Prologue – Economics in the Time of Corona

The Covid-19 pandemic poses unprecedented challenges for our economy. What are the options to deal with these? And why is the banking sector once again the elephant in the room? In a blog series, we want to shed light on these questions.

On February 22, Italy reported the first two humans that fell victim to Covid-19 in Europe. Barely six weeks later, thousands of people have died from this new coronavirus, and virtually the entire continent has shut down. To prevent further infections, people have stopped traveling, reduced work and stayed at home. Production and consumption is collapsing.

While many aspects of economic life come to a halt, others continue. Companies might not sell their products and services anymore, but they still have to pay interest on their debt, rent for their premises, taxes, salaries and other operating costs. For most businesses, the Covid-19 pandemic reduces income much more than expenses. This is causing economic distortions of unprecedented dimensions – and called for governments and central banks to step in.

Within the seven weeks since this fateful February 22, governments and central banks have implemented programs of a dimension that surpasses everything done throughout the Financial Crisis of 2007-08. Many of the measures now taken are no-brainers. One can argue about their scale or scope, but governments must support people so that they are able to afford to stay home and stop spreading the disease. We will not discuss these measures any further, as we do not consider them too controversial.

Other measures have targeted the corporate and financial sector, and these policies are much more controversial. We think that many of the interventions to prop up businesses rest on wrong assumptions and are misguided. The path our decisionmakers are about to take will needlessly cause enormous economic and political damage in the not-so-far future. Moreover, we are convinced that we have promising alternatives.

Therefore, we will publish an entire series over the coming weeks to develop an alternative playbook. First, the economic mechanisms of the Covid-19 pandemic and its impact on the corporate and the banking sector will be analyzed. We will then propose more effective measures in dealing with today’s economic challenges, both for easing short-term pain and setting our economy back on track once the pandemic retracts.

Before we do so, however, we will present in this prologue some basic concepts that play a key role for economic policy in the months to come – notably, the idea of liquidity, solvency, bail-outs and bail-ins.

Rivers run dry

The shutdowns in various countries to stop Covid-19 from spreading has first and foremost drained the liquidity of companies. Consequently, the first emergency response of governments and central banks was to inject liquidity into the corporate sector. But what exactly is liquidity?

Liquidity is all about money. Although money exists mainly in paper or digital form, we often use metaphors of streams, reservoirs, pools, floods, or ebbs to describe the balance of cash flows and the liquidity running through the economy. So, think of all the liquidity reserves of a company as a lake. One river leads into, and another one out of the lake. If the upstream river dries out while the downstream river continues to drain the lake, the lake dries out. So far, so simple, and this is exactly what happens right now for many companies.

Cash inflows dry out while cash outflows continue. As long as a company has enough cash reserves to service upcoming obligations like salaries or interest payments, it remains liquid. But the reserves run lower and eventually, they dry out. The company becomes unable to pay upcoming bills. It becomes illiquid.

We have depicted below the balance sheet of a liquid company and contrasted it to the balance sheet of an illiquid company. A liquid company has enough cash reserves and inflows to service short-term obligations. Note that liquidity is not directly related to the level of debt and the amount of equity.

Now illiquidity is a life-threatening situation for a company: Its creditors can force the company to kill itself, that is, to force it to liquidate all the assets and to rewind its business operations to pay the outstanding bills. If this happens in sync on a macroeconomic level, the economy might get trapped in a vicious cycle of increasing illiquidity – because someone’s liquidity outflow is always somebody else’s liquidity inflow. If unchecked, many sound and healthy companies would default.

Measures to stop the drought

In a system-wide crisis such as the Covid-19 pandemic, central banks and governments can and should address short-term and system-wide liquidity issues with temporary support. Without liquidity support, too many healthy companies get liquidated, production seizes and employees needlessly lose their jobs – in this case, even a short shutdown can cause long lasting economic damage.

Knowing these knock-on effects, governments and central banks indeed stepped in. They have either lent directly to companies to temporarily bridge the lack of cash inflows or guaranteed loans extended by banks to companies while central banks provided extra liquidity to banks so they can in turn grant loans to companies. Furthermore, many governments also allowed companies to delay tax and social security payments.

