms and restaurants, et cetera.

                                  We see a similar trend in the US, the federal government has published guidelines for phase three opening of the economy and some of the US states are taking first steps, particular the rural states was more dispersed populations like Alaska, Montana, Oklahoma, but also some states with larger popular centers like Texas and Georgia. 

    This is clearly a gradual lifting of restrictions and they all have an eye on avoiding second waves of infection.  But it does come at a time where we do see the effect of social distancing as it succeeds in reducing effects numbers and it's also in line with what we have seen in other countries that experience the outbreak earlier like China, for example.

    Jeff Meli:              When we think about the recovery, we have to put a couple of pieces together.  First, we have to start with the depth of the recession and that's still something of an unknown like I said earlier, but we are getting some more information about activity and particularly about labor markets.  We also need to factor in a various fiscal and monetary policy responses.

    Christian Keller:   Yes.  And when I put the pieces together, I conclude that the recovery has a real chance of being quite robust. 

                                  First of all, it's not a financial crisis, it shows quite convincingly that financial crisis are the ones that bring us slow and tepid recoveries while the financial sector is strong, the recoveries tend to be quite robust as well.  Secondly, we have a very large and very rapid monetary and fiscal response, probably the largest ever and this coordinated response should do two things, first, it should limit the damage and make sure the lights stay on while we are in lockdown and second, as we get out, it should provide the necessary boost to demand and help us recover.

    Jeff Meli:              Well Christian, I'm more skeptical about the prospects or recovery, and that's not to diminish the speed or the magnitude of the policy response which I think has been substantial. 

                                  First of all, it is true that the crisis didn't start in the financial sector, but I actually think it could still spread there and we could end up with the bad effects of a financial crisis after all.  Second, the policy response will itself require financing, we're talking about trillions of extra sovereign debt that will need to get issued and that's going to come with its own costs which I think will also hamper the recovery.  So it is the case that the literature shows that spending like this helps, but we have never seen a crisis of this magnitude before and I'm not so sure that the typical tools are going to work. 

    Christian Keller:   Well before we talk about the recovery, maybe we should emphasize the unprecedented depth of the downturn.

                                  I think we both expect the global economy to shrink by several percentage points in 2020, it is significantly more than doing the global financial crisis when global growth was just slightly negative.  And it's really more than in any point in postal history.  At further perspective, the IMF used to consider a global recession when the world economy would extend by less than two and a half percent in a year.  This year, it is likely that the global economy shrinks by over two and a half percent.  In short, this is the worst global economic crisis in generations. 

    Jeff Meli:              Yes.  On the extent on the downturn we agree, but I'd point out that your global forecast Christian as gloomy as it sounds, is built on actually a pretty swift recovery in the second half of the year which is offsetting to some extent the ongoing contractions that we're seeing in activity.

                                  We've never had economic activity fall as rapidly and as deeply in such a short period as we are predicting in the first half of 2020.  So actually, the forecast would be even worse if the rebound that you're expecting doesn't come to pass.

    Christian Keller:   It's true.  And I do emphasize that our scenario is big on the assumption that the virus does not resurge in any meaningful way which would bring back the lockdowns that we currently experience.

                                  With that in mind, let me emphasize again why I'm optimistic.  I think we could get a meaningful rebound over the next four to six quarters because A, this is not a financial crisis as I said earlier and financial, in particular, banking crises have been well established as causing the slowest and most sluggish recovery because it takes banks sometime to repair the balance sheets and build capital, and in the meantime, they're hesitant to land.  This is exactly what we experienced in 2008, 2009, 18-month long recession followed by a very slow growth and a very slow improvement in unemployment.  That experience has I think tempered a bit our expectations for this recovery and I think that may be the wrong template.

    Jeff Meli:              Well, I certainly agree that the crisis didn't start in the banking system like it did last time but I'm not actually so quick to conclude that banks are in the clear.  So we just finished first quarter bank earnings season.

