Walter Molano | Applying LUV to economic recovery
Published:Friday | June 19, 2020 | 12:22 AM
OP-ED CONTRIBUTION: EMERGING MARKET ADVISER
New York Governor Andrew Cuomo has repeatedly said that the wearing of face masks is an act of love. Although it will not protect the person from contracting the coronavirus, it reduces the chances that he or she will spread it to someone else.
Love is rarely a topic for economic analysis, but in this case we are more interested in the acronym, LUV, which refers to the shape that an economic recovery may take.
Will it be an L, where the economy collapses and flatlines indefinitely? The Organisation for Economic Co-Operation and Development, OECD, seems to think so. Last week, Angel Gurria, the former president of Bancomext, declared that the effects of the coronavirus economic downturn would be long-lasting, and it would take more than a decade to return to pre-pandemic levels of output.
The International Monetary Fund, IMF, made similar statements, saying that COVID-19 was producing serious damage to the global economy, and it was pushing millions of people into poverty. Yet, not everyone is in agreement with this assessment. Investors are furiously buying up assets, pushing some asset prices into record territory. The Trump administration is also hoping for a strong, V-shaped rebound in order to boost his chances in the polls, come November. There are also some sober voices, like United States Federal Reserve Chairman Jay Powell, who take a more middle-of-the-road approach.
Last week, the Fed released its famous dot-plot report, which showed that the members of the board expected interest rates to remain close to zero through 2022. While two years is a long time, it is not the 10 years of devastation envisioned by the OECD. Therefore, the Fed’s expectations are more for a U-shaped recovery.
But, what does economic theory tell us?
The coronavirus has clearly induced a demand-shock recession. The restrictions on human circulation slashed consumer demand. This led to a sharp decline in commerce and economic activity, as stores were forced to close and people were ordered to shelter at home.
Consumer pain
Fears of the pandemic pushed down consumer confidence. After starting the year with consumer confidence at all-time highs, the index plunged to a low of 71 in April. Fortunately, governments rushed in with measures to stabilise consumer sentiment. Central banks cut interest rates. The Federal Reserve went on an asset-buying spree. Governments announced major stimulus packages to help out households and businesses.
The key issue that will determine whether the economic recovery will be U-shaped or V-shaped will be the extent of the damage to the financial sector. The sudden stop in commercial activity seized up the circular flow of the economy, thus impacting firms’ abilities to service debt or make rent payments. Measures to provide rent relief also multiplied the economic pain.
Fortunately, low or no interest rates mitigated some of the damage, as banks did not have to make interest payments to depositors. Still, a prolonged downturn could easily result in a more generalised financial crisis.
The only difference between a liquidity crisis and a solvency crisis is time. Right now, firms and banks are facing a liquidity crisis due to a drop in income, but the longer the shutdown lasts, the slower will be the recovery.
Fortunately, macroeconomic theory gives us a reason for hope. The famous Solow growth model, which we have referred to in the past, may provide some clues. One of the things that has confused economists is why economies can bounce back so quickly after a disastrous event, such as a war, hurricane or devastating earthquake.
The so-called Miracle on the Rhine was the incredible recovery of the German and Austrian economies following the destruction of World War II. The same occurred in Japan after World War II; despite the firebombing of its major industrial centres and two nuclear bomb attacks, Japan emerged as an economic powerhouse soon after the war ended.
The Solow model showed that even when the capital stock of a country is destroyed, the inherent skills and productivity of the labour force will produce a surplus over the depreciation rate, which will quickly push the economy back towards equilibrium output.
In other words, once the current restrictions on circulation are lifted, the economy will naturally move back to its pre-crisis level of activity. So far, the data seems to confirm this. The consumer confidence index in May showed a marked recovery, jumping up to almost 74, while the current economic conditions index spiked to 84 in May, from 74.3 in April.
Out of the three LUV scenarios, it is starting to look more like a V-shaped recovery. Of course, there is a chance we could have a second round of COVID-19 contagion, which would lead to a W-shaped recovery — and which would be similar to the U-shaped scenario. It would change the analysis from one of LUV to one of WULV.
Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.