This article first appeared in Forum, The Edge Malaysia Weekly on April 6, 2020 - April 12, 2020
It is widely known that the Chinese word for crisis consists of two characters — “wei ji”. Wei stands for danger and ji, opportunity. Every crisis is pregnant with not only danger and risks but also opportunities — for some to make money, for others to learn valuable lessons and for society to reorient or restructure its priorities, institutions and even the system.
The Covid-19 pandemic could turn out to be the singular, biggest crisis in a century — a once-in-a-100-years event. It is a health crisis which, if not stopped in its tracks, will become the most serious since the Spanish flu of 1918, that killed more than 50 million people. Within a couple of months, the number of people infected has reached almost a million with over 40,000 deaths worldwide.
This crisis has morphed into an economic and financial crisis because of globalisation. Due to the high degree of economic, financial and transport integration, countries have become so interconnected and interdependent that a breakdown or severe shock in one part of the world will reverberate through the whole system. That is why when Covid-19 hit China and forced a shutdown in certain regions, it sent a supply shock to the world economy.
Economists have initially focused on the supply shock and hoped that when China recovers, the impact on the world economy could be minimised and a recovery would be swift. However, with air travel so prevalent, the virus was transmitted worldwide within a matter of weeks. In February, only a few countries were affected, but today, 193 out of 195 countries are hit.
While the epicentre of the pandemic is Wuhan, China, the aftershocks felt throughout the world are now more serious than the place where it originated. The West, in particular Europe and the US, has become the next pandemic epicentre. Already the number of deaths in Italy and Spain, as at the time of writing, is more than double that seen in China.
Entire countries are on lockdown. This is not a demand shock but a demand collapse, the likes of which we have not seen for more than 100 years. The repercussions are almost indeterminable. When businesses are closed, companies lose their revenue and workers are laid off. Firms with interrupted cash flow will slide into illiquidity and eventually go bankrupt, leading to more workers getting retrenched, and aggregate demand drops. The Federal Reserve Bank of St Louis predicted that unemployment in the US could reach 32%, surpassing that of the 1929 Great Depression.
Impact of monetary policies — setting the stage for a crisis
Although this economic crisis did not emanate from the financial sector, what happened in the sector over the last decade played a critical part in aggravating it.
Central banks in the US, Europe and Japan have lowered interest rates to near zero, hoping that this will encourage people to borrow, spend and invest. It is intended to reduce the debt burden as the indebtedness of households and enterprises has been ratcheted up in recent years. But the past few years have shown that this had little traction. It was like pushing on a shoestring. Worse still, the credit and liquidity were not going to the right places. Individual households with little financial resources and small businesses were shunned by banks.
Instead, banks lent to corporations and financial institutions. Corporations gorged on cheap money and world debt-to-gross domestic product rose from under 200% of world GDP to over 300%. Unfortunately, much of this debt did not go to productive investment as investment as a percentage of GDP remained stagnant. Instead, it went to inflating financial asset prices and the use of financial engineering tricks such as share buybacks.
When companies buy back their own stock, demand pushes up the price and the number of shares on the open market is reduced by the amount bought. With a lower denominator and the same earnings, earnings per share automatically are inflated. Stock prices are based on EPS — the higher the EPS, the higher the stock price and the more the CEOs’ remuneration as these company executives are rewarded based on share price performance.
The average remuneration of CEOs in the US has risen 940% since 1978 while that of workers inched up only 12%. CEOs made 287 times more than their average employees in 2018. It is reported that the top 10 US airline companies used 96% of their free cash flow for stock buybacks, pushing share prices to record highs, instead of paying down debt and strengthening their balance sheet during good times. This practice is ubiquitous and not limited to the airline industry. The moral hazard is that having depleted their cash, these airlines are now seeking a
US$200 billion bailout from the US government. Last year, corporations buying their own stocks constituted the dominant source of equity demand — more than households, mutual funds and exchange traded funds.
Irrespective of the causes of financial crises, of which there are many, the one constant condition is excessive debt. Companies and individuals borrow beyond their ability to generate the income needed to pay off their debt. The huge amount of liquidity unleashed by central banks created this mountain of debt, leading to a big asset bubble. It is a dry powder keg waiting to explode. For months, economists debated what might trigger a financial crisis waiting to happen. Could it be the trade war between the US and the rest of the world, the US-Iran standoff, the pandemic, cyberwarfare or the diversification of US Treasuries? Few, if any, anticipated that a humble, invisible bug, the coronavirus, would be the agent to ignite the powder keg.
Significantly, all the major financial crises over the last few decades were not caused by consumer price or wage inflation, which central banks watched over like hawks. They were caused by financial asset inflation, which is a direct result of the loose monetary policies described above. As usual, central banks kept their eyes on the wrong ball. Not only that, they encouraged such behaviour by their asymmetric policies — on the one hand, allowing asset prices to rise, eschewing any state policy intervention and chanting the free market mantra and, on the other, intervening to bail out or prevent a decline in asset prices.