                                  We've now seen all the – all the banks report and one thing that struck me is the level of provisions that banks are taking, they are enormous.  So provisions means banks are expecting losses, it's the charge they take against future expected losses from loans they've made that we haven't actually seen the loan losses materialize yet because obviously the job losses are still building and businesses are just starting to come to terms with the – with the damage that's been done but it's clear that banks are expecting a surge of defaults from retail customers, small businesses, large businesses.  I mean, the economic damage here is incredibly widespread. 

    Christian Keller:   I think you may be underestimating the extent to which banks raise capital.  Of course, if everyone in the economy defaults, then no amount of capital is sufficient.

                                  But as I said earlier, I do think the fiscal response should help cap the defaults.  And banks now have higher capital levels and they have in other periods in modern times and regulators have stressed us at the balance sheet at very severe outcomes.  In fact, we are seeing now regulators taking steps to use these strengths to help accelerate the recovery, for example, by reducing counter cyclic capital buffers. They wouldn't take these steps if they have not extreme confidence in the strength of the system.

    Jeff Meli:              Well I hope you’re right, Christian.  But I do think that whether or not banks end up having their own problems which accelerate the depth of the economic damage probably depends on how effective the policy response is.  So if the fiscal response falls flat, then I think we will likely see defaults overwhelm all this extra capital that you're talking about. 

    Christian Keller:   That would segue into my other source of optimism, the policy response.  Again, the evidence from past crisis shows that when policy provides stimulus in time, recessions are less deep and recoveries are quicker and stronger.

                                  Today, we see a very focused monetary and fiscal response.  Central bank has – have not hesitated to employ available instruments including rate guards, QE, larger scale liquidity programs, and they've firmly established their role as a lender of last resort.  And, again, the pace of QE is actually faster than the early days of the global financial crisis not only by the Fed but also by the ECB which seems we have learned from its more hesitant response during the global financial crisis.

                                  And very importantly, this has been accompanied by a fiscal policy response on a massive scale.  This includes spending of five percent to ten percent of above the line, meaning revenues and expenditure, but at the same time, also very large liquidity support programs in forms of loans and guarantees.  These type of below the line measures make up for total fiscal response of up to 20 percent to 30 percent of GDP.  Implications of these measures for the public finances will vary and they may be only realized overtime, but, again, it's a very, very meaningful response.

    Jeff Meli:              Well, there's no denying the facts the speed and the size of the response from monetary and fiscal authorities has been impressive, I mean they’re timed coincidentally, obviously because the virus is putting pressure on all these economies at the same time.

                                  But I wouldn't really call them coordinated, there are actually, I think, some pretty big differences in the types of support being introduced in the US compared to a bunch of the countries in Europe, for example. 

    Christian Keller:   I think the differences in design reflect institutional differences that exist between economies.  For example, European corporates are much more reliant on bank credit versus in the US where corporates are much more reliant on the capital markets.

                                  We also have the automatic stabilizers in from of unemployment insurance and shorter work schemes in Europe while in the US we have a much more flexible labor market that experience is typically larger drop losses during the crisis are then typically also facilitates a quicker recovery afterwards.  And these differences require different policy designs.  But, again, the crucial point is how determined policymakers have reacted across continents and will this adds up to what is probably the largest counter cyclical policy response in modern times.

    Jeff Meli:              All right.  I want to go through each of monetary and fiscal policy separately.  So let's start with the monetary policy response.  I think actually a lot of the monetary response has been an effort to keep markets functioning rather than to try to bolster the economy.

                                  So a lot of markets stopped working or functioning smoothly during the height of the crisis.  We saw pressures in the frontend of the financing markets, things like commercial paper and short-dated corporate bonds.  We saw disruptions in mortgage backed securities in the US, we even saw disruptions in really liquid markets like Treasuries where there were all sorts of relative value relationships that got thrown out of whack and bid offer spreads really widened.

