This post title may not seem relevant right now. But, let me explain it first. I was looking through my post drafts folder this morning, deleting ones that never made it to publication. And this post title popped up as having been saved for 10 March.
I thought it was an interesting question even now, because a lot of people are speculating about different approaches to the Covid-19 crisis. So I decided to write it as a retrospective, with the information we now have over a month later.
I think this might illicit some thoughts on what happens next. Let’s see when I finish the post.
Downside risk mitigation strategies
As a former ‘credit guy’, my tilt is toward taking extreme negative scenarios off the table, eliminating so-called tail risk, because that’s where you see defaults. And bond investors are about getting the highest coupon payments they can with a minimum of defaults.
The premise of bonds is that you effectively give a loan with intermittent interest payments, followed by a balloon principal payment at the end of term. That’s very different from a mortgage, for example, where principal is paid off right from the first payment. So bond investors hate defaults. And, thus, they hate tail risk.
Why am I starting here? It’s because I was thinking this way about Covid-19 very early on. On 3 February, I wrote a post I titled “More on the coronavirus, tail risk and policy error“. Here’s the crucial bit from the end:
The US economy is still beyond stall speed at the moment. But, the event risk from this virus is large and growing. The amount of time we have to say there’s no reason to worry just yet can be measured in days, not months or even weeks. The potential for policy error right now has to rank high.
Translation: In a normal economic scenario, growth in the US economy in early February would have been considered largely shock-absorbed from sudden exogenous shocks. But, even by February 3rd, one could see that the coronavirus presented an increasing tail risk. And the right thing to do is to recognize that and prepare to eliminate that tail risk.
With hindsight, we can now see that it wasn’t a normal economic scenario because the economic shock from the coronavirus has been overwhelming. But, equally, we can also see that a lack of preparation has hurt the US.
The US example
The reason I bring this up is that right now there is a political firestorm brewing over President Trump’s response to coronavirus. This is due both to the mushrooming case count and deaths and a recent article penned at the New York Times highlighting how politics delayed Trump’s response. See “He Could Have Seen What Was Coming: Behind Trump’s Failure on the Virus“.
Trump’s legacy and re-election chances hang in the balance now. And so, we should expect this debate to become sharply politicized and polarizing.
The reality, though, as my post from early February shows, is that it was easy to understand that bad things were going to happen globally, not just in China. Remember, that was when we had 361 known coronavirus deaths and 17,205 confirmed cases. The Philippines had just reported the first death outside of China over that weekend.
But, if one had the ‘eliminate tail risk’ mindset, one could have made decisions that attenuated both the loss of life and economic disruption of coronavirus.
The Iceland example
I am left thinking about my post on how we achieve minimal economic disruption from Covid-19.
…just going through this thought process outlines how important testing is and how disruptive a lack of testing always will be. If you don’t have the tests, you can’t know who has the virus. And if you don’t know who has the virus, you can’t operate an effective containment strategy without inhibiting freedom of movement.
So, the first conclusion is that a pandemic utopia cannot exist without adequate testing.
A lot of countries have adopted different approaches to the Covid-19 outbreak. Sweden, for example, has relied much more heavily on voluntary social distancing. Whereas its neighbor Denmark has had a more severe lockdown.
For weeks, the numbers of COVID-19 cases and fatalities were proportionally similar between Sweden and Denmark, but while the economic results of the strict isolation are being felt in Denmark, Sweden’s mortality rate has reached more than 88 dead per million, compared with around 47 dead per million in Denmark.
–As virus deaths rise, Sweden sticks to ‘low-scale’ lockdown, AP, 13 Apr 2020
At first blush, this difference between Sweden and Denmark in the lockdown approach seems the most relevant one. But I would argue, as I did last week, that it’s testing that matters most. Another Scandinavian country, Iceland, that has taken a more Swedish approach shows you that.
Iceland’s isolated location and sparse population mean that some vital information about the novel coronavirus is coming out of the island nation — especially considering that it’s already tested 10% of its population, which is more than any other country, according to USA Today.
[…]
So that means the “best data” on coronavirus is coming from Iceland at the moment, John P.A. Ioannidis of Stanford University told USA Today. And Kari Stefansson, CEO of deCODE genetics, which is helping to carry out Iceland’s testing efforts, said that Iceland may be one of the best live coronavirus laboratories we have in the world as it continues to randomly test its people.
And it’s already made some important discoveries. Among them: that between 0.3% and 0.8% of Iceland’s population is infected with the coronavirus, while half of those who tested positive were asymptomatic as the time of their tests.
“That’s a bit scary,” said Stefansson. “They could be spreading it and not knowing it.”
There are no strict lockdowns in Iceland – just as there are none in Sweden. And Iceland has a death rate of 17 per million, whereas Sweden now has a rate of 92 per million (up from the AP’s 88 number). The difference? Testing.
My take
So, as we think about leaving lockdowns, I think the same logic applies: testing is job #1. Test as many people as possible as often as possible, including random testing to get a sense of asymptomatic infection. That’s the only way people will feel safe returning to work after a lockdown. And it’s the only way you can find infection clusters and isolate them while getting on with life in as normal a way as possible.
As I wrote last week:
I think a large second wave of infections is almost inevitable now. The economic collapse associated with these lockdowns has become so acute that it has become the single most important driver in policy making in industrialized countries.
In the most short-sighted countries (like the US), loss aversion will drive out all other considerations. And the likelihood of lifting lockdowns before measures are in place to control a second wave is high. This means greater loss of life and greater economic disruption, in my view. And so, I tend to look at worst case economic outcomes for the US as closer to baseline than best case ones.
The US also has a more porous social safety net than many other advanced countries. That makes a second infection wave a bigger problem because that wave will lead to greater economic deprivation than in other advanced economies.
As I wrote yesterday, Depressions are made not just by the real economy collapsing but also by that collapse infecting the financial system. The real worry now then has to be about the fragility of the US financial system, which before this crisis, was much stronger than the system in Europe. This is America’s saving grace for now.
My own concern is that, with perhaps 39% of oil firms going bust in the next year and a President raring to relax lockdowns despite the fact that the White House still has no road map for restarting the economy, we will see a big second wave of infections in the US and a spate of credit writedowns that infect the financial system with the real economy’s weaknesses.
It doesn’t have to be that way. Policy makers could be pro-active. The Fed, for example, could ban bank dividends until the coast is clear. Unfortunately, that’s not how policy makers usually act – especially when the ideology is about markets being most effective. Greenspan’s dictum from the tech bubble is where the US is on policy “be ready to clean up the mess when [bubbles] burst“. So, for the US and a US-centric world, expect tail risk to rear its ugly head in the coming months.
P.S. – I have been meaning to write in greater depth about the US banking system and the European Central Bank backstop for sovereigns. So expect something on those topics in the coming days.