Tracing the legacy of Covid-19

This article appears in the June 2020 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

As economies shuttered and financial markets reeled in March, governments and central banks responded on a massive scale.

The U.S. Treasury plans to borrow almost US$3 trillion in the second quarter — more than five times the previous quarterly borrowing record set at the height of the 2008–09 financial crisis — to pay for government programs supporting businesses and unemployed workers. The Federal Reserve has vastly expanded its asset purchases.

The Canadian government had announced measures totalling $151.7 billion in late May, and the Bank of Canada is buying at least $5 billion in federal government bonds every week from the secondary market. The parliamentary budget officer expects the federal deficit to hit $252.1 billion in 2020–21 — the largest on record measured as a share of GDP.

The post-crisis economy will look significantly different from forecasts at the start of this year.

We asked two economists about the biggest risks and potential legacies of the Covid-19 crisis.

The economists

Frances Donald Global chief economist, Manulife Investment Management, Toronto

Bruce Mizrach Economics professor, Rutgers University, New Jersey

What element of government or central bank intervention poses the most significant risk to financial markets down the road?

Frances Donald

One of the biggest questions economists and market participants are grappling with is how to unwind the incredible amounts of monetary and fiscal stimulus that have been added to this economy.

The post-financial crisis environment showed us how difficult it was for the Federal Reserve to normalize its balance sheet and raise interest rates. It created tremendous market volatility, and there are arguments to be made that the Federal Reserve had already over-tightened before we entered into Covid-19.

When we think about how central banks are going to behave over the next decade or so, there will be tremendous pressure on them to try to not just taper their purchases, but reduce the size of their balance sheets. Markets will have to grapple with that.

When it comes to government spending, there will come a period where governments recognize that their elevated levels of debt are probably not sustainable over the long run. There will have to be a reckoning.

That may come in various forms. It may turn out that we need to experience — like Europe did in 2011 — a period of austerity: spend less, tax more. It may be that we have a moment where we’re discussing modern monetary theory a bit more, and central banks have to purchase more government debt in order to ensure some demand over time.

But either way, while few economists will tell you there was too much monetary policy or too much fiscal spending during Covid-19, the ability to unwind it will likely be difficult and take, in my view, several decades.

Bruce Mizrach

The biggest risk the central bank has taken during the Covid crisis is that it has committed to purchase assets, including corporate bonds, and to provide credit to risky lenders.

Originally, the corporate bond-buying program was only supposed to be for investment-grade bonds. But, eventually, the Federal Reserve felt the need to expand this to bonds that had been downgraded just recently to junk.

The Federal Reserve has committed to providing liquidity to the municipal sector, as well — so states and localities issuing bonds. I would say the biggest risk so far is that the Fed is taking onto its balance sheet instruments that have substantially more credit risk than the instruments they bought during the financial crisis.

The Federal Reserve is backed by US$75 billion on the corporate bond-buying program by the U.S. Treasury. If those assets deteriorate substantially, it’ll be not only the central bank but also the government on the hook for this.

The Federal Reserve is also participating in purchases of asset-backed securities. They proved to have substantial credit risk — even though they were highly rated — during the financial crisis. Folks in the Federal Reserve, the private sector, and at Fannie Mae and Freddie Mac said, “We only purchased the AAA portion of these asset-backed securities.” Well, it turned out that those AAA portions didn’t just go down to AA or A; they were downgraded all the way to junk.

There was substantial credit risk even on the most highly rated asset-backed securities. There should be some concern on the part of the public about those purchases.

The financial crisis led to Dodd-Frank, Occupy Wall Street and austerity following the European debt crisis. It also contributed to the rise of populist movements in some western democracies. What will be the legacy of Covid-19?

Frances Donald

Covid-19 will likely act as an accelerant on top of a variety of economic trends that were seeded several years beforehand. Heading into Covid-19, there had already been a fairly large push for de-globalization. This idea we learned about in our Econ 101 textbooks — that free trade was the best possible thing to happen to an economy — was being tested. When several countries began to enact more protectionist policies in 2018 and 2019, companies had to deal with the idea that supply chains would be disrupted.

Covid-19 was an entirely different shock that sent the same message. If you’re sourcing labour, supplies or parts from abroad, [several] things can cut off your supply chain very rapidly.

Businesses may consider sourcing labour and parts domestically. While it might be more expensive in the near term, it acts as an insurance policy: they don’t have to worry about borders rising, or tariffs, if they’re only sourcing from their national economy. What that probably translates to is higher prices for everybody.

But we have been faced with a tremendous demand-side shock. In the next 12 to 18 months, we’re likely looking at prices falling. That’s consistent with a recession.

We’re also likely to see reduced immigration after Covid-19 — not just because borders are closed, but because countries have to deal with extremely elevated unemployment rates. That would suggest finding jobs for those who are already on the ground will become more economically and politically important in that specific timeframe.

This concept of de-globalization didn’t start with Covid-19. But now we’ve had not only trade wars as a reason to rethink globalization, but also a pandemic.

Covid-19 also shone a spotlight on some of the weaknesses in the economy. They include income inequality, and childcare as a critical pillar of economic functioning. It shone a spotlight on long-term care facilities and how important those are from a social perspective. What I expect is that Covid-19 will also be an opportunity to right some of the wrongs that were silently persisting under the surface. At least that’s my hope.

Bruce Mizrach

The corporate bond market underwent a great deal of stress in March. The Federal Reserve simply had to announce a corporate bond-buying program and that was enough to stabilize the market. That’s not going to be true in the future.

It took us five years to add US$2.5 trillion to the balance sheet during [and after] the financial crisis. We added it in seven weeks back in March and April. The speed and size of these operations is unprecedented.

The concern is that next time, if the Federal Reserve only intervenes with US$500 billion, everybody will say, “Oh, well that’s so small compared to what you did during the Covid crisis.”

It’s a little bit like spoiled child syndrome. It’s going to take ever-larger commitments from the central bank to prove to the markets that it’s credible in its desire to stabilize. If you give your child a toy every week, when their birthday comes and you just give them another toy, they’re not going to think that it’s anything special.

[Future crises will] require larger and faster commitments from the Fed. You won’t be able to expand by US$50 billion a week for three months. You’re going to have to shoot your whole bazooka in three weeks. That’s one legacy.

Another, far more fundamental, thing is we’re blurring the lines between the function of the Federal Reserve and the function of the Treasury. Folks are asking the Federal Reserve to, for example, help out states and municipalities, which has not traditionally been a function of the central bank.