                                  I think a lot of those disruptions in markets were linked to the constraints on banks.  So the other side of having a very safe banking system is that banks’ balance sheets aren't that flexible and when a crisis hits, they have a difficult time intermediating, we got a preview of that with the chaos in the repo markets in September which was subject of episode 17.  Look, I think the monetary response is better than nothing, it's certainly better than not responding but I'm not really sure it actually helps with the recovery. 

    Christian Keller:   This may be true for programs like commercial paper even though I would argue that forestalling defaults does have real benefits. 

                                  But on QE, I would insist that it did help the economy during the financial crisis.  We may not always how exactly QE worked but a counterfactual world without QE would very likely have looked worse in terms of growth and inflation. 

    Jeff Meli:              You know, my bigger issue Christian is with the fiscal response.  So you mentioned the size of the deficits that are being created and I think you meant that as a good thing, like to show how forceful governments have been.

                                  But I think that these deficits have their own consequences.  So, for example, not too long ago during the financial crisis, we were talking about debt overhang, so how sovereign debt over a certain size leads to poor future economic outcomes.  We are blowing those limits across the entire developed world as governments respond to this crisis.

                                  And it's not just because of this spending that you mentioned, that is a big part of it, but the other part is that tax receipts are also going down so the deficits are actually being created from both sides of the ledger.  Well, look, I'm not claiming that they shouldn't – government shouldn't respond, I think what they're doing is way better than the alternative of not responding at all, but that's different than saying that the economic response will scale with the size of the spending. 

                                  So you mentioned like we have literature that shows that this kind of spending helps buffer times of crisis and that is true, but the literature really is looking at small crises at least compared to the scale of COVID-19, with a small crisis, you get a small boost in spending and a reasonably good result.  Here, we have a huge crisis, we're doing huge spending but I don't know that you necessarily get the same outcome.  We're going to have the highest debt levels in the developed world ever in a time of peace. 

                                  That debt will require some combination of higher taxes, financial repression where certain institutions are forced to hold government debt, it will crowd out other financing, I mean this will have consequences on the recovery. 

    Christian Keller:   No doubt, we will emerge from this with much higher government debt levels.  But there has been some rethinking among economists about sustainable debt levels and the role of government spending.

                                  We're in a world now where economies’ real equilibrium interest rates have continued to fall for some time across all regions.  The reasons are likely a mix of developments like demographics, technology, and possibly also inequality.  The current crisis is unlikely to reverse the strength and it may even further accelerate it.

    So if we live in a world where real interest rates remain at historic lows, governments can afford higher debt burdens than what we thought in the past.  And at the same time, government spending may also play a more useful role than maybe what we thought in the past.

                                  I would say though, there clearly are differences between how much debt countries can afford and governments with credible institutions issuing in their own currencies are in a different position than, for example, economies that need to issue in other currencies, Japan is one example. 

    It has been issuing debt in its own currency that is largely held by its own residents and it has been able to sustain debt levels way above 200 percent for some time now.  US and other economies may be able to go the Japan way and in the meantime, their central banks are buying much of the new issuance and therefore they limit negative effect, for example, of the crowding out that you mentioned earlier. 

    Jeff Meli:              And I'll point to another finding in the literature, Christian, which is that during crises like these, you never really make up the lost activity.  There's no such thing as an actual V recovery.

                                  So V means you get back to the pre-crisis path in GDP level terms, that doesn't happen.  Really, the best you can hope for is that you get back to the same pace of growth, but the output lost during the crisis is actually permanent.  So even with a quick recovery factored in, we're forecasting a cumulative global GDP loss of close to $9 trillion over the next two years.  And what's worse is that often during crises, economies don't return to the old growth trend, they actually settle at a slower growth trend which is what happened after the global financial crisis.

