The COVID-19 crisis is less than a month old and as necessary steps are taken to mitigate the pandemic, another larger and much more dangerous crisis is looming.
Should the medical shutdown extend into the early summer, what might the economic consequences be?
The answer is a lot of short-term pain with a distant possibility of longer-term gain.
The mandated shutdown of non-essential industries has placed the economy on a fast track to systemic collapse.
With stock markets already down significantly, many pundits have predicted that, unless things return to normal quickly, markets could enter a secular bear market lasting for at least five to seven years. Secular bear markets consist of large bear markets and smaller bull markets.
Lacking serious improvement, it’s entirely possible that stock markets could decline by 90 per cent or more over the next six months.
If this happens, the financial dominoes start to fall.
Today, all major pension funds are invested in stocks. They need stock growth and market liquidity to meet their actuarial targets (roughly eight per cent growth annually). If markets collapse, fund managers will be forced to liquidate assets at steep discounts to support their cash requirements.
That means pension funds could eventually collapse entirely, leaving millions of pensioners in dire circumstances.
Simultaneous to a market failure, it’s likely the credit default swap (CDS) market will collapse, again. CDSs are insurance-like financial derivatives that companies and others use to protect the value of assets from loss. None other than Warren Buffett has described CDSs as “financial weapons of mass destruction.”
Just prior to the 2008 financial crisis, outstanding CDS obligations amounted to $67 trillion; they have now ballooned to many quadrillion. Unregulated CDS markets are risky in the best of times and aren’t designed to survive systemic crisis.
Investment banks are up next. They rely on what’s called the ‘repo’ market for their liquidity, the cash they need to operate every day. And as Lehman Brothers demonstrated in the 2008 collapse, repo markets are linked to other markets and dry up in crises. Of course, investment banks have vast CDS exposure and if the worst happens, their ability to survive would be imperiled.
Canada is squandering its intangible future by Robert McGarvey
If the financial system fails (and it’s starting to happen now), the commercial banking and major public company dominoes will fall. That will extend the financial crisis into the real economy, creating a 1930s-style economic contraction or credit collapse.
But is there also opportunity in this crisis?
This crisis will change capitalism profoundly but before we create a better capitalism, we need an emergency effort to save the admittedly far-from-perfect present one.
The big lesson learned during the Great Depression of the 1930s was governments have to act quickly to provide liquidity to recapitalize the economy. Otherwise, economic gravity will lead to a self-perpetuating downward spiral.
To avoid such a fate, we need to provide governments around the world with additional resources and new tools to refinance their economies.
But where are these additional resources to come from?
Apart from tax, governments and bankers leverage assets to generate the financial resources they need. And the additional resources needed to reflate the economy already exist but we can’t see them because – at present – they’re undocumented.
According to the World Bank, up to 80 per cent of the value drivers in the modern economy are intangible. That means, as a rule, they don’t appear in corporate financial records or in government statistics.
Because managers don’t see intangibles as assets, their accountants won’t capitalize them. But worse, even if they did, bankers don’t recognize intangibles either and can’t leverage them. We’re all the poorer for it.
Recognizing these intangibles immediately as formal assets would strengthen companies, allowing them to survive in the short to medium term and open new financing channels in the capitalist system.
In addition, if we could convince governments that there are vast undocumented intangible assets (privately and publicly owned) in their economies, they’d be able to – as in the era of the Second World War – create new monetary resources from their treasuries to reflate their economies without risk of inflation.
After the dust settles, we’ll need to fundamentally change how capitalism works. Part of that is recognizing the value in intangible assets like human capital and natural capital, in technology and in relationships of various kinds, in order to build a more balanced, equitable system.
If we’re able to implement such changes, we’ll also trigger new and much better corporate decision-making. And we’ll hopefully help erect a more efficient and equitable capitalist system.
Robert McGarvey is an economic historian and former managing director of Merlin Consulting, a London, U.K.-based consulting firm. Robert’s most recent book is Futuromics: A Guide to Thriving in Capitalism’s Third Wave.