Over the last century or so, most Western economies have demonstrated distinctively cyclical behaviour. Known as the boom-bust cycle, the credit cycle or the economic cycle, the superposition of inflationary and deflationary oscillations over a reasonably linear increase in productivity growth, has defined the natural order of the financial markets and, if used correctly, is a healthy characteristic for long-term prosperity. The cycle is the result of combined government and central bank intervention with human psychology, which will be explained in more depth below. However, we now find ourselves in uncharted waters, with the most recent economic shock and economic downturn caused not inherently by natural economic factors, or by government intent, but the spread of a global pandemic, leaving governments and central banks without the use of their established toolkit with which to control the economic cycle. Historically, governments would enter a period of economic tightening, knowing full well that it has the tools with which to reverse it when needed and kick-start a new era of economic growth. This time, however, the tools may not be as readily available. So what implications does this have for the future of the economy, and perhaps is the boom-bust epoch, at least as we know it, over?
What is the boom-bust cycle?
The natural cycle of a typical economy will take the following form:
- Expansion: Interest rates are reasonably low, borrowing is high and the economy is awash with credit. Subsequently, people feel wealthier, spend more and therefore continually push incomes higher! (Since one person’s spending is another’s income). Since incomes increase, in a self-perpetuating manner, as again does spending. Sounds great, right? So, what’s the problem? Ultimately, since this rate of expansion exceeds the natural rate of productivity growth, this economic boom is unsustainable. First, there is inflation. Inflation is, in very simple terms, an increase in the price of goods. If excessive, and above the level of income growth, this is dangerous and governments are forced to take measures to counteract it. Second, if we consider borrowing as simply borrowing from one’s future self, the more borrowing that takes place, the more that must be repaid in the future. The more that must be repaid, the lower one’s spending must be relative to income, and since, again, one person’s spending is another’s income, the whole cycle begins to reverse.
- Contraction: A contraction then occurs due to reduced spending (from lowered incomes, increased prices and necessity to pay back debt). This causes the overall economic activity to decrease and again, in a self-perpetuating manner. These are all inherent reasons for the contraction, but additionally, in order to combat excessive inflation, the central bank will often increase interest rates in order to decrease credit spending further, ultimately aiming to reduce the total amount of debt running through the economy.
- Deleveraging: A contraction is inevitable and in many respects, a necessity of a healthy economy. This is because it induces a period of deleveraging. Deleveraging is effectively the reduction of the debt burden, both individual debt and government debt. The overall reduction of debt is critical before a new expansion cycle can be initiated, otherwise the total debt and ultimately the interest on that debt can exceed income and spiral out of control. By combining forces, the central bank and government have four main tools at their disposal to deleverage the economy – these are summarised in the following section.
- New expansion: Finally, once the debt burden has been brought under control a new era of economic growth and expansion may safely be initiated. This is done by reducing interest rates again and increasing credit lending. In doing so, borrowers become more credit worthy, credit increases, spending and incomes follow, and the whole growth begins again!
Above, the cycle is broken down into four main stages. Of course, in practice the total economy is a constant balance between these steps and each being called upon to varying degrees based on the economic climate of the time. The categorisation however, is a useful narrative towards understanding for the purposes of this article.
The deleveraging toolkit
As mentioned above, in order to fight excessive inflation and dangerous levels of growth, governments and central banks will be forced to increase interest rates and initiate a contraction and then deleveraging cycle. This will often coincide with an inherently deflationary response from individuals, as debts are repaid and incomes drop. Typically, this is nothing to worry about and should be controlled carefully by central banks and governments to reduce the unwanted side-effects of a deflationary economy (unemployment, reduced productivity, and negative growth). To do this, they have four main tools at their disposal, and a perfect deleveraging will involve a precisely balanced combination of all four, minimising the painful effects of tightening an economy:
- Cut spending: Also known as austerity, cutting spending helps to reduce the amount of debt, but is inherently deflationary and painful since the cuts are often felt hardest by those that need it most.
- Reduce debt: Debts can be reduced by restructuring (reducing the amount of debt repaid, or the time period over which they are repaid) or defaults. These also help to reduce the amount of debt, but again, are deflationary and painful. Lenders are hit, in cases where they are repaid less than they originally lent out and are subsequently more reluctant to continue to lend.
- Redistribute wealth: This is often done through taxes. During a contraction, unemployment will inevitably increase. As such, the government will require even more money to increase state support and start new growth and employment initiatives. One way of achieving this is a redistribution of wealth via taxes. People with a greater level of wealth are taxed more, increasing the government’s income, which can be used to service government debt as well as provide the money for redistribution where needed. Again, this is often a politically unfavourable and painful measure.
- Print money: Finally, central banks can print money, which is both inflationary and stimulatory. If used correctly, and the printed money perfectly offsets existing debt, this is a highly effective measure. If used incorrectly, as in Germany in the 1920s, there runs a high risk of hyperinflation and eventually, an even greater increase in debt.
By appropriately balancing these four forces, economic and social stability may once again increase without raising inflation beyond a safe level. Everything works as it should and in the long-term, everyone is happy.
