Policy errors during a balance sheet recession and 25% unemployment

I ended yesterday’s post writing that the only thing one could predict with certainty was that there will be policy errors going forward. When faced with so much uncertainty on both the healthcare front and on economic policy, it’s inevitable that policy makers will make mistakes. So let’s start with one possible mistake brewing in the UK.

Austerity in the UK

This comes via Ambrose Evans-Pritchard of the Telegraph.

There is a special place in Purgatory for Her Majesty’s Treasury. It came close to subversion during the Brexit drama. Its Covid-19 blueprint for fiscal retrenchment borders on macroeconomic insanity.

The 10-page ‘policy package’ leaked to the Telegraph – hopefully for the purpose of discrediting it – is a sure-fire formula for structural damage and an economic depression.

“It is crazy. We should be cutting taxes to support the economy as we slowly come out of this,” said one prominent central banker.  “The idea that we need significant spending cuts or tax rises is completely wrong.”

Apparently someone in Her Majesty’s Treasury thinks that raising taxes and freezing wages to pay for the £300bn coronavirus tab is the way to go. A confidential document was leaked outlining a whole panoply of austerity measures, including ones that break key Conservative Party manifesto pledges.

This proposal would see the government cutting spending just as businesses and households in the UK were massively cutting their spending to avoid bankruptcy and destitution. The private sector is deleveraging now. And it will likely continue doing so for the foreseeable future too. For example, data show that New Zealanders repaid an unprecedented amount of their credit card debt in March as panic set in over the economic impact of Covid-19.

You could attribute this to the lockdown. However, I spoke to Richard Koo last week for Real Vision. He’s talking about a balance sheet recession for the long term, where households and businesses focus on paying down debt. His says that “Americans who lived through the Great Depression never borrowed money until they died. This experience was so bad. We’re going to have a similar situation”. The video link is here.

And, of course, that spending is someone’s income in the private sector. The UK Treasury proposal would then be needlessly adding a debt deflationary impulse to an already precarious economic situation.  It’s plain bonkers.

But that doesn’t mean it won’t happen.

Denmark schools open for a month

Let’s use Denmark as an example here. Nominally-speaking, Denmark is a currency issuer, meaning the government has monetary sovereignty and cannot be bankrupted in a currency it creates, which are essentially government IOUs. I say nominally because Danish monetary policy is tightly coupled with the European Central Bank in order to provide currency stability. But, in exigent circumstances, the Danish central bank could do anything it wants to support government fiscal policy.

At the same time, Denmark is doing a ton of deficit spending to support the economy during this pandemic. This includes paying 170,000 people up to 30,000 kroner per month to stay home. That’s as much as $4,341 per month. So, if you work in a fitness studio, for example, and the government has ordered it closed to prevent viral contamination, you get paid to stay home and your income won’t suffer at all.

Here’s how the Danish government puts it (link in Danish):

“The coronavirus outbreak has meant that many people have lost their jobs. But we have been spared the explosion of unemployment seen, for example, in our largest export market, the United States. And I think that is not least due to the tripartite wage compensation agreement. The scheme has secured many employees full pay”

That’s Denmark’s Employment Minister Peter Hummelgaard Thomsen explaining the situation in a recent press release.

Meanwhile, Denmark, which locked down early, has re-opened. Schools, for example, have been open in Denmark for a whole month now. And the latest update on coronavirus infections in Denmark show only 46 new infections yesterday, the lowest level since March. Next up for re-opening are restaurants.

For example, the amusement park Tivoli in Copenhagen officially opens on June 8. But, already starting Monday, some of the park’s restaurants will reopen, Tivoli says. This includes one of my favorites Wagamama, Nimb Basserie and Nimb Bar, all of which have entrances from the street. This means that you don’t have to enter Tivoli to reach your table. Other restaurants such as Gemyze will not open until June.

So, this is a situation where you’re not getting back to 100% overnight. But, the viral outbreak seems to be controlled as the economy slowly regains a semblance of normalcy, with government continuing to deficit spend to maintain private sector incomes. That’s the opposite of what the HM Treasury memo is recommending for the UK.

In the eurozone, where the member states are currency users, you can’t do this without flouting the deficit and debt rules and the explicit support from the ECB. Were Italy to try this approach, how long would they be able to get away with it before they were forced into an HM Treasury memo-style austerity?

I think it’s combustible stuff. And it’s one reason to think that Denmark will economically outperform the likes of Italy (and the UK) over the medium term.

The US is a laggard

Goldman Sachs is now predicting that the US jobless rate will peak at 25%, not 15%. Think about that in the context of what I wrote in yesterday’s post regarding how long it would take to recoup job losses. This is an absolute catastrophe. It’s orders of magnitude worse than Denmark, just as the Employment Minister there points out. That’s why Americans are so eager to get back to work.

To make matters worse, the US is going about this the wrong way in every which way you can think of it. First, the US failed to shut down early and let the virus spiral out of control. Then, it didn’t ramp up testing quickly enough to quarantine and trace contacts. Now, it is re-opening without adequate testing or hospital capacity in place. And it is doing so without re-opening schools first.

My wife, who is a pre-school administrator and teacher in Northern Virginia, came in while I was writing this post complaining, “how are parents supposed to go back to work if they don’t open the school first. These guys have got it totally backwards.” I couldn’t have said it better myself.

So, don’t expect a magic rebound when the US re-opens. The private sector balance sheet issues will prevent that. The lack of child care will prevent that. The fear of viral contamination and death will prevent that. And data from states like South Carolina show that re-opening in these circumstances is only marginally beneficial to the economy.

As Richard Koo told me, speed is of the essence in all of this. The US has dithered and continues to dither in terms of policy. We have to be prepared for outcomes with serious downside risks.

My take

Over a month ago, on the Real Vision Daily Briefing, I suggested a relative value trade of investment grade bond ETFs vs high yield ETFs. This was right before the Federal Reserve decided to buy the bonds of fallen angels and high yield ETFs to support those fallen angels.

The premise was that bad things were going to happen in the US economy and it would hit the high yield market more severely than it would investment grade credits. And even though you have the Fed wading into junk, they are not providing the blanket liquidity support that they are for investment grade credit.

So, that trade is still operative, even more so given the economic policy choices the US has taken that I outlined above. My expectation is that we will see a spate of defaults in the high yield space, which will hit high yield ETFs like JNK and HYG despite the Fed’s buying. The investment grade ETF LQD will be relatively well-protected because of the Fed’s ability to buy individual names as well as the ETF, even if companies are downgraded to junk. That will mean a continued divergence in performance. Kevin Muir is saying the same thing over at the Macro Tourist.

And just as I was putting the finishing touches on this post the US Department of Labor came out with another ugly jobless claims number. The seasonally-adjusted headline was 2,981,000 new claims. In unadjusted terms – which are more accurate – that’s 2,614,093 more people filing for unemployment insurance in the US.

So, Goldman is onto something here. We are going to Great Depression levels of unemployment in the US, while other countries like Denmark are returning to a sense of normalcy after a severe recession. That’s because of major policy errors in the US and an economic system lacking a good social safety net, and therefore not well-equipped to handle a pandemic. Remember, job loss also means healthcare loss for many during a global health crisis. That adds to the debt deflationary impulse of this balance sheet recession.

The bottom line here is that this is a depression, not a recession – at least for the United States. And slowly but surely, people are starting to realize this fact. I continue to expect more downside for risk assets from here as the economic downside risks materialize.