#168. Polly and the sandwich-man

SCOPING FINANCIAL RISK

By their very nature, events like the Wuhan virus epidemic (or whatever the history-books end up calling it) polarise opinions, some of which become ever more extreme as the crisis unfolds.

At one end of the spectrum, those who claimed that the coronavirus was just some kind of minor variant on ‘normal’ seasonal ailments are being taught a harsh lesson in reality.

At the other extreme, though, many continue to insist that this is an ‘existential’ event, from which neither the economy nor the financial system (or anything else that we hitherto took for granted) is going to emerge, at least in any recognizable form.

If you believed either of these things, you probably wouldn’t bother trying to plan, or, as is the case here, to try to ‘scope’ the course that economic and financial trends might take.

Generally, though, extremes, whether of optimism or of pessimism, usually turn out to be wrong. Neither the Pollyanna nor the Sandwich-Board Man approach is going to help. Whistling a cheerful tune isn’t going to give us greater visibility on the post-crisis situation, but neither is walking around wearing a placard proclaiming that “The End is Nigh”.

The rational and practical response is to reason from what we do know to what we need to know. This is why, in economics and finance, we do need to try to scope this crisis.

To do this effectively, it makes sense to adopt two working principles.

One of these is that we bring new thinking to bear, so that we’re not just playing new tunes on the broken fiddle of ‘conventional’ economics.

The other is that we’re clear about the limitations imposed by the uncertainties implicit in the situation.

This is where ‘scoping’ differs from prediction. What follows doesn’t try to forecast what will happen, just to set some parameters on what might.

From troubled skies

Though the epidemic itself couldn’t have been anticipated, many of us have long recognised that trends and conditions pointing towards “GFC II” – a different and more extreme sequel to the 2008 global financial crisis (GFC) – were already in place.

A condensed version of this narrative is that the authorities responded to the “secular stagnation” of the late 1990s, first with ‘credit adventurism’, and latterly with ‘monetary adventurism’ as well. Where the former put the credit (banking) system at risk, the latter called into question the viability of the entire fiat monetary structure. Beyond buying some time (at a very hefty price), neither expedient has achieved anything worthwhile, but has inflicted an enormous amount of damage along the way.

It is, indeed, reasonable to conclude that we’ve spent more than two decades packing dynamite into the foundations of the financial structure.

Signs that economic reality might have started to break through had become apparent well before the current crisis erupted. Sales of everything from cars and smartphones to chips and components had already turned down, world trade in goods was already shrinking, and severe financial stresses were already emerging, particularly in China, and in some of the more irrational parts of the global ‘cheap money’ economy.

This is why, rather than having hit us out of blue skies, this crisis is really a bolt from the grey. Whether people had noticed these gathering dark clouds largely depended on whether they were looking at the situation from a point of view founded in reality, or were still persuaded by the ‘conventional’ tarradiddle that there was nothing too abnormal in the situation (or, at any rate, nothing so abnormal that it couldn’t be handled by our omnipotent, omniscient central bankers).

The energy perspective

These past exercises in ‘adventurism’ have had a shared assumption, which has resulted from a fundamental misconception about how the economy really works.

In order to believe that we can boost the performance of the economy by financial gimmickry – whether by pouring cheap credit into the system, or by flooding it with even cheaper liquidity – you’d have to start by assuming that the economy is a wholly financial system. If this assumption was correct, you could conclude that fiscal and monetary policy are the effective levers of control.

In reality, of course, these assumptions are mistaken. An economy that exists wholly in the realm of the human artefact of money – and is unrelated to the physical world in which we live – is a fiction.

As regular readers will know, my approach is based on the understanding that the economy is not a financial system, but an energy dynamic.

Briefly stated, the surplus energy interpretation of the economy has three central tenets.

The first is that nothing of any economic utility whatsoever can be produced without the use of energy.

The second is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process (with the consumed-during-access component known here as the Energy Cost of Energy, or ECoE).

The third part of this “trilogy of the blindingly obvious” is that money has no intrinsic worth, and commands value only as a ‘claim’ on the output of the ‘real’ (energy) economy.

