“History does not repeat itself, but it often rhymes” Mark Twain
Despite the obvious differences in cause, the current virus-triggered economic meltdown and the Great Financial Crisis of 2007-2008 have some peculiar parallels.
In 2015 I wrote the following candid, if not particularly prescient, words:
“Could the next … crisis instead be a CCP crisis, or a hedge fund crisis, or an insurance company crisis? Will it be triggered by property prices or by emerging markets or some new risk? For my own part, I worry about geopolitical strife causing problems – especially if they arise from tensions with the nascent economic superpower of China. But, if I’m honest, I will admit that I really have no idea.”
And nor, I would say, did anyone else. But now, sadly, we do know its nature: this one is a viral pandemic crisis.
The economic effects have already been dramatic even at this relatively early stage. Stock markets are in free fall while volatility rockets. There has been a stampede to ‘safe’ assets. Urgent pleas for governmental assistance from distressed companies are rising in volume every day.
It’s all very familiar from 2008. But in economic terms the two crises are, of course, fundamentally different.
The GFC was almost purely endogenous; a great self-inflicted snarling up of the monetary pipes of banking that caused financial panic. The COVID-19 crisis, on the other hand, had an exogenous spark to light the fire: literally ‘force majeure’. It’s a massive, global, simultaneous demand and supply shock.
As a result, the sectoral epicenters of the two crises are quite different. In 2008 the banking sector was hit first and hit hardest and it was only later that its sickness radiated out to infect the ‘real world’ economy.
In 2020, the hardest-hit firms are those hobbled by restrictions on travel and social congregation: airlines, airports, rail companies, providers of live entertainment, hospitality firms etc. Adding to the chaos is a spat between Saudi Arabia and Russia that, by unlucky coincidence, has crushed oil prices – thus stressing some higher-cost oil producers.
Time alone will tell if these problems – in a reverse of 2008 – come back to cause symptoms of distress in banking. Banks’ balance sheets are certainly stronger than in 2007-2008 but we are only at the first stage of this crisis.
But so much for the differences: I’m more interested in the parallels.
The first is that both crises were set in motion by dislocations that, in purely economic terms, were quite small – or potentially small – compared to their huge knock-on effects.
Back in 2008, Ben Bernanke, Chairman of the Federal Reserve, put it like this about the initial trigger for the GFC:
“…prospective subprime losses were clearly not large enough on their own to account for the magnitude of the crisis…rather, the system’s vulnerabilities…were the principal explanations of why the crisis was so severe and had such devastating effects on the broader economy.”
In this crisis the same is true. Before I go on, and before I attract hate mail, let me say that I have a lovely 84-year-old mother as well as several elderly, or chronically ill relatives and in-laws whom I am naturally extremely concerned about.
That said, seen – not through my eyes – but through the callous, indifferent and mechanistic eyes of economics, the real and prospective death toll of this epidemic is relatively minor – as is its raw economic impact.
Take Italy: over the last month, as of today, a shocking number of 2,500 people have lost their lives. But, during the same period, based on Italy’s normal mortality rate of 10.3 people per thousand per annum, we would have expected around 50,000 to die in a run-of-the-mill year.
What’s more, since the disease, like natural mortality, most heavily affects the elderly it almost certainly means that the marginal increase in lives lost is only a fraction of the headline number. Bluntly put, many of the victims – who because of their age are in any case less economically productive than the population’s average – would have died anyway.
But, of course, this cruelly reductionist calculus is NOT how any civilized nation thinks. Each one, in its own way, is scrambling to protect its valued older citizens and thus, by doing so, the economic impact of the disease is being massively magnified. This pattern resembles 2008, when perfectly rational risk mitigation actions by individual banks hugely exacerbated the otherwise containable fall out from sub-prime.
Another parallel is the way that interdependence and complexity is magnifying the economic effects. Back in 2008, it was the intricate web of computerised linkages between banks in every corner of the globe that was the transmission mechanism for financial infection. With COVID-19 it is, instead, the web of travel linkages both between and within nations that makes up the pathway for real infection. Curtailing these links is what is causing economic disruption right now.
And, just as in 2008, this disruption is leading to herd-like crowd behaviour. Then it was bank runs and ill-tempered queues outside Northern Rock. Now, the news footage is showing people queueing and fighting over toilet paper. To misquote Marx: ‘History is repeating itself both as tragedy and as farce’.
Another intriguing parallel is around the crucial role of leverage.
In the Great Financial Crisis leverage was front and centre. Banks did not have sufficient capital – or, rather, were feared not to have sufficient capital which, during a crisis of credibility, funding and liquidity, amounts to the same thing. Capital represented the safety buffer to allow the banking system to cope with an unexpected shock; the fear was that it was insufficient.
Now, in the current crisis, the safety buffer – the ‘capital’, by analogy – is the capacity of countries’ healthcare system to cope with a surge of severely ill patients. The concern – once more – is that it is not. Hence the attempts at lockdown, at ‘flattening the peak’, the clarion call for retired doctors, the scramble for ventilators. The systemic leverage (as measured by the ratio of the impact of tail risk to the means to absorb it) is proving too high, just as it did in 2008. We need to decrease it.
And, as in 2008, elaborate computerised modelling is playing a central role. Then it was one of the root causes of the crisis: it allowed the for the creation of derivatives too complex to understand and gave false comfort that excess leverage was safe via credit ratings and risk measurement methodologies like VaR. Now, instead, it is firing up after the fact to help governments cope with the effects of ‘health system leverage’. In doing so, its effect is benign.
Probably the most important way that this crisis is rhyming with 2008 is the role that the state is playing. Back then, when the crisis reached a crescendo after the default of Lehman Brothers, national governments were forced to step in to rescue the economy: TARP, nationalization, massive cuts in interest rates, QE. A gigantic barrage of – mainly monetary – artillery was fired at the problem.
This time, because the crisis has a different nature and because – let’s face it – there is very little room for any meaningful extra monetary loosening, the artillery will be fiscal. The need is obvious. For instance, over three million people are employed in the hospitality industry in the UK alone. As the country locks down, these employees will face what is effectively unemployment for many months. That’s before we start to look at workers in transport, in airports, in retail and many more affected sectors.
Accordingly, the UK has already promised a multi-hundred-billion-pound programme to prop up its economy. So has France. The US appears to be going down the same path. The rhetoric has been one of war and mobilization. To me, the more precise parallel is the New Deal and the Great Depression. But either way, it will mean an astonishingly large role for the state in many western countries’ economies – certainly when compared to recent history – and I am not convinced that the response will not need to get even bigger.
Looking to the future, are there any lessons from 2008 that might inform us as to what will occur?
One prediction I will make by reference to the GFC is that, in the same way as post-GFC legislation attempted to reduce leverage and risk in the banking system, similar efforts will be made to reduce the ‘leverage’ of health systems. More surge capacity will be called for and created; international mechanisms to coordinate response will be strengthened. (However, I sincerely hope that, unlike 2008, there will be no long process of trying to find scapegoats in the aftermath.)
Also, what I think is certain is that – in precisely the same way as it has been difficult to wean the world economy off the monetary policies introduced after the GFC – it will be many years before the fiscal effects of this crisis wash out. In saying this, I am merely observing the lessons of history: the economic effects of wars and depressions on the state’s role in the economy have typically lasted for decades. Think of the longevity of the mechanisms of the New Deal, of Bretton Woods, or of the welfare state in the UK.
It all means that we are living through times that will be cited in history books for centuries.
In a way, I find that strangely comforting.