We are in an unprecedented situation economically. Because of that, we might conclude that there is no playbook for dealing with a crisis of this type.
The question is, can we learn anything from the handling of past economic downturns and is there anything that we can apply from that past experience?
I sat in on a conference call with the senior leadership from real estate firm Marcus and Millichap late last week that attempts to address this question. Of course we are all in uncharted territory, so it’s impossible for anyone to say they have all the answers. Clearly if any did make such a claim, they’d be delusional.
2008-2010 saw a contraction of the economy of 4% over an 18 month period. This time around we’re seeing a 29% contraction in the economy in a matter of a few weeks. This number could degrade further as the impact of the health crisis deepens.
Now we have a relatively healthy financial system compared with 2007. Companies are highly leveraged, but corporate balance sheets have been pretty strong compared with history.
If we compare this current situation to 2007, the banks only had $44B in reserves in 2007. Today the banks are sitting on $1.7 T in reserves. They were vastly undercapitalized in 2007.
Back in 2007, household debt was at 100% of GDP. Today, household debt is at 74% of GDP.
Back in 2007, the economic damage was caused by major cracks in the financial system, whereas today it’s being caused by a health crisis. The concern of course is primarily for the health and wellbeing of the population. The secondary concern is on the economic damage potentially spilling over, causing massive loss of jobs, large scale corporate bankruptcies, and that in turn could destabilize the global financial system.
The news media today are portraying the economic numbers with a combination of surprise, shock and horror. That’s partly their job to sensationalize the outcomes. But really there’s not a lot of surprise to me that the lockdown is damaging to the economy.
The folks at Marcus and Millichap created an economic model that uses a number of baseline expectations. They based their model on the folks at Moody’s Analytics.
Frankly, what the folks at Marcus and Millichap have presented seems to me to be a nearly best case scenario.
Yes, the US banks are much better capitalized. The US banks reserves have never been stronger.
Simon Black and Peter Schiff had a conversation about the state of our global debt situation. That discussion centered on the massive amount of debt that is being created, and the lack of equity to support that debt. On a global basis, we have about $250T of debt. The banks don’t own all of that debt, but the banks are an integral part of the system and if their customers feel the pain as a result of bond defaults, the banks are not immune.
The banks are only sitting on somewhere between 7.5T – 10T of Bank capital. That puts bank equity at about 3% of the global debt. If we saw a destruction of only 3% of bank’s debt, the banks would be technically 100% insolvent. The question is, would a 30% decline in GDP as the folks at Moody’s have surmised be enough to wipe out 3% of bank debt on a global basis?
We are about to enter a period of economic stagnation combined with one of the most inflationary periods in the past century. We’ve seen pockets of hyper-inflation throughout history in South America in the 1980’s, most recently in Zimbabwe and Venezuela, in Weimar Germany after the Great depression, and of course in the good ol US of A during the American Revolution. The result has been the same each and every time. Every time has seen an economic collapse and a large scale destruction of savings, and a corresponding destruction of debt.