Why this no longer works
In January 2020, with interest rates already very close to 0% and a large amount of government debt, we were heading towards a necessary period of tightening and deleveraging. Whether it were to take place in January 2020, in a month’s time or in another 12 months, it was assuredly inevitable. However, in March a seismic shock in COVID-19, hit the global economy. Shops and restaurants were forced to shut. Families and workforces were forced to stay at home. Travel halted, spending stopped, markets plummeted and we were thrown, whether we wanted to be or not, into a global economic contraction. This time however, unlike any time before, incomes dropped (due to the inability of many to continue to work) before the market. So the government and central bank is now faced with an upcoming period of deleveraging and needs to utilise the four forces above to set about an economic turnaround. But can it? Let’s take a look at these four tools one by one and see which are still available after the COVID-19 shock.
- Can the government cut spending? No, unemployment, for example in the US, hit 14.7% in April and continues at around 8% at the time of writing, so now, more than ever, the very survival of individuals and small businesses (not to mention public services) depend on government support. With the fatal effects of a global pandemic, a cut in spending will have terrible and potentially morbid implications and is therefore simply not possible.
- Can we reduce debt? Not easily. With small businesses in particular unable to operate effectively due to forced lockdowns and social restrictions, if anything, through a requirement for increased borrowing, debt will increase. Further, with more and more borrowers unable to repay previous debts, the number of defaults and the accrual of interest continue to increase.
- Can taxes be used to redistribute wealth? In part, yes. But with effective results, no. Let me explain the two reasons why. First, a lot of wealth is now held in organisations that play an increasingly integral role in the wellbeing of society. For example, more and more people depend on the likes of Amazon for groceries, basic home appliances and maybe soon, their pharmaceuticals. Unfortunately, a lot of wealth is held in companies that provide services that are essential enough and through online platforms (which, as a side effect of the pandemic, is increasingly important) that increasing the tax on such companies could result in increased prices and thus cause problems for low-income consumers. Second, and potentially more potent, the pandemic has sent a shock to consumer spending habits. With the dramatic implications of a global pandemic still very much at the forefront of behavioural habits, those that most require the redistribution of wealth, due to unemployment or dramatic loss of income, have shown a tendency to save this subsidy rather than spend. This fear factor, inducing people to save additional cash rather than spend it has resulted in up to a 5x increase in accumulated cash balances among the lower and middle income deciles. Both the liquidity printed by the central bank and cash redistributed through taxes are finding their ways quickly into store-holds of wealth, things that people think are safer, and not back into stimulating economic growth. Year-to-date we have seen an increase in the accumulation of cash balances of 12.5% of GDP globally and 17% of GDP in the US, and savings rates have risen to 20% in some cases. People, even after a redistribution of wealth, having just about weathered the most recent economic shock and concerned about more to come, now look at cash on balance sheets or in bank accounts as an asset rather than a spending opportunity.
- Finally, can central banks just print more money? Actually, they already have, a lot! For example, the Bank of England added £100bn to its so-called quantitative-easing (QE) package in June of this year. However, although keeping stock prices afloat, this additional money, again due to the fear of future turmoil, is very quickly being channelled into savings and store-holders of wealth and is not contributing enough to encouraging an economic boom. Further, the huge amount already printed has both increased government debt significantly and will very soon begin to have an inflationary effect, if not monitored carefully.
What are the implications?
Are we headed for an almighty second dip in the recession? Despite some prevailing economic doomsday predictions, probably not. However, with the ineffectiveness of the conventional stimulatory tools, we could see a painfully slow economic recovery from the last twelve months, if not stagflation. In order to tackle the enormous global debt accrued during the fallout from the pandemic, governments can try and tighten the economy and deleverage. The problem however, is that they are in no position to get things going again afterwards, with amounting debt and interest rates already set at ~0%, and will therefore be highly reluctant to do so. Interestingly, during this downturn and contrary to previous downturns, rather than deleveraging, companies have actually accumulated more debt!
With the amount of money printing required to keep economies moving, even slowly, we could see a discernible decrease in the value of money. Further, we have already seen and will probably continue to do so, cash and bonds transforming from investment vehicles into funding vehicles. In the long-term, if governments and central banks remain with their hands tied with regards to their ability to initiate a growth cycle following an economic tightening, we might not see the continuation of the boom-bust cycle, at least not in the form as we have to date.
Following the unexpected shock of the COVID-19 pandemic, governments and central banks find themselves in a position where they are not able to control the ebbs and flows of the capital markets. Normally, contractions are initiated by increasing interest rates and a drop in credit, however, the beginning of 2020 saw a major contraction initiated by global lockdowns and a sudden drop in income. With enormous debt, widespread unemployment, seismic changes in consumer spending and saving habits, and interest rates already set at ~0%, governments and CBs find themselves with little resources left to pick economies back up again. The current approach of showering the economy with new money, is indeed causing an uptick in global liquidity, but at the same time global economic activity and spending remains concerningly low. This is probably the first time in modern history that an economy finds itself in this particular balance, therefore, however the economy emerges in the coming decades, it will almost certainly not emerge in the form that we have known before.