Growth will struggle unless inflation rises...

 

The NEW CORONAVIRUS is sadly proving deadly not only for humans but also for the global economy, says Arkadiusz Sieron at Sunshine Profits.

 

Central banks have fired their bazookas, but monetary policy is helpless against this pandemic with its supply disruptions and self-quarantine effectively freezing economic activity. Even the central bankers seem to acknowledge their impotence. As Jerome Powell said during a recent press conference:

It didn't take long to persuade the governments to intervene and increase their spending.

 

For example, Spain announced a $220bn stimulus package, or almost 16% of its GDP. The UK unveiled even larger stimulus: an unprecedented $400 billion financial rescue package, amounting to almost 15% of GDP, to "support jobs, incomes and businesses". Germany went even further: the country authorized its state bank, KfW, to lend out as much as $610bn, or almost 16% of GDP, to companies to cushion the effects of the coronavirus.

 

Trump has already signed two packages, worth only $108bn, but Republican and Democratic senators have reached a deal on a roughly $2 trillion stimulus package. If you think it's a lot, then in terms of US GDP it is 'merely' 9.4%. So there is a room for further stimulus if needed.

 

Will such mammoth fiscal stimulus help? Well, the devil is in the details.

 

A lot depends on what governments spend money on. Expenditures on healthcare and research into a coronavirus vaccine is desperately needed as even fiscal hawks (like us) would admit. But funding infrastructure projects would not be too helpful right now. You see, this is a unique situation in which the whole economies freeze out in order to flatten the curve and prevent the healthcare system from collapsing. But when firms do not operate, they have no revenues. Without revenues, people have no wages. Without wages and revenues, loans are not repaid. Without repayments, the banking system collapses – and the whole system goes down like a house of cards.

 

Some support is therefore needed to prevent that, so that people can meet or delay their obligations. But whether this massive fiscal stimulus will be helpful or not, it will have one very important consequence. The fiscal deficit will soar. Forget about austerity, surpluses or even a balanced budget.

 

Why is this important? Well, global debt levels were already sky high. Adding together borrowings from households, governments and companies, it grew to $253 trillion already in Q3 2019, more than 322% of global GDP, the highest level on record. 

 

At a country level, let's take Italy, whose economic fundamentals have been already poor with a fragile banking system, growth stagnation and high public debt.

 

 

Now, as the European country most affected by the virus, with the highest number of cases and fatalities, plus the lockdown of its economy, Italy will enter a grave recession (the economy is expected to shrink by 5% at least), while its public debt will surge from 135% to above 140% of the GDP, or even more.

 

Other southern Euro countries will also face a potential reemergence of their sovereign debt crisis. This time Greece's debt-to-GDP starts at over 180%, compared with 146% in 2010; Spain at 95% vs. 60%; Portugal at 122% vs. 96%; and France 98% vs. 85%. And private debts have also increased over the last years.

 

The US is less indebted and not so badly hit by Covid-19 (at least so far), but its economy is also forecast to shrink in 2020. The combination of lower GDP and tax revenues with higher public expenditures will balloon the deficit and federal debt from slightly above $23 trillion, or 107% of GDP, in 2019 to almost $26 trillion, or more than 120% of GDP, in 2020.

 

How can all these countries meet repayments on all their new debts? Well, they could increase taxes. But taxes are already high and unpopular. So governments could also accelerate economic growth – but it is rather unlikely given the pre-pandemic trends and the accelerating response. And if they hike taxes, growth will not speed up for sure.

 

So the only remaining option – and more probable from the historical point of view – is it to inflate away the debt. With higher inflation, the real value of government debt will be lower. Financial repression can meantime corral mandatory investments into "safe" assets, meaning government bonds, that are guaranteed not to keep up with the real or even massaged inflation data.

 

We believe that when the dust settles and investors realize what is happening, they will turn to the ultimate inflation hedge – gold.