Bringing the Economy Back from Life Support

With recent data showing a coronavirus-driven recession in the United States appears inevitable, the question for many investors is how long it will last. Sonal Desai, Chief Investment Officer, Franklin Templeton Fixed Income, weighs in on the differences between this one and other recessionary periods—and whether policymakers can engineer a recovery.

It is happening: US jobless claims went from almost nothing to about 10 million in the space of two weeks. Nonfarm payrolls plunged by 700,000 in March—they had been rising by almost 200,000 a month on average for the last 10 years. The US unemployment rate jumped from 3.5% to 4.4%—cue in the shocked chorus of analysts and media. The recession is here and the economy is now on life support.

But what kind of recession will this be, and what kind of recovery will follow?

I have seen countless comparisons to the Global Financial Crisis (GFC) and the Great Depression. Perhaps the COVID-19 recession will be as bad as 2009 or 1929, or even worse—but this time the scale of the recession is still partly within policymakers’ control. This is a very different recession—and understanding the difference is crucial to figure out how