Abstract: Whether the spread of the novel coronavirus and the correction in asset prices will lead to a bigger crisis is a worrisome issue. On August 1, 2019, the Federal Reserve decided not to reduce its balance sheet, which indicated that exiting the quantitative easing was once again indefinitely held off. In my exchanges with some US economists, including Federal Reserve officials, I have repeatedly expressed my concern over the long-time implementation of loose monetary policy by central banks in Europe, the United States, and Japan, but some of them argued that the fact that economic growth rate and inflation rate are low just indicates that monetary easing is still far from enough. At present, the inflation level is low and unemployment is not high either, which means that the Phillips curve is quite flat. The last time that such a scenario happened was back in 2003-2004, when many people thought that macroeconomic control had entered a golden period. Unfortunately, later, we came to realize that a storm was actually brewing beneath the calm surface at that time.
I. Are we on the eve of another global recession?
On the first day of Chinese Lunar New Year, I started thinking about the economic impact of the novel coronavirus. In 2003, I wrote a paper with Don Hanna, my former colleague at the Citigroup, on SARS's effect on the economy. My initial guess was that there would be two factors making the economic impact of the novel coronavirus outbreak different from that of SARS. The first one was that the online economy would partially alleviate the shock of the epidemic; the second one was that the higher personnel mobility would likely make the coronavirus spread faster and wider. But I still did not believe that the epidemic would evolve into one that could kill more than 30 million people as predicted by Bill Gates.
However, the speed and breadth of the epidemic's global spread over the last two weeks has been completely different from that of SARS, which was largely out of my expectation. Now I feel that perhaps the biggest economic impact of the novel coronavirus will not occur in China, but in some developing countries in regions such as South Asia, the Middle East and Africa; and many developed economies, including the United States, Japan, France and Italy, will also be adversely affected.
The global spread of the epidemic was followed by a panic in the capital market. The Fear & Greed Index compiled by the CNN Money has shown extreme fear in the market over the past few days. In the last week of February, the New York Stock Exchange Composite Index fell by 11%, with the total loss in market value reaching $3.4 trillion, an equivalent of 16% of the US GDP in 2019. That was the third largest decline since World War II, following the subprime mortgage crisis in 2008 and the Black Monday in 1987. It is likely that market panic has not reached a tipping point yet, as the epidemic is still spreading with some countries having already begun to take more drastic anti-epidemic measures, while some still having no idea on the proper countermeasures. None of these are good news to economic activities, in particular the capital market sentiments.
What truly worries me is whether the spread of the novel coronavirus and the correction in asset prices will lead to a bigger crisis. On August 1, 2019, the Federal Reserve decided not to reduce its balance sheet, indicating that exiting the quantitative easing was once again indefinitely held off. In my exchanges with US economists, including Federal Reserve officials, I have repeatedly expressed my concern over the long-time implementation of loose monetary policy by central banks in Europe, the United States, and Japan, but some of them argued that the fact that economic growth rate and inflation rate are too low just indicates that monetary easing is still far from enough. At present, the inflation level is low and unemployment is not high either, which means that the Phillips curve is quite flat. The last time that such a scenario happened was back in 2003-2004, when many people thought that macroeconomic control had entered a golden period. Unfortunately, later, we came to realize that a storm was actually brewing beneath the calm surface at that time.
"Monetary policy can continue to ease as long as inflation rate does not rise." The Quantity Theory of Money proposed by the monetarism icon Milton Friedmann became a theoretical reference for such a policy idea. But since the 1980s, despite the ups and downs of monetary policy in the United States, consumer prices have remained relatively low, and the quantity of money seemed to have decoupled with price level. In a research using European data, Viral Acharya, a professor at the New York University and former deputy governor of the Reserve Bank of India, found that ultra-accommodative monetary policy could unintendedly create disinflation. Because if a large amount of liquidity supports zombie enterprises, it will increase inefficient production and aggravate overcapacity.
One thing that the subprime mortgage crisis has told us is that even if a continuously loose monetary policy environment may not push up the inflation level, there might be other side effects, which is one of the reasons I do not fully support the so-called "modern monetary theory".
For such a reason, I have been trying to study whether there are still financial risks like those before the subprime mortgage crisis in the US financial system. According to many US experts, no such risk factors have been observed so far. Even if there are risks, they will be relatively mild—for instance, underperformed enterprises are highly leveraged; stock prices are perhaps overvalued; the bond market is full of bubbles. Some of them also believe that, although there is no obvious trigger for a new recession in the short term, once a recession happens, there would be not as much space for both fiscal and monetary policies as in 2008. What deserves particular attention is that will the spread of the novel coronavirus become a trigger for a new recession. A 10% downward adjustment in asset prices will exacerbate risks that should have been relatively benign, such as the mismatch risk.
Of course I am not sure that the global economy will necessarily experience a recession in 2020. But the risk has risen sharply in the past two weeks, with the Organization for Economic Co-operation and Development (OECD) recently cutting its 2020 global growth forecast from 2.9% to 2.4%, expecting 0.8% growth in the UK and the eurozone, and 0.2% in Japan. US growth is slightly better, but Goldman Sachs' chief economist predicts at least one quarter of negative growth for the US economy. "… it is still too early to say much that is definitive about the economic threat from coronavirus," said Lawrence Summers, a Harvard professor and former US Treasury Secretary.
