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Will the Coronavirus Pandemic Prove to be the Mother of all Financial Crises

Former Managing Director of Ahmedabad Stock Exchange
Apr 15, 2020 5:26 AM 4 min read
Editorial

A top economist predicted that the coronavirus pandemic could cause the "mother of all financial crises." “Everything depends on how long it lasts, but if this goes on for a long time, it’s certainly going to be the mother of all financial crises," said Kenneth S. Rogoff, leading economist at Harvard University.

 

The Global Financial Crisis (GFC) of 2008 that briefly shook the world economy, dwarfs before the present COVID-19 crisis that is sending the world economy into a tailspin. GFC originated due to the reckless lending extended to sub-prime customers in USA and the contagion spread to the entire global financial system. However the intensity of the financial crisis was confined largely to the banks of Europe and America. Banks in developing countries like India, with negligible exposure to complex financial products, felt a few tremors while the epicenter was in USA and Europe.

 

In its war against the the global financial crisis, the US Federal Reserve (Fed) has deployed a wide range of tools including the traditional tricks of monetary policy like interest rate cuts plus a range of unconventional measures. In the early stage of financial crisis starting in late 2007, the Fed began responding to rising unemployment with the main traditional monetary policy tool of interest rate cuts. The idea is that cuts to the key Fed rate (federal funds rate) lead to lower interest rates throughout the economy. Those low rates spur businesses to make new investments, spur people to buy houses or invest in renovations, and spur purchases of major durable goods like cars. Starting in September 2007, the Fed began steadily reducing interest rates until December 2008. By mid-December 2008, the Federal Funds Rate had reached nearly zero percent and could go no lower.

 

With interest rates at zero, the Fed has started trying a series of unconventional monetary policy measures. One of the key tools of unconventional monetary policy measures has been the targeted assistance to financial institutions. The Fed made a judgment that the collapse of Lehman Brothers showed that further major bank failures would be extremely costly to the economy. Consequently, the Fed persuaded the US Congress to pass the Troubled Asset Relief Program (TARP), a major bailout of the financial system. The basic idea was to lend money very cheaply to every financial institution around, including to the to the European banks in New York, to prevent additional bankruptcies.

 

Another monetary policy tool deployed was the quantitative easing, which means buying up lots of long-term debt issued by the federal government, injecting extra money into the system. By these conventional and unconventional measures, Fed successfully avoided the cataclysmic scenario by averting a crisis in the financial system spreading to the real economy.

 

Will the Coronavirus Pandemic Prove to be the Mother of all Financial Crises

 

As countries struggle with the economic catastrophe brought on by the coronavirus pandemic, central banks around the world have reached out for the textbook of the 2008 global financial crisis. They are cutting interest rates and pumping liquidity into the banking system.

 

The crisis posed to the global economy by the coronavirus pandemic is very different from the global financial crisis.

 

COVID-19 pandemic has first paralysed the real economy, by disrupting production, distribution and supply chains. In the second phase, a supply side crisis will lead to mass unemployment which in turn will lead to a demand side crisis. In the third phase, the crisis in the real economy will spread to the financial system as individuals and companies go bankrupt. A sharp decline in economic activity and a rise in unemployment will lead to a deterioration of household and corporate finances, which in turn will result in increases in delinquencies.

 

The crisis posed to the global economy by the coronavirus pandemic is universal for all the countries in the world, unlike the global financial crisis which was concentrated mainly in USA and Europe. Fed alone can not save the global economy this time around, as the coronavirus pandemic has affected the economies of all the countries. The economic contagion this time is not just confined to USA and Europe alone. US Fed does not have the fire power to pump dollar swaps into all the world economies.

 

Central Banks across the globe may pump additional liquidity into the banking system. But that can only give temporary relief to the beleaguered financial institutions and at best buy them some time. How long the virus will rule the world is uncertain. Till such time the virus spread continues, the real economy will be paralysed or limping. Till the real economy gets back on its feet, there can be no real and sustainable relief to the financial system. 

 

Monetary policy tools can not make much impact during this unprecedented economic and human crisis. All efforts should be made so that real economy doesn't grind to a halt in the process of containing the virus. Only fiscal policy is capable to provide "whatever it takes" to revive the real economy. India's fiscal stimulus package already announced is just 1% of GDP, whereas countries like USA have announced fiscal stimulus packages up to 10% of GDP. If the pandemic is here for a long haul, which seems to be the case, the containment measures need to be calibrated such that they do not destroy production and supply chains. There should be targeted fiscal stimulus measures and tax cuts to boost employment and aggregate demand. A part of such fiscal give-aways should get compensated by effecting steep cuts in government's revenue expenditure.

FIN.

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