Since our programs in April have been postponed to the Fall, we are bringing you Tower Center Thursday Thought. Every other Thursday, we will post a Q&A with one of our Fellows on the current pandemic and their thoughts on how it might affect the economy.
This week, we interviewed Senior Fellow Dr. Kathleen Cooper on the implications of this pandemic for the U.S. economy.
Would you agree that this is a highly unusual situation for the U.S. economy? We are experiencing both a supply and demand shock. Can you think of any historical parallels?
The current economic situation is unprecedented for the U.S. Most of our recessions have been the result of either a tightening of financial conditions, an oil price spike, or a simple inventory adjustment. The so-called Great Recession was due to an historic locking up of the financial system. Recessions have generally been accompanied by a loss of confidence that prolonged the contraction but not to the degree nor for the reason that is currently in play. We’ve never had a recession caused by a public health disaster such as we are now experiencing, with the result being a dramatic collapse in incomes and demand due to widespread economic closure. This is clearly the largest shock to our economy since World War II, and shortages remain of key supplies needed to fight the disease and reopen the economy.
The federal government was quick to act. Do you think the relief (stimulus) package is appropriate? Will it be adequate to get us through this crisis?
Both the Federal Reserve and the federal government were quick to act, which was crucial to help the millions who have been thrown out of work by the stay-at-home orders of state and local authorities. Although I am deeply concerned about the enormous budget deficits that the country is running, now is not the time to stop short of aiding those who have been forced to leave their jobs or close their businesses. Payments to individuals are appropriate, as are payments to small businesses and not-for-profits that are shut out of pursuing their respective missions. My concern is that the program of asking banks to be the intermediaries between small businesses and the funding they need to survive is cumbersome at best. People expect global banks to be the intermediaries, but a very large share of small business loans are made by regional and community banks. They have the relationships with small businesses; so they must be engaged in the process, which is now happening. In the end, more funding and faster approvals will be needed if the shutdown continues throughout May and especially if it continues longer.
The Federal Reserve’s response has been almost without limit, compared with a much slower response during the global financial crisis a decade ago. They learned then and developed new responses, in addition to interest rate policy, and were ready to deploy much more quickly this time around. My only concern is how the Fed will rein in these new tools once the crisis stage is past.
What are the chances that this economic contraction will spill over into the financial sector and lead us to a banking crisis?
I do not expect this contraction to lead to a banking crisis. The banks in this country and elsewhere are much stronger and better capitalized than a decade ago. There is no doubt, though, that US banks will suffer significant loan losses and much weaker profits due to their customers’ distressed conditions and to zero interest rates. More frightening to me are the coming effects on emerging market economies as these countries suffer dramatic economic losses attempting to stem the virus’s spread with even weaker health care systems. With the U.S. dollar staying strong, these emerging markets will be forced to pay back dollar-based loans with even weaker currencies. The global nature of this recession is deeply troubling and is one more reason that it will not end swiftly.
Which sectors of the U.S. economy will be hit hardest by the recession and which will weather the storm? Could you say something specifically about the energy sector?
Clearly, all travel- and entertainment-related businesses (airlines, hotels, amusement venues and restaurants) as well as real estate and personal service businesses are being devastated in the current environment. Many restaurants, personal service, and small retail businesses are likely to come back once the economy begins to reopen, but many will fail. Travel- and entertainment-related businesses will be slower to come back, with most experts not expecting significant recovery before the middle of 2021. As is usual during recessions, sales of real estate and durable goods such as automobiles will be hurt and will take time to recover. In early April consumer sentiment dropped precipitously, which will prolong and deepen the downturn.
The energy industry is often negatively affected during recessions due to declining commodity prices, but the effects are much more pronounced this time around. Unfortunately, the virus spread occurred concurrently with a collapse in oil prices as Russia and Saudi Arabia disagreed over production levels in the face of falling demand. The effect on U.S. shale production and global oil prices has been catastrophic for the industry, causing sharp cutbacks in capital spending plans and ultimately jobs. While an agreement to coordinate OPEC+ production levels has been announced, enforcement will be difficult and is unlikely to produce cuts consistent with the much lower demand. The industry will work its way through this very difficult period but will come out leaner and less profitable.
Could you take out your crystal ball and tell us how long and deep the downturn will be? Will we see a V- or U-shaped recovery or will we end up in a classic liquidity trap with an L-shaped, full blown depression?
In my view, February was the peak of the long expansion that began after the global financial crisis. Real GDP fell steeply in the first quarter, and the second quarter is expected to show a dramatically sharper decline of more than 25% at an annual rate. It is entirely possible that the economy will begin to grow in the third or fourth quarter, which would mark the official end of recession. However, non-economists never believe that recessions are over until the economy returns to the levels of income and activity achieved prior to the recession’s onset, and I do not expect the US to regain that position until the end of 2021 at the earliest. To be specific, I do not expect a full-blown depression, as posed in the question, but there will be lasting damage to our economy and Americans will remain nervous about their fortunes well into next year even if the official recession ends much sooner.