Will we have a V, U, or L future?

Since the 2008 deep recession, we’ve had an upward movement of Gross Domestic Product and other measures of economic well-being.  Growing income inequality and too-low wages were notable criticisms.  But even these issues were being addressed.  After all, there is no better anti-poverty program than a strong economy.

Then came the COVID-19 pandemic.  A business owner friend said it’s like a boxing match Round One when the first punch is a bout-ending knockout.  He has never seen such a sudden downturn in his many years as a business-to-business CEO and owner.

What will our national growth rate look like in the months and years ahead? There are three potential outcomes for the nation, a V-pattern (rapid recovery to pre-pandemic levels), U-pattern (slump followed by recovery), or an L-pattern (the economy stays depressed for years to come).

Achieving a V-pattern for the nation, a rapid return to our old path requires proactive steps to stop the virus across the globe. With delayed testing in the U.S. and varying strength of our public health systems across 50 states—as well as the number of lesser-equipped health systems in many countries—the V path is unlikely.

The U shape is a recession with a return to growth.  How long the recession lasts is a crucial question for businesses and households.  It’s also a policy decision for our federal government. In South Korea and to a lesser extent, China, we might see this pattern because the current indications are that they have done a better job of containing the virus.

In the U.S., our fiscal (U.S. Congress, state legislatures and executive government leaders) and monetary policymakers (U.S. Federal Reserve) are trying their best right now to keep our future pattern to a U, with a limited period in the economic doldrums.  Our social distancing requirements are but the first, necessary step to achieve this pattern. If all states would comply with social distancing, we might have a fighting chance.

We should be thankful professionals are still in control at the U.S. Federal Reserve (Fed).  They have pulled out all the stops to protect the economy, faster than we’ve ever seen the Fed react. Some of the steps, like their direct lending, were set in place during the 2008 recession.  The Fed has dropped target interest rates to 0 to .25%.  It is offering forward guidance that it wants to keep interest rates low for a long time.  And it is aggressively purchasing assets (i.e., turning illiquid assets into liquid cash) including mortgage-backed bonds, commercial paper, and municipal debt.  The Fed’s emergency program just received $454B in taxpayer-financed investment, protecting the Fed against losses on up to $4T in lending. This amount is record-breaking.

Keeping interest rates low will help homeowners refinance, and businesses invest after the COVID19 period subsides.  That impact will help shorten the recession.

The recent federal recovery bill CARES, coupled with two previous ones, injects a total of $2.8T (or 13% of annual US GDP) into the economy.  It’s a lot, but it may not be enough.  Unfortunately, Congress did not include automatic triggers that would speed up future spending, which is likely to be needed, from my perspective.  Sadly, the cash coming to citizens and support for businesses will take time to get into our system, and the timing of any future fiscal policy actions is uncertain at best.

State governments will be a drag on the economy in months and years ahead.  Unlike the federal government, they cannot run a deficit.  Their costs are going up at the same time that their revenues are falling precipitously.  State and local spending will stay low, as it did following the 2008 recession.  Pension asset values have plummeted, requiring more funding going forward. Unemployment claims will also be costly.  And capital gains tax income in states like California will fall.

In short, the cumulative impact of the novel coronavirus pandemic on state budgets will be “like nothing we’ve ever seen before,” officials said during a March 27th webinar held by the National Conference of States Legislatures, according to Bloomberg News.  Sadly, the recent federal bill offers no help to states other than for healthcare; but the Fed may be able to offer loans as a last resort.

If fiscal and monetary policy are the tools to shorten the bottom of the U, what are they fighting against besides contractionary (i.e., growth-inhibiting) state and local policies?  Worsening household balance sheets will reduce consumer spending, which drives over 70% of our economy.  And remember the wealth effect that led to high stock prices to boost consumption?  It’s now working in the opposite direction.  Uneven recovery in both health and business across the globe may leave supply chains choppy for a while. Multiple companies (especially small ones) will have closed up during the pandemic, and, absent state and local efforts to encourage entrepreneurship, may stay closed.  It will take a while for businesses to rehire the millions of people taken off the payrolls.  And you can be sure that health insurance premiums will rise significantly next year, a problem for businesses, governments, and households.

Might an L pattern – a downturn that does not turn back up for a long time – arise?  Three conditions could drive this result, according to Janet Yellen, the former FED Chair and now a resident scholar at The Brookings Institute.

First is an extended and deadly COVID19 virus passing slowly through our nation and not matched by additional fiscal policies to offset the losses. Monetary policy is fully deployed now unless the Fed discovers new tools.

Second is weakening in the banking sector so that there are no funds to fuel an upturn.

The third is a crisis in the commercial paper market such that corporations that need cash flow can no longer issue short-term debt.  We’ve had a run on corporations borrowing at low-interest rates to fund stock buybacks and dividend payments in years past.  The money was cheap, and investors liked the commercial paper market premium over safer investments, like Treasuries or bank C.D.s.  Our corporate borrowing binge could cause far more bankruptcies than the COVID-19 virus would otherwise create.

What may be true for the nation, may not be true for all its parts.  I worry about graduating seniors entering the job market, small businesses, and rural communities.   Already we are seeing delays in the program to support small businesses.  A U for the nation may be an L for the vulnerable.

V, U, or L? Create a scenario for each.