2020 crisis fixes are 2021’s biggest risks
Can we afford it if the vaccine doesn't fail?
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All indications are that 2021 will host one of the most dramatic economic recoveries ever, with the suppression of the coronavirus driving new consumption and production, reversing 2020’s lockdowns.
Still, there is ground for skepticism about the promised rebound. The biggest potential culprits: vaccine failure and a breakdown of the Fed’s low interest rate regime. Both pose huge risks, reflections of deep-seated flaws in the economic system as a whole.
The west’s vaccine-based virus response rejected proven hygiene-based strategies with high levels of state economic intervention. Instead, the United States and its allies made private pharmaceutical companies the leading element in responding to the virus, with states rolling back regulations and transferring resources in support.
Now at the expense of 300,000 U.S. lives the strategy is on the cusp of working, but major obstacles remain. First, the vaccine has to be actually produced, distributed, and taken. Pfizer already had to cut its expected deliveries in half due to bottlenecks on raw materials. States are also unsure how many shots they will get -- federal sources tell them different numbers, ranging from tens to hundreds of thousands -- and so distribution plans have a high degree of uncertainty at this point.
As for uptake, the vaccination requires two shots, and if substantial portions of the population miss the second shot -- current estimates are that 30% will skip it -- it could open the door for vaccine-resistant mutations of the virus. The CDC at present has no plan to prevent this. The vaccine also seems to entail significant side effects, which not only discourage adoption, they could sideline the healthcare workers expected to get the shot first.
Furthermore, even if distribution goes off without a hitch, we have zero information about how long the vaccine will last. COVID antibodies appear to only last three months after recovery, shorter than the vaccination rollout period. If the vaccine has a similar duration of effectiveness, the initial recipients could be at risk again while the virus is still spreading, making the strategy a failure.
The good news: this is a worst-case scenario, and the vaccine is likely to work well enough for long enough to reduce the pandemic’s threat. But this does not bring us out of the economic woods for 2021, as this very boost to the economy could upset the fragile financial order built by the Federal Reserve this year.
March’s virus outbreak sparked a desperate scramble for cash by investors, and their asset fire sale crashed bond prices. Since bond interest yields move inversely to their prices, interest rates spiked sharply.
High, uncertain interest rates make short-term borrowing -- necessary for day-to-day operations in all large industries -- expensive or impossible. Firms have to slash expenses and shut down operations, crushing economic activity and aggregate demand. This can begin a deflationary cycle, the kind of crisis Great Depressions are made of.
The Federal Reserve responded by cutting its prime interest rate to nearly zero and announcing $700 billion in asset purchases -- creating artificial demand for bonds, raising their prices, and dropping their interest rates. Investors approve of this sort of state intervention, but it can also distort prices. Interest rates serve as the price of credit, and lenders will not meet all debt demand at these suppressed prices, as evidenced by tightening credit conditions this year.
At the same time, with rates so low long-term investors have their own unmet need for yield on their savings. This has driven historic demand for corporate debt, and the higher the yield -- i.e. the bigger the credit risk of the borrower -- the hotter the demand has gotten. The average real yield on a 10-year corporate bond is now in negative territory for the first time: bond buyers are effectively paying corporations for the right to lend them money. Bank of America’s High Yield Index reached its lowest level ever last week, and Portugal’s junk-rated sovereign debt now has a negative interest rate.
The risk now is that if and when the economy grows next year it should drive up interest rates, which reflect future growth expectations. If demand rises faster than companies can restore capacity -- especially with U.S.-China “decoupling” dislocating supply chains -- it could spur inflation, further fueling a rise in interest rates.
That’s bad news for a debt-addicted economy, as consumers have to scale back credit-financed purchases, business margins get squeezed, inflated stock prices take a bath, and leveraged speculators in shadow financial institutions like hedge funds struggle to cover their interest payments -- risking a financial crisis. As for the “zombie companies” kept afloat by constant credit rollovers in a low interest rate environment, defaults will abound, putting hundreds of billions of dollars at risk.
So capital’s resistance to state intervention for the public interest pushed all of the system’s chips in on a strategy that still might not work. And if it does, the state intervention capital demanded for its own sake might fly apart. The 2021 story will be about how these conflicts unfold. Read Contention to see how it all turns out.
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Photo Credit: Christian Emmer