The first problem is the liquidity crisis caused by the interruption in the production of goods and services, which manifested in the first phase of the crisis through the emergence of payment backlogs. The second problem is the spectre of unemployment resulting from the shutdown or reduction of companies’ business activities. The third problem is the settlement of losses caused by the cessation or limitation of production during the lockdown. The fourth is the return to the pre-crisis path of economic growth.
Each of these problems requires different instruments or different use of the already existing, economic policy tools. Proper economic policy should be focused not only on the short-term weakening of the crisis-related phenomena, but also on the long-term effects of the applied instruments, which may prove costly from the point of view of returning to a path of sustainable, economic growth. It is especially crucial to be mindful of the scale of the burdens taken on by the public finance sector.
The liquidity crisis
The liquidity crisis requires three types of measures: maintaining lending to enterprises, regardless of their current financial situation, suspending the fixed payments of enterprises where possible, and stabilizing the prices in the financial markets. It should be emphasized that the tensions in the payments system should be viewed as a temporary phenomenon. Therefore, this problem should be solved using repayable financial instruments, both in the form of loans, as well as a suspension of the servicing of liabilities. Such measures force enterprises to rationally adapt to the changing conditions, e.g. by searching for new forms of business activities, new products, and/or reducing costs. Entrepreneurs’ stimulated activity should lead to development of different cash flow scenarios and adjusting to them ways of obtaining liquidity, including the issuance of their own financial instruments. For this reason, it is important to maintain the trade in financial instruments, which in turn requires institutions that will take on the role of a market maker.
As we can see, the financial sector, and especially the banks, should be the leaders in the fight against the liquidity crisis. In the passive variant the banks, at the very least, should not limit the current lending to existing customers. In the active variant they should support new customers with credit and engage in the market of short-term securities issued by companies (e.g. by purchasing bills of exchange). In order to stimulate bank’s activity, it is necessary to provide it with liquidity from the central bank and to create mechanisms enabling the public sector to cover a part of the credit risk. The liquidity pumped into the banking sector should also reach the less prominent parts of the financial sector, that is, investment and insurance funds. The active operation of these institutions should be facilitated by the issuance of short-term commercial papers.
Regular customers of banks shouldn’t have any problems in obtaining short-term financing from banks thanks to the low short-term interest rate of the central bank and the ease in obtaining possible refinancing from the central bank. But new clients’ access to financing can be more difficult because of the sharp rise in risk perception. This problem will mainly concern micro and small companies. In the case of small businesses that meet the de minimis conditions, they should be able to get guarantees. Micro-companies are in a more difficult position because many of them financed their activity using their own funds or made use of consumer credits, which are more expensive but easier to get. In this case, the chances of obtaining financing from banks are slim. At the most such support could be a suspension of repayment of previously incurred consumer credit. The liberalization of the mechanisms for the creation of provisions for non-performing loans (NPL) should provide an incentive to postpone the repayment.
In most cases, the liquidity crisis should be brought under control through an active response of the banking sector supported with an appropriate policy of the central bank. The public sector should only become involved in the system of credit guarantees for small businesses and should utilize the option of automatic suspension of public levies for micro-enterprises. Over time, the use of repayable instruments will allow the identification of sectors and companies that are forced to continually roll over the obtained financing, signaling a transition from a liquidity problem to the issue of the long-term settlement of the generated losses.
The slowdown in production and the reduction in sales in conditions of a liquidity crisis forces companies to reduce employment and to stop using services provided by self-employed persons. In this situation, we can choose between two strategies: allow the quick layoffs of redundant workers or use instruments enabling the artificial retention of workers. The first strategy is applied in countries with a very flexible labor market, in which the process of hiring and firing is quick (among other things, this is the cause of the rapid increase in unemployment in the United States and its likely rapid decline after the lockdown). The structure of the European labor market is different. On the one hand there are people employed under a regular employment contract, and on the other there are people who are self-employed. Due to the existing labor market regulations, firing workers is an expensive process, therefore relatively short limitations in production activity will be conducive to solutions based on employee retention. The array of available instruments is sufficiently broad, ranging from various forms of paid leave to reduced working hours. Enterprises may be encouraged to maintain their employment levels through the suspension of social insurance contributions and subsidies for reduced wages in amounts close to the unemployment benefits.
In contrast to the liquidity crisis, tackling the issue of unemployment requires the authorities to launch payments that will constitute a lasting burden on the budget. Given the low levels of cash reserves, the households’ and micro businesses’ limited ability to borrow, it is necessary to rapidly mobilize funds paid out in the form of unemployment benefits and subsidies for self-employed persons.
Covering the losses resulting from the national lockdown
The interruption in the production of goods and services associated with the lockdown leads to a drop in sales and revenues. The settlement of this loss is an important problem. In the system of orthodox market economy, a decline in production is accompanied by a corresponding decrease in profits and wages. Therefore, the settlement of the resulting losses in the real economy takes place naturally, through a reduction in employment, which is accompanied by a decline in the wage bill, and through a process in which the balance sheet losses are covered by the companies’ equity, or through mechanisms of M&A or bankruptcies. Of course, the orthodox market system allows the existence of a commercial insurance system (for example, unemployment insurance schemes), which allows for the “dilution” of the losses and their partial coverage using the accumulated insurance funds. In the modern market economy, the key mechanism “diluting” the losses are the public finances.