We have depicted below how liquidity injections enable illiquid corporations to pay their bills that are coming due. Such liquidity interventions are, however, not free, as they increase the debt burden of the company.

Liquidity measures can bridge money outflows for a few weeks. But if the economic distortions due to the Covid-19 pandemic last longer, they are not sufficient to keep all of the corporate sector afloat.

Liquidity is no universal remedy

Over time, liquidity issues can escalate into solvency issues. When revenues collapse more than costs go down, losses follow suit. These losses eventually eat into the equity buffer of a company, endangering its solvency situation.

This point is key: Solvency is related to liquidity, but the two concepts are not the same thing.

Notwithstanding, many journalists and economists mix up the two things. While cash and liquidity are intuitive and tangible concepts (cash can easily be counted), equity and solvency are both intangible concepts. Equity is the amount of cash that hypothetically remains once all assets of a company are sold and all debt repaid. As long as this amount – the equity – is positive, a company is deemed to be solvent. To illustrate this idea, we have depicted below the balance sheet of a solvent company and contrasted it with an insolvent company.

As you can see, liquidity does not matter for solvency. What matters is that the value of the assets of a company exceeds the value of its liabilities. With this in mind, it should not come as a surprise that an equity shortfall can never be resolved by borrowing more money. We have illustrated this ineffectiveness below:

No matter how many trillions of euros and dollars public institutions lend to insolvent companies, these liquidity measures do not address their solvency issues. A company with solvency issues eventually fails, as it is unable to roll over its debt.

The losses have to be shouldered by someone

We are convinced that widespread solvency issues are only a matter of time. The Covic-19 pandemic will result in an economic recession, and likely not one of the smaller kinds. The chief economist of the International Monetary Fund (IMF), Gita Gopinath, has recently predicted that the coming recession will be the worst economic downturn since the Great Depression in the 1930ies.

Liquidity interventions will not be enough.

So, we also need solvency interventions and these are harder to get right than liquidity interventions. Liquidity interventions are temporary: The money that is lent out is supposed to be repaid at a later point in time. Solvency interventions, however, transfer wealth from one group in society to another one.

The most popular solvency intervention is the bail-out. In a bail-out, governments rescue insolvent companies with taxpayer money. The figure below illustrates this situation.

As you can see, a bail-out is a bad deal for the taxpayer – if it was not, a private investor would gladly jump in for the taxpayer. With a bail-out, taxpayers get less than what they give, as their money is used to offset losses that should have been shouldered by creditors and previous equity holders.

Despite this fact, policy makers right now do not see any limits on bail-outs. U.S congress has passed the largest bailout package in history. One statement by James Bullard, a Federal Reserve president, exemplifies the thinking behind those measures: “Match any lost wages. Match any lost business. No questions asked.”

The hope is that bailout packages can completely undo the economic impact of a pandemic. This hope, however, defies reality. The losses caused by Covid-19 are real and irreversible. No government intervention in the world can bring back the business activity that is lost during a shutdown. All that bail-outs or any other solvency intervention can do is to redistribute the losses.

Bail-outs are a bad idea

Hence, we should not ask how we can undo the effects of the pandemic – because this is simply not possible. Instead, we should ask how to best deal with the resulting losses. If we frame the question like that, we come to realize that bail-outs have many disadvantages:

First, it would be naïve to assume that bail-out packages will be fair and balanced. To use the words of the inspector general of the 2008 bail-out package: “fraud and scandal are inevitable in a bail-out as sweeping as what is now being contemplated…” The people with the best political connections will get most out of these bail-outs, while everyone else loses out.

Second, bail-outs change the incentives of people owning and managing the bailed-out companies, as well as the people owning and managing the financial companies that have lent to the bailed-out companies. This will exacerbate moral hazard, which has already become so widespread after the financial crisis of 2007-08: Over the last ten years, companies have borrowed enormous amounts to buy back their shares, intentionally deteriorating their equity position while boosting returns on equity and shifting risks from the owners to the taxpayer – heads I win, tails you lose.

Boeing and the U.S. airline companies, for instance, spent more than $90 billion dollars for share buybacks over the past decade. The aviation industry is now widely expected to receive a similar amount in bail-outs to cover the losses caused by this pandemic – politicians are just about to validate racking up debt to ramp up shareholder returns as sound business practice. Going forward, large companies will be paying out all profits in good times and asking the taxpayer for bail-outs during bad times.