The credit connection

From this understanding, we can start with the observation that financial ‘claims’ have grown far more rapidly than the ‘real’ economy on which such claims can be honoured. Comparing data for 2018 with the numbers from 2008 reveals that each $1 of reported “growth” in the global economy over that decade was accompanied by $3 of net new borrowing.

The crucial interconnectedness in this situation is that pouring money and credit into the system doesn’t just increase the aggregate of financial claims, but also inflates the apparent size of the economy itself.

The ways in which this happens can be re-visited at a later date, but what we need to know now is that it happens.

The chart below illustrates this relationship. The vertical axis shows percentage growth in GDP during the years since the 2008 global financial crisis (GFC), whilst the horizontal shows annual borrowing, as a percentage of GDP, over the same period.

The clear outlier here is China, whose annual growth has been around 7%, but whose annual rate of borrowing has been about 25% of GDP. This is why slightly more than doubling Chinese GDP (+115%) required a near-quadrupling of debt (+290%), and why borrowing has exceeded growth in the ratio 3.6:1.

The numbers for India look a lot better (though they’ve been worsening for some time), because the country has achieved strong growth without a dramatic recourse to borrowing. Both France and Japan are on the negative side of the trend-line, borrowing a lot, but getting precious little growth in return.

Fig. 1

#167 Value Destruction 01B

Individual economies aside, though, the critical observation which emerges from this is that ‘the more you borrow, the more apparent growth you can report’.

Most of the countries shown on the chart – and the world and regional aggregates, too – are at, or close to, a trend-line which connects the extent of borrowing with the quantity of GDP growth that has been reported.

What this means, as it applies to current circumstances, is that the numerator of debt (and, for that matter, of broader commitments), and the denominator of GDP, are not discrete, but are linked together.

Upwards tendencies in debt have had an inflationary effect on apparent GDP. This means that a straightforward ratio which compares debt with GDP is extremely misleading because, when you increase the one, you simultaneously increase the other.

This in turn means that debt/GDP ratios operate in ways which tend towards complacency.

The prosperity benchmark

Energy-based calibration of prosperity, as undertaken by the SEEDS model, is designed to provide a measure of economic output which, as well as taking ECoE into account, is distinct from this ‘credit pull’.

The result is to revise the interpretation of economic trends, indicating that, rather than ‘an economy of $87tn, growing at 3% annually’, we entered this crisis with ‘an economy of $53tn, that is hardly growing at all’.

Taking non-government debt as an example, let’s examine the implications of this approach.

During 2009, nominal world GDP was $60tn, whilst private debt was $85tn, for a debt/GDP ratio of 141%. Since then, both debt and GDP are supposed to have grown by just over 20% in real terms, which means that the ratio between them (shown in blue in fig. 2) seems hardly to have changed at all.

When we shift the basis of calibration from GDP to prosperity, though, the resulting calculus is both very different, and a great deal more cautionary.

Compared with a real increase of 23% in private debt, aggregate world prosperity hasn’t actually grown at all since the GFC. One reason why this is so different from the narrative of “growth” is that most of the headline increases in GDP have been the simple consequence of spending borrowed money.

The other is that ECoEs have risen relentlessly, long since passing levels at which prior growth in Western prosperity goes into reverse, and, more recently, entering a band where the same thing starts to happen to the EM (emerging market) economies as well.

This means that the ratio which expresses GDP as a percentage of prosperity (shown in red) has expanded markedly, from 183% in 2009 (and 125% back in 2000) to a current level of just over 230%.

A reasonable inference from this is that the debt-to-prosperity ratio has moved a long way out of equilibrium, leaving it poised to fall back to a prior, much lower level.

Departure from debt equilibrium is, of course, exactly what you would expect to have happened after more than a decade in which people have been paid to borrow. But quirks in the calculations which use GDP as a measure of debt exposure have served to disguise this critical trend.

Indeed, when you take this enormous process of subsidised borrowing into account, any suggestion that proportionate indebtedness hasn’t increased becomes wholly counter-intuitive.

An understanding of this principle enables us to scroll back across the years of financial excess in search of ratios which might represent a sustainable equilibrium.

This same calculation, when expressed as debt aggregates in constant dollars (as in the right-hand chart), suggests that a sharp decrease in outstanding non-government debt might have become inescapable.

Unless we’re prepared to assume that dramatic inflationary effects will destroy the real value of debt (a ‘soft default’), the implication is that we may be facing a process of extensive default, for which the term used here is a default cascade.