Despite the measures taken after the 2007/08 global financial crisis that strengthened the banking sector, other structural reforms did not occur. Banks’ balance sheets were significantly strengthened, thanks to public bailouts and stringent capital ratio requirements, but other parts of the financial system became more speculative, fragile and unregulated. Finance, which caused the global financial crisis, was the big winner post-crisis as the structural fallout was not severe enough. Today, the health and economic crisis threatens to bring about a major financial crisis again.
Where do we go from here?
I started this essay by stating that crises offer opportunities for us to do something different. It can be for the better or for the worse. Major crises are moments when classes in society contest for power to restructure the economy, politics and society. The failure of President Herbert Hoover to deal with the devastation of the Great Depression led to the election of President Franklin Roosevelt (1933 to 1938), who introduced major structural reforms in the economic, financial and political spheres.
Roosevelt’s “3R” policies were relief, recovery and reforms. He implemented large-scale public works to mop up unemployment, introduced a social security safety net — which still exists today — tamed and regulated finance by separating investment banking from commercial banking via the Glass-Steagall Act, and set up regulatory watchdogs for the stock market such as the US Securities and Exchange Commission. They led to the eventual recovery of the economy and, most significantly, to a well-regulated financial system that did not experience any major financial crisis for more than 40 years. Government took on a bigger role in the economy.
The stagflation crisis of the 1970s, triggered by oil price hikes and countered by accommodative monetary and fiscal policies, led to serious inflation and the demise of Keynesian policies. Discretionary policy by governments had become discredited by the failure to produce growth while reducing unemployment. As a result US President Ronald Reagan and British Prime Minister Margaret Thatcher resurrected neoliberal market ideology — the role of government was severely rolled back and the private sector and market took control. Liberalisation, deregulation and privatisation were the new mantra. Government’s role was limited to creating conditions for business to grow and to fix the problems when market failures and problems arise.
The financial sector behemoth
The financial sector was the main beneficiary of these policies. Finance became deregulated and banks merged and became too big to fail. The US financial sector was close to double its size to account for 19% of GDP, but it took home 40% of total US corporate profits. Financial innovations exacerbated speculation, risk taking, volatility and fragility. Consequently, major banking crises erupted about every 10 years with almost clockwork precision — beginning with the US-Latin American banking crisis in the early 1980s, Asian financial crisis in 1998, global financial crisis in 2008 and the imminent financial crisis in 2020. Finance, instead of serving the real economy, has become its master as these crises originated in the financial sector — the tail is wagging the dog. In each of these crises, the financial players were bailed out at taxpayers’ expense and became bigger.
If there is any silver lining to this dark cloud, it is found in some of the unintended positive consequences of this crisis — carbon emissions that are choking the world are down significantly, traffic congestion has lightened up, the mountain of garbage generated has declined, communities have got together to help the more unfortunate and nature is reclaiming its space.
As one US celebrity who was infected said in an interview, it is nature’s way of hitting back at what humanity has done to it. We were supposed to be the guardians and trustees of this earth, but we abused it. Deforestation and the destruction of natural habitats have reduced the space between humans and wildlife, opening more chances for new forms of viruses and contamination. Epidemiologists have warned for decades of the potential and dangers of new pandemics. This is the most serious but, unfortunately, it may not be the last.
This multiple crisis — health, economic, financial and environmental — is a wake-up call for humankind to rethink its hyperconsumerist economy that prides growth and, at that, one that benefits a tiny segment at the expense of the majority. It offers us the opportunity to restructure society to one that is more socially and economically equitable, more respectful of nature and our environment, and a saner balance between non-materialism and materialism.
Since the global financial crisis, there was a nascent effort to move away from the obsession with GDP growth as the measurement of a society’s welfare and well-being. The small nation of Bhutan spearheaded the alternative concept of Gross National Happiness. But these movements were muted and sidelined. The current crisis offers us the opportunity to bring them to the fore. New Zealand Prime Minister Jacinda Ardern recently said she would prioritise her people’s well-being over growth.
Seventy years ago, economist Karl Polanyi published The Great Transformation. His great contribution was that markets have existed for thousands of years before the rise of industrial capitalism in the 18th century. Markets where goods and services are exchanged to meet social needs have also been subordinated to social, political and cultural norms. But this arrangement was overturned when market was deified to become the only organising principle in society. Markets in society became the market society. This formed the basis of the neoliberal ideology that has dominated politicians and their policies in the last 40 years.
The present crisis lays bare the myth of the invincibility of the market. The market has broken down in a big way and the state is being asked to step in to solve this crisis — from the bailing out of companies to paying wages of workers, to cutting interest rates and providing soft loans to small business guaranteed by the state. In the US, President Donald Trump invoked emergency authority and directed companies to produce vital health equipment needed to fight the pandemic. Once this is over, we should not be going back to business as usual.
Markets will continue to exist and play a part in the economy. But they must be subordinated to society, to be regulated by the state to serve a greater good. The new economy must prioritise the people’s as well as nature’s well-being over profit-making for a few.
Lim Mah Hui is an economist and former banker while Michael Hengs a former professor of management science
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