Third, widespread bail-outs require the government to pick the winners and losers in the economy. This choice is everything but easy. Many companies that will receive bail-outs no longer have a valid business model. Yet they will survive, preventing startups or healthier corporations to take over their market position, which will drag down the economy as a whole – an effect that has been observed already in Europe with so-called zombie firms.

Fourth, bail-outs will drown the entire society in even more debt. Already shattering records at the end of 2019, global debt levels will take another leap higher if we decide to bail out everyone, everywhere, with no questions asked. This additional debt will burden society for decades to come, and block the route towards a swift recovery once the pandemic passes.

Finally, bail-outs cause political backlash as they shield the politically connected and punish political outsiders. Protecting owners and creditors of some selected corporations while overburdening taxpayers amid a massive rise in unemployment and poverty fuels anger, populism, and nationalism.

So, bail-outs are problematic on many levels. But do we have better measures to deal with solvency issues?

The obvious way out

There is an alternative to bail-outs that can keep companies open for business, suppliers paid, and people employed. We actually don’t have to look far to find this alternative to deal with insolvency issues. It’s the twin of the bail-out: the bail-in.

In a bail-in, the company renegotiates the debt with its creditors, either agreeing to write the debt down, convert it into equity, or a combination of the two. This way, the company can recover its equity position, as illustrated below:

The advantages of bail-ins are just as obvious as the disadvantages of bail-outs:

Losses are imposed on the owners and creditors of the companies, those with the highest ability to bear them and those that received the profits during the good times – heads I win, tails I lose. Owners and creditors likely think twice about share buybacks and prepare better for another crisis. Finally, bail-ins reduce debt levels, as debt is renegotiated and written off.

Governments must now ramp up the capacities of the bankruptcy frameworks to enable companies to restructure their debt while continuing their business operations. Again, swift liquidity support is key. It not only helps economically viable companies to stay in business and prevent a system-wide liquidity dry-up, but it also buys time for restructuring those companies that run into solvency problems. Hence, governments are well advised to be quick with liquidity. The same does not hold true for solvency measures. As we have shown, rash and wide-spread bailouts are no lasting solution. If some solvency support was considered inevitable, then it should only be granted deliberately and in conjunction with bail-in procedures.

Fortunately, the US has already a good basis in its bankruptcy procedures to facilitate bail-ins and debt restructuring: It is called Chapter 11. Europe also has its bankruptcy laws, but it is fair to say that it is not as well prepared as the US. However, the European Union recently adopted the Restructuring and Second Chance Directive that could become the counterpart of Chapter 11. This new directive could be key in successfully restructuring European companies running into solvency issues.

So instead of adopting a corporate bail-out package, policy makers in the US and Europe should adapt the existing bankruptcy laws to setup sustainable debt restructuring procedures. This call for bail-ins is not off wall. In fact, over 230 Economics, Law and Finance professors have proposed this course of action. So why are bail-outs nevertheless so popular these days, while no one is talking about restructuring and bail-ins? The answer lies in our financial system.

A large portion of the debt that is written off during bail-ins is owed to banks. Banks stand to suffer the heaviest losses if we bail-in instead of bail-out companies. So more than 10 years after the great financial crisis of 2008, the elephant in the room is still the banking system. While banks and regulators keep telling us the financial system is now “safer, simpler, fairer”, most large financial institutions are still highly fragile. But this is for our next blog post in this series. Stay tuned!

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Blog series
The Coronavirus pandemic and its impact on global finance

This blog post is the prologue of a series of articles that we will publish over the coming weeks. We think that the Coronavirus pandemic will have a thorough impact on the global financial architecture. With our analysis, we want to shed light on how the banking systems in Europe, the US, and China might be affected, and what the impact on the global monetary system could be.

Prologue
Economics in the time of Corona
April 17, 2020

Part I
The upcoming banking crisis in Europe
March 27, 2020

Part II
How bank regulators and the European Central Bank should prepare
To be published next month

Part III
The Golden Age of banking in the United States
To be published next month

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