We are forced to face the problem of an appropriate distribution of the losses between the public sector and the entities in which the loss occurred. State interference is necessary for at least two reasons: in order to protect the standard of living that households are accustomed to, with particular emphasis on people at risk of unemployment; and in order to prevent the mass bankruptcies of companies which could threaten the continuity of production processes.
Ultimately the goal is to keep businesses in a condition, which ensures that the losses incurred during the lockdown will not hinder the future return to a path of economic growth. In the case of households, the objective is to bring consumption after lifting the lockdown to the pre-crisis levels, in spite of the loss of incomes. In relation to businesses, the main objective is to restore the pre-crisis levels of production and employment. As a result, the path to recovery should be swift and should take the shape of the letter “V” and not the shape of the letter “U”.
Why is the involvement of public finances in covering losses long-lasting? The liquidity crisis only requires the active involvement of the banking sector, stimulated by a loose monetary policy of the central bank and the guarantees of bank loans for small enterprises. Budgetary instruments keep unemployment down until the economic recovery. In contrast, the losses of businesses and households absorbed by the public finances are transformed into a long-lasting increase in public debt, which requires a long time to be neutralized.
The decrease in the net savings of households and the slowly increasing wage bill inhibit the return of consumption growth to the previous long-term levels. In order to increase the propensity for consumption, it is necessary to neutralize the effects of the current debt. This can be achieved in a permanent way by increasing the ability to borrow or by introducing instruments which create a permanent income. In both cases, this requires a long-term commitment of public finances. In the first case, this would mean taking over the costs of the higher loss-ratio of consumer loans from the banks. In the second case, this would mean a government subsidy program providing a fixed income which creates a financial buffer protecting against the changes in the labor market. Similar instruments should be applied in the case of micro-enterprises, whose financing methods are similar to those of households.
When companies roll over short-term loans incurred during the liquidity crisis, this indicates problems with covering losses. In such a situation it is necessary to take out a long-term loan allowing for the restructuring of the company. However, the financial sector may not be willing to provide sufficient support. A direct capital injection is necessary. The appropriate entity in this case is a public investment fund, which obtains financing directly on the market using debt instruments guaranteed in whole or in part by the State Treasury. The resources obtained by the fund should be spent on financial instruments which include the possibility of converting debt into equity capital. A successful process of corporate restructuring should result in the fund’s gradual withdrawal. As a result, some of the invested public funds would be gradually regained.
While providing capital support it is also necessary to take into account the possible “zombie effect”, that is, long-term support for companies that would be doomed to bankruptcy in normal conditions. The public investment fund should be aware of this problem. In the event of an unsuccessful restructuring of a company, the fund should withdraw its financing, even if there is a risk that the previously invested resources could be lost. A bankruptcy puts an end to an unsuccessful project and allows freeing the resources and putting them to other activities.
Getting the economy back on a path of the sustainable growth
Achieving the pre-crisis levels of production and employment does not mean that we automatically enter a path of sustainable growth. The economy will be weakened by the debt overhang, which will grow in both the private and the public sector. A large part of the private debt will be concentrated in industries that suffered the most during the lockdown. A part of this debt will be taken over by the public finances. Besides the acquired debt of the private sector, the public debt will also be burdened by the deficit from the period of the lockdown.
The neutralization of high levels of debt will be a difficult challenge for European countries, most of which are already heavily indebted. A rapid reduction in debt by achieving a primary budget surplus may be a risky strategy. Increased taxes or reduced social spending could slowdown economic growth. A gradual neutralization of debt could occur naturally in conditions of persistently low real interest rates. The policy pursued by the European Central Bank goes in this direction.
For countries outside the Eurozone the above strategy requires the fulfilment of several strict conditions. Firstly, it is necessary to control inflation, in order to prevent a permanent de-anchoring of inflation expectations. Secondly, an elevated level of inflation must not lead to a build-up of imbalances in the asset markets (for example, an increase in real estate prices). Thirdly, the fluctuations in the exchange rate must not significantly affect the process of rolling over foreign debt. Fourthly, the fiscal policy must be consistent with the objectives of the monetary policy.
Although central banks are doing a lot to support the national economies, they will not replace an active fiscal and economic policy. The latter will have to help companies in adapting to the permanent changes that the pandemic will cause in the production structure, cooperation systems, and in foreign trade relations. The retreat from globalization will require the development of new rules of international cooperation. As we can see, returning to sustainable growth is be the most difficult challenge ahead.
Andrzej Raczko, PhD, is a former Poland’s Minister of Finance and an advisor to the Governor of the central bank, NBP.
The views expressed in this article are the private views of the author and are not an expression of the official position of the NBP.