The Investment Scientist

Professor Sussman: The Secondary Effect Can Be More Devastating!

Posted on: April 8, 2020

 

3__L3__001.pngToday the Oxford University Business School arranged a webinar in which my  macro-economics professor, Oren Sussman, explained to us the economic impact of the Coronavirus. I will summarize the key takeaways below. 

The capitalist system is characterized by periodic crises. The last one was the 2007 housing crisis. Even without the Coronavirus outbreak, we were on borrowed time. The long expansion since the last crisis was very much fueled by easy money from the Fed and imprudent fiscal policy from the federal government. As a result, the whole economy is overly leveraged (that is to say,  having too much debt.) An economy without too much debt is like a pond of water. A stone thrown at it will create ripples that will eventually dissipate. An economy with too much debt is like a pane of glass. A stone thrown at it can break the whole thing. Prior to the Coronavirus outbreak, our economy was already like a pane of glass.

The $2.2T rescue package passed by the Congress and signed into law by Trump will soften the shock – think of it as putting a layer of cloth on top of the pane of glass – but it does not address the underlying brittleness of the economy. The amount of money further calls into question the United States’ fiscal prudence.

The direct economic cost of the Coronavirus will not be that big even if the stoppage lasts for three months. It’s the high debt ratio and the interlocking obligations that could amplify the economic cost. A good analogy is a household with a six-month emergency fund and no debt. Losing a job for three months is a situation that can be handled. Compare this to another household with no emergency fund and with rent to pay. This household will have to miss their rent payment. The landlord will then have to miss his mortgage payment to the bank. The bank will have to miss its own obligations. This domino effect will cause the economy to come to a screeching halt. This secondary effect is much more devastating than the direct cost of the Coronavirus.

The best way to mitigate this secondary chain reaction would be for Congress to legislate that this Coronavirus outbreak is a force majeure event, and all are allowed to defer their obligations by three months. If done in a coordinated and equitable manner, this could backstop the domino effect.

If nothing is done, it is quite likely the economy (the pane of glass) will break somewhere, probably in a spot we are least able to foresee.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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