Fig. 2

#167 Value Destruction 05

The bigger picture

Before we move on (in future discussions) to consider what a default cascade might look like in practice, it’s important to note that formal debt doesn’t, by any means, capture the full extent of financial exposure. A better way to look at this is to reference financial assets or, more specifically, the aggregate of such assets excluding those of the central banks.

Financial asset exposure, always important, has taken on renewed significance during the uncertainties of the epidemic, and a causal link can be identified between, for example, the extremity of British financial exposure and recent sharp falls in the value of Sterling. Private financial assets stand at 1100% of British GDP, whereas the ratio for the United States is only 460%, so a fall in the value of the pound against the dollar is a wholly logical response to extreme financial uncertainty.

At the global level, financial assets data for countries accounting for about 80% of the world economy is available, and this data puts private financial assets at 450% of GDP. This a number which, like the debt/GDP ratio, hasn’t worsened since 2009.

Expressed against prosperity, however, this metric has expanded, because real financial assets have grown (by about 15%) over a decade in which prosperity hasn’t increased at all.

If, as we did with debt, we track back across the years of excess in search of the equilibrium ratios towards which a return might seem likely, the inference is that, like debt, the broader class of financial assets may face a severe retrenchment and this, again, points to various forms of default.

Clear and present danger

In what is intended as a scoping exercise, attaching numbers to these interpretations requires the caveat that our conclusions must recognise the extremity of uncertainty implicit in current conditions.

Indications from SEEDS-based analysis suggest that we should not be too surprised if debt of $60tn, and broader financial assets of an additional $100tn, are at risk.

These, as stated earlier, are scoping numbers, not forecasts.

Even so – and given the sheer scale of what we know is happening to the economy – these numbers need not seem all that surprising. The Pollyannas out there might say that little or none of this is actually going to happen, whilst the words “Told you so!” might be added to the doomsters’ sandwich-boards. The strong likelihood is that, in finance at least, the sandwich-boarders are a lot nearer the reality than the ditty-whistlers.

On the basis of this scoping exercise, we can anticipate that the global financial system could be facing a hit of $160tn, which is 185% of GDP.

That might be something from which the economy itself could recover, albeit in a battered and bruised form.

But you’d have to be a long way towards the Pollyanna end of the axis of optimism to think that the financial system could survive without either severe inflationary effects or a systemically-dangerous process of default.

CORONAVIRUS – THE SCOPE OF FINANCIAL RISK

 

#167. Tests and correctives

VALUE AT RISK, OIL PRICES CRUSHED – A SYSTEM ON TRIAL

In any moment of crisis, it’s easy to be pulled two ways, between the immediate and the fundamental. But it helps when, as now, we can recognise that both themes meet at the same point.

In this sense, “the 2020 Wuhan crisis” (or whatever it ends up being called) has acted as a catalyst for severe risks built into the system over a protracted period of mismanagement, incomprehension, self-interest, hubris and sheer folly.

Just so that you know what’s coming, this discussion is going to concentrate on two issues.

The first of these is the scope for value destruction in the current situation. Here I believe that the use of an independent benchmarking system – based on energy economics – provides an advantage over the monocular, ‘the economy is money’, way of looking at these things.

The main theme here, though, is energy in general, and oil in particular.

On the one hand, the consensus assumption is that we’ll be doing more of every sort of activity (including driving and flying) that depends on having more energy (and more petroleum) in the future than we have now.

On the other, however – and even before the recent slump in oil markets – crude prices simply can’t support even the maintenance of oil supply, let alone the 10-12% increase seemingly required by consensus expectations.

What I aim to do here is to explore this contradiction.

Before we start, though, I’d like to apologise to anyone who, over the past two weeks or so, has wondered why their comments seem to have vanished into the ether, or why there seems to have been much less debate here than usual. What appears to have happened – for no apparent reason, and wholly outside my control – has been that most notifications of comments awaiting approval have ceased to reach me. For the time being, and as frequently as possible, I’m going to review the list of outstanding comments manually.

Short shock, long folly, value exposed

Right now, as markets and sentiment gyrate wildly, we’re watching a fascinating intersection between the immediate and the fundamental playing out before our eyes.