    Christian Keller:   In that respect, I would say that a look at equity prices clearly suggests that investors expect the economy to get back to the same trend growth that we had before the crisis. 

    Jeff Meli:              You know, I think I have two responses to the equity rally that we have experienced over the past several weeks, the first is that all the quantitative easing you talked about could be distorting equity prices.

                                  You mentioned our experience during the financial crisis was that quantitative easing helped the economic recovery.  Another experience we had was that it supported asset prices and as you mentioned, the quantitative easing we are experiencing now is far more rapid than what we saw during the financial crisis and that could be a big factor behind the boost in equity prices rather than something fundamental about the health of the economy.

                                  I also would point out that the stock market is not the same thing as the economy.  The stock market is the largest, most powerful companies in the economy and I think those companies are very well positioned to come out of this crisis with more market share than they had going in, accelerating a trend towards aggregating market share at the biggest companies that the US and other developed economies have been experiencing for the last 15 or 20 years.  That sort of aggregation of market power which has been the subject of previous episodes of the Flip Side could actually get more – could actually accelerate.

                                  So that's – a company like Amazon taking share from local retailers or chain restaurants taking share from family owned restaurants, those big companies have all sorts of access to financing, they have flexible balance sheets, they can weather this storm much more capably than small entrepreneurs can.

    I'm actually worried that you're going to see massive wealth destruction across that sort of – that entrepreneurial class in America, so restaurants obviously, but all sorts of other small and medium enterprises in other industries.  I think that some of the rally in the stock market is actually a warning sign about the kind of economy we're going to have once we emerge from this crisis.

    Christian Keller:   Yes.  Good points.  This is potentially one of the changes, but there probably will be a number of structural changes that will emerge as a result of the current crisis.  For example, take global value chains, for decades now we have increasingly a split of production and had supply chains that reach across continents making us very reliant at times on certain – on certain countries and certain producers.

                                  It seems that after the crisis, be it for geopolitical reasons or also simply for the fact that one wants to have certain important products closer to home, we will probably see some re-localization with regard to global value chains.  The second part is behavioral changes.  You see, a lot of people, for example, now are using e-commerce and also working from home.  Even after the crisis is over, they may want to continue working this way, for example.

                                  This could have implications for commercial real estate.  Furthermore, we will likely see longer lasting implications for travel, tourism, and also entertainment.  I think it's – in sum it is fair to say that we will likely see a structurally different global economy as a result of the current crisis. 

    Jeff Meli:        Well those are good topics for future episode of the Flip Side.  Thanks for joining me, Christian.  Clients of Barclays can access all of our COVID-19 related research at #virus available on Barclays Live. 

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The Flip Side

Episode 21: Navigating the virus economy: Will the CARES Act stimulus package save the US economy? 

Jeff Meli and Michael Gapen discuss the CARES Act and debate whether the plan will provide enough near-term stimulus to individuals, small businesses and large corporations to save the US economy.

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About the analysts

Jeff Meli is Head of Research within the Investment Bank at Barclays. Jeff joined Barclays in 2005 as Head of US Credit Strategy Research. He later became Head of Credit Research. He was most recently Co-Head of FICC Research and Co-Head of Research before being named Head of Research globally. Previously, he worked at Deutsche Bank and JP Morgan, with a focus on structured credit. Jeff has a PhD in Finance from the University of Chicago and an AB in Mathematics from Princeton.

 

Christian Keller is Head of Economics Research at Barclays, leading a global team covering both developed and emerging markets. Christian is based in London and joined Barclays in 2007 from the International Monetary Fund (IMF), where he had worked since 1999. Based at the IMF headquarters in Washington DC, Christian worked on IMF programs with emerging market economies in Europe, Latin America, and Asia and served as the IMF’s Resident Representative in Turkey from 2005 to 2007. Christian graduated with a PhD in Economics from University of Köln, Germany, and holds a joined-MA in Economics and Finance from University of Köln and HEC, Paris.

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