On March 3, the Federal Reserve responded sharply, cutting rates by half a percentage point. Unfortunately, it has not seen any effect yet, and I think in doing so the Fed had wasted its ammunition prematurely. In 2008, the market was more worried about counterparty risk and liquidity exhaustion, for which monetary policy easing could work well. Now that the market worries that the spread of the virus will halt economic activities, monetary policy may make little difference. Jean-Claude Trichet, former president of the European Central Bank, even said that coordinated rate cut by central banks could induce panic.
II. China's "unusual response" at "unusual time"
The sudden deterioration of the external economic environment is bad news to China. At first, we optimistically estimated that if the epidemic could be completely controlled in a month, China's economic activities should be able to begin recovering soon. But it now seems that the external environment can hardly support a V-shaped rebound as it once did in 2003. Therefore, economic decision-making will be more difficult this year than that in 2008, which centered solely on ensuring economic growth by all means. The current situation is much more complicated—on the one hand, shocks on the economy are not simply external, but also internal; on the other hand, with the "four trillion" stimulus package administered in the last crisis, the overall leverage level in the economy has increased significantly, especially for local governments and state-owned enterprises (SOEs), which has made the space for further debt financing extremely limited, and the effect of macroeconomic policies in stimulating growth significantly weakened. China has just signed the phase one trade agreement with the US, and if it implements the commitments in the deal, pressure on balance of payments will be huge this year.
China's current economic policies are based on two major objectives—one is anti-epidemic, and the other is economic restoration, though there would be overlaps between the two goals. Many policies since the outbreak of the epidemic, such as deferring social security fund contributions, reducing rent, management fee, water and electricity costs, as well as lowering lending rates, mostly aimed to help enterprises struggling as a result of the epidemic overcome the difficulties. The most important purpose of these policies should be to avoid a vicious circle among the collapse of a large number of small and medium-sized enterprises (SMEs), large-scale unemployment and the universal rise of non-performing financial assets of banks, which will lead to systemic risk. That is, the policy purpose is not to rescue individual enterprises, but to ensure the overall economic and social stability. The biggest risk to SMEs is a cash crunch, which means policymaking could keep eyes on increasing business income, reducing operating costs and ensuring access to external financing.
As the spread of the epidemic has been temporarily curbed in China, the government has begun promoting the resumption of production while maintaining the anti-epidemic efforts. At the same time, policy focus should be shifted to economic restoration. With rising global economic risk, domestic economic policies have become particularly important.
Normally, I am not a supporter of excessive monetary and fiscal easing policies. However, it is by no means a "normal" situation now. A key problem now is that can the economy hold up in the second quarter? Macroeconomic policy should be countercyclical. The adoption of a macro control policy should also be able to support the structural reform, preventing the worsening of structural contradictions. At the same time, policymakers should also be flexible. For instance, requiring fiscal deficit not to break the red line of 3% of GDP is too rigid. Rather than rigidly sticking to the so-called threshold, we should focus on the health of government's balance sheet. Nevertheless, we should still be cautious about such a red line.
Fiscal policy should be more active in a way that can stabilize economic growth. But we should guard against three tendencies:
First, government should not be parsimonious in spending fiscal resources, as put by the life philosophy that has long been kept by Chinese—“Eat solid food when busy and eat liquid when idle".
Second, the upper-level governments should not simply make policies without providing funds. In the past, some local governments recklessly sold land and built up debts, which, to some extent, were out of helplessness, because they could hardly meet various policy requirements, such as economic growth target, without necessary capital. We should not simply pass the responsibility to local governments or even enterprises. The central government could help solve problems by measures like issuing special purpose bonds or increasing deficit, but no matter what kinds of measures are taken, the central government should make the overall coordination; otherwise new problems would be created.
Third, stimulus policies should be innovative, instead of relying on massive investment into infrastructure sectors such as railway, roads and airports. It is better to take into account both the short-term goal of steady growth and long-term one of improving quality.
At a recent meeting, the Standing Committee of the Political Bureau of the Central Committee of the Communist Party of China decided to increase investment in public health services and emergency materials; speed up the construction of new infrastructures such as the 5G network and data center; and attach more attention to mobilizing the enthusiasm of private investment. These three decisions could bring positive outcomes—the first one aims to improve livelihood, especially making up for the shortcomings exposed in the epidemic; the second one aims to provide "new infrastructure" to meet the needs of further economic development; the third one aims to restructure the economic engines for the Chinese economy, which has long been contemplated, but too long delayed. My colleague Professor Xu Jianguo has put forward a sound suggestion. He recommended a housing reform which can enhance economic growth momentum both in short, mid- and long-term. Specifically, it involves building 10 million affordable houses each year with an average area of 50 square meters per house. This would require an annual direct investment of 10 trillion yuan, which can not only support short-term economic growth, but also help transform the household registration for farmer workers and lay a solid foundation for long-term growth.
Monetary policy should also be further relaxed at appropriate timing and extent. What the Fed has been going through recently shows that rate cuts are largely ineffective when the market is mainly worried about the spread of virus. It is also the same with China, that is, the impact of aggressive monetary easing will be quite limited until the epidemic is controlled. After the epidemic is under control, further interest rate cuts and increasing liquidity could be considered; but at the same time, we need to pay attention to the transmission of monetary policy. For instance, easing liquidity might not directly help SMEs. To solve this problem, we should first see if liquidity can flow to financial institutions close to these enterprises, such as agricultural and commercial banks, city commercial banks, digital financial institutions and so on. But moderately increasing liquidity and reducing financing costs can help enterprises improve their balance sheets and enhance economic vitality anyway.