The system that’s being shocked by the coronavirus crisis was a system that was already in very bad shape, and we can be pretty certain that, if the catalyst hadn’t (or maybe hasn’t yet) come from Wuhan, it would have (or assuredly will) come from somewhere else.

As somebody might have said, ‘if you build a monster, don’t be surprised if it bites you’ – and as somebody once did say, “some days you eat the bear, some days the bear eats you, and other days you both go hungry”. I’ll leave it to you to decide what roles greed, incomprehension and sheer folly have played in the building of the financial monster.

One of the critical issues now has to be the potential for ‘value destruction’ in the current crisis. Amongst the advantages of having an alternative, non-financial (energy) approach to economics is that it provides a second basis of measurement (in this case, the SEEDS prosperity benchmark) for just this kind of contingency.

‘Value’ really falls into two categories. The first is largely ‘notional’, and covers assets such as equities and property. Since nobody could ever monetise the entirety of either asset class, these ‘values’ are functions of the changing narratives that we tell ourselves about what things are ‘worth’. No money actually leaves somebody’s bank account because of a slump in the market price of his or her property or share portfolio.

‘Real’ value, on the other hand, consists of defined commitments which may become incapable of being honoured. The obvious example now is debt, on which businesses or households may be forced to default because their sources of income have dried up.

My approach here has been to use the Surplus Energy Economics Data System (SEEDS) to scroll back through the long years of financial excess in search of reference point ratios more sustainable than those of today.

Without burdening you with too much detail on this, SEEDS-based calculations suggest that up to 60% of the world’s private debt could be at risk, with the exposure of the broader structure of other financial assets at about 70%. My calculations are that up to $70 trillion of debts, and as much as $190tn of broader financial commitments, may be exposed.

Huge though they are, it must be emphasised that these are estimates of the scope for ‘value destruction’ – and how much of this scope turns into real losses depends upon many variables, chief amongst them being the duration and severity of the virus crisis, and the policies adopted by the monetary and fiscal authorities.

Assuming that these authorities act with more wisdom than they’ve exhibited so far – and stop firing off their scant remaining rate policy ammunition before the target comes over the hill – then the outcome isn’t likely to be anywhere nearly this bad, and a full-blown cascade of defaults can be avoided. Meanwhile, it’s possible to see stock markets settling perhaps 40% below their pre-crisis levels, with property prices down by 30%.

This, of course, presupposes that decision-makers don’t resort to putting so much gas back into the balloon that it really does detonate, leaving us scattered with the fragments of exploded hubris. In essence, do we use this event to re-group, or do we insist on ‘irrationality as usual’, regardless of cost?

After all, with the levers of the system in the hands of people who actually think that over-inflated stock markets, and over-priced property markets, are both ‘good’ things, there’s almost no degree of folly that can wholly be ruled out.

Energy – cutting away the foundations

Properly considered, there are two separate market crises happening now, both of them linked to the Wuhan coronavirus event.

One of these is the wave of falls in global stock markets, which the Fed and other central banks are trying, Canute-style, to stem. It would be far better if markets were left to get on with it, with the official effort concentrated on getting businesses and households through the hiatus in their cash flows.

The other crisis – linked to the epidemic by the anticipated sharp fall in petroleum demand, though triggered by a spat between major producers – is the sharp fall in the price of crude oil.

Some observers have suggested that the fall in oil prices will offer some relief for consuming economies, whilst others point out that the oil sector itself is going to be hit by a wave of financial failures, just as much the same thing might be poised to happen across vast swathes of the rest of the economy. The real issue, though, is how much damage this is going to inflict on the oil and gas industry, and where it leaves the industry’s ability to invest.

For those of us who understand that the economy is an energy system, the link between these events takes on a fundamental significance. Oil may be “only” 34% of global primary energy consumption, but it continues to account for a lot more than 90% of all energy used in transport applications. Fossil fuels (FFs), meanwhile, still provide more than four-fifths of world energy supply, a number that has changed only fractionally over decades.

Enthusiasts and idealists might talk about a post-fossil economy, just as the airline industry tells us that it can continue to grow whilst moving towards zero net carbon emissions. But, in both of these instances, as in others, there’s a very big gap between aspiration and actuality.

In search of neutral ground, we can do worse than look at long-range energy demand projections from the International Energy Agency (IEA), the U.S. Energy Information Administration (EIA) and OPEC.

All three publish central case forecasts, essentially mixing consensus-based economic assumptions with the mix of policies in place around the world. In broad terms, all three are agreed that, unless there are changes to these central parameters, we’re going to be using 10-12% more oil in 2040 than we use today.

‘Please sir, can I have some more?’

If you look at these projections in greater detail, it further emerges that we’re going to be doing a lot more of the things for which oil, and energy more broadly, are pre-requisites.

We are, for example, going to be driving more, even though electrification should keep the rise in oil demand for road use pegged at single-digit percentages. By 2040, there are expected to be more than a billion (74%) more vehicles on the world’s roads than there are today. It seems to be assumed that, by then, about 40% of the global fleet will have been converted to EVs, but that will still see us using more oil on our roads – not less.

We’re also, it seems, going to be flying a lot more than we already do, requiring a lot more petroleum, despite an assumed pace of energy efficiency gains seemingly running at about 1.5% annually. My interpretation suggests that passenger-miles flown are expected to rise by about 90% over that same period, though, thanks to compounding efficiency gains, petroleum use in aviation is expected to rise by “only” about 38%.

Within the overall energy position, the expectation is that our consumption of primary energy will be about 28% greater in 2040 than it was in 2018. Within this increment (of 3,900 million tonnes of oil equivalent), about 12% (450 mmtoe) is expected to come from hydro, and 44% (1,720 mmtoe) from wind, solar and other forms of renewable energy (RE). Nuclear might chip in another 5% of the extra energy that we’re going to need.

But the remaining 39% or so of the required increase is going to have to come from expanded use of fossil fuels, some of it from oil though most of it from gas (though it’s also noteworthy that no reduction in our consumption of coal seems to be anticipated). From the above, it will hardly be a surprise (though it is certainly disturbing) that annual rates of CO2 emissions from the use of energy are expected to carry on rising.

If any of this is remotely likely, though, why are oil prices languishing around $30/b?

To be sure, we know that demand is going to be impacted by Wuhan, and that producers including Saudi and Russia are scrapping over who should absorb this downside. But oil prices were hardly robust, typically around $65/b, even before the epidemic became a significant factor.

The fact of the matter is that we simply cannot square oil prices of $30, or $60, or even $100, for that matter, with any scenario calling for increases in supply.

We all know that global oil supply has been supported by American shale production, which has in turn relied on subsidies from investors and lenders. Now, though, it’s becoming ever more apparent (as was set out in a recent official report from Finland) that even ‘conventional’ oil supply is in big economic trouble.

It’s a sobering thought that, were capital flows to dry up to the point where there was a complete cessation of new drilling, US shale liquids output would fall by about 50% within twelve months. But it’s an even more disturbing thought that, unless capital investment can be ramped up dramatically, conventional oil supply is going to erode, less spectacularly, perhaps, but relentlessly.

So here’s the question – how, under this scenario, are we supposed to find sources for an increase in oil supply going forward? More broadly, and with oil and gas generally produced by the same companies, can we really increase the supply of natural gas by more than 30% over the coming twenty years? And can we – and, for that matter, should we – be using just as much coal in 2040 as we do now?

No ‘get out of gaol free’ cards

Two suggestions tend to be offered in answer to such questions, so let’s get both of them out of the way now.

One of these is that the use of renewables – whose output is currently projected to rise from 560 mmtoe in 2018 to more than 2,280 mmtoe by 2040 – can grow even more rapidly than is currently assumed.

But the reality seems to be that meeting current assumptions – boosting hydro-electricity supply by 50%, and quadrupling power from other renewable sources – is already a tough ask. The unlikelihood of these ambitious targets being beaten is underscored in the figures.

Energy transition has been costed by IRENA at between $95 trillion and $110tn, the latter equivalent to 720x today’s equivalent of what it cost America to put a man on the Moon. This time, of course, it isn’t just rich countries that have somehow to find this level of investment, but poorer and middle-income nations, too.

Annual capital investment in REs was, in real terms, lower in 2018 than it had been back in 2011, mainly because prior subsidy regimes have tended not to be scalable in line with expansion. Yearly capacity additions, too, stalled in 2018.

The really critical snag with “big bang” transition is simple, but fundamental. RE technology has yet to prove itself truly “renewable”, because capacity creation, and the building of the related infrastructure, cannot yet be undertaken without the extensive use of fossil fuel energy in the supply of materials and components.

The second notion – which is that we can somehow “de-couple” the economy from the use of energy – is risible, even in an era in which we often seem to have “de-coupled” economic policy from reality. The EEB was surely right to liken the search for “de-coupling” to “a haystack without a needle”.

Until somebody can demonstrate how we can drive more, fly more, manufacture more goods and ship them around the world, build more capital equipment, and supply more of basics such as food and water, without using more energy, “de-coupling” will continue to look like a punch-line in search of a gag.

This is really a matter of physical limitations – and there’s no “app” for that.

Stand back………….

On the principle that “what can’t happen won’t happen”, we need to stand back and consider the strong possibility that the consensus of expectations for future energy supply is simply wrong.

Let’s assume, for working purposes, that RE supply does, as expected, expand by 2,170 mmtoe by 2040, and that hydro and nuclear, too, perform in line with consensus projections. In this scenario, supply of non-fossil fuel energy would, as specified, be higher by about 2,370 mmtoe in 2040 than it was in 2018.

At the same time, though, let’s make some rather more cautious assumptions, well supported by probabilities, about fossil fuels.

For starters, let’s assume that shale oil production doesn’t slump, and that other forms of oil production remain robust enough to keep total supplies roughly where they are now. This would mean that oil supply won’t have fallen by 2040, but neither will it have delivered the widely-assumed increase of 10-12%. Let’s further assume that gas availability rises by 15%, rather than by 30%, and that the use of coal falls by 10%.

In this illustrative scenario, fossil fuels supply remains higher in 2040 than it was in 2018, but by only about 300 mmtoe (+3%), instead of the generally-expected increase of 1,540 mmtoe (+13%). This in turn would mean that, comparing 2040 with 2018, total energy supply would be higher, not by the projected 28%, but by only about 19%.

…..and do less?

My belief is that this is a more realistic set of parameters than the ‘more of everything’ consensus about our energy future. If energy supply does grow by less than is currently assumed, growth in many of the things that we do with energy is going to fall short of expectations, too.

Let’s unpack this somewhat, to see where it might lead. First, if expectations for RE are achieved, we can carry on using more electricity, though not at past annual rates of expansion.

But less-than-expected access to oil would have some very specific consequences. With population numbers still growing, we’ll need to keep on increasing the supply of petroleum products to essential activities, such as the production, processing and distribution of food. You’ll know that my expectations for “de-growth” anticipate a lot of simplification and ‘de-layering’ of industrial processes, and there’s no reason why this shouldn’t apply to food supply. But it remains hard to see how we can supply more food from less oil.

In short, there are reasons to suppose that oil supply constraint is going to have a disproportionate and leveraged impact on the discretionary (non-essential) applications in which petroleum is used. At the same time, faltering energy supply – and a worsening trend in surplus energy, reflecting the rise in ECoEs – is likely to leave us a lot less prosperous than conventional, ‘economics is money’ projections seem to assume.

From here, it’s a logical progression to question, in particular, whether the assumption of continued rapid expansion in travel might, in reality, not happen. We could take – but, so far, haven’t taken – ameliorative actions, including limiting car engine sizes, and promoting a transition to public transport. My conclusion – which is tentative, but firming – is that we might be a lot nearer to ‘peak travel’ than anyone yet supposes.

The assumption right now seems to be that, as and when the virus crisis is behind us, we’ll go back to buying more cars and using them more often, flying more each year than we did the year before and, perhaps, rediscovering a taste for taking cruise-ship holidays.

Let’s just say that such an assumption might well prove to be a long way wide of the mark.

 

#166. Lines of contagion

COULD THIS BECOME A BANKING CRISIS?  

Whilst the world watches the wild gyrations in stock markets, and investors try to absorb the economic implications of the Wuhan coronavirus, it’s important to remember that market falls are neither the only, nor indeed the most important, financial effects of this situation.

It doesn’t take all that much joined-up thinking to spot the lines of financial contagion that threaten to transition this from an industrial problem into a threat to the banking system.

What matters now isn’t how much theoretical asset value investors may have lost, but the real, cash-flow consequences for businesses and, by extension, to their lenders.

Essentially, slumps in equity prices simply reduce the amount that owners could get for their shares now, compared with those that they could have realised a week or so ago. Except where stocks have been acquired using debt, there are few immediate, cash-outflow effects. Shares that were once worth $50 might now be worth only $40, but no money has actually flowed out of the typical investor’s bank account.

The real (and systemically-hazardous) damage being inflicted by the epidemic is happening, not in stock prices, but in business activities ‘at ground level’. With systems in lock-down, workers idled and supply-chains ruptured, a large and growing proportion of the world’s businesses are unable to produce, sell or deliver goods and services – which also means that they don’t get paid.

Just because revenues dry up, obligations do not. These include wages, rents, administrative overheads, sums owed to trade creditors, maintenance costs, tax payments and – in this context, most critically of all – the servicing of debt. Fundamentally, then, what looks to a watching world like an asset pricing drama is, in reality, a cash flow or liquidity crisis.

This in turn puts the banking system in the eye of the storm.

What affected businesses need now is financial support. They need lenders to give them more time to pay and, for the duration of what might turn out to be a very protracted loss of revenue, they also need additional funds to cover their various outgoings.

Firms which do not get this support face collapse, either because they can’t meet their debt service obligations, or because they simply run out of money. This is where the notional losses of value on the market’s ticker-boards turn into a real, systemically-damaging destruction of value.

This doesn’t mean that firms are powerless supplicants over whose fortunes their lenders sit in judgment. If businesses do start to fail, the banks could face rapid and crippling losses. Slashing interest rates, the central bankers’ prior preferred tool, can do little or nothing to resolve this issue.

Rather, governments and central banks have to find ways to ‘support the support’ that businesses need from commercial lenders, and they need to do it urgently.

A reduction in the rate of interest that you’ll be paying in the future doesn’t help you to pay wages, creditors, taxes and overheads now, and neither does it solve a liquidity crisis compounded by scheduled debt service outgoings.

It may be obvious that lower borrowing costs aren’t going to tempt frightened travellers back on to aeroplanes or into the shops, but it’s equally true, and even more important, that the simple lowering of rates doesn’t, and can’t, keep businesses going. Banks, then, need to be lending more – and this at the very time when both inclination and prudence might be counselling them to lend less.

Decision-makers in government and central banking need now to be asking themselves two critical questions.

The first of these, of course, involves working out ways to push support through the commercial banking system to the businesses that need it.

But the second is what do to if ‘operation support’ either fails, or is only a partial success. If cash-strapped companies start to fail to any significant extent, the inevitable consequence will be a compounding cascade of defaults.

This isn’t a problem that can be solved by putting yet more borrowers into the limbo of “zombie-ism” – being allowed to add owed interest to outstanding capital balances doesn’t enable firms to meet their ongoing cash needs.

The likeliest outcome at this point is that the authorities will recognise and react to the business liquidity crisis, but won’t be able to do so in ways that are sufficiently comprehensive, and which meet the urgency of the situation.

This, I suspect, is when a lot of recent history starts to be regretted. The scale of stock buy-backs in the United States, for example, has effectively replaced large amounts of shock-absorbing equity capital with inflexible debt. China has spent ten years almost quadrupling its debt in order to slightly more than double its GDP. Globally, monetary policies adopted during the GFC, and then kept in place for far too long, have paid people (and businesses) to borrow. Cheap liquidity has created huge areas of exposure, with stock markets just one example amongst many.

Anyone who thought that over-inflated asset prices were the only hostages handed to fortune by credit and monetary adventurism could now be drawn face to face with an uncomfortable reality.

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PLEASE NOTE

11th March 2020

As you’ll have seen, there’s been a big jump in the number of comments posted here.

This has happened because I’ve just found out that the system which notifies me of comments awaiting approval has stopped working, seemingly a couple of weeks or so ago.

Please accept my apologies for this (and my grateful thanks go to the person who worked out what was causing this glitsch).

Until this is sorted, I’m going to do the approvals process manually, looking regularly at the list rather than waiting to be notified. I hope this won’t be much slower than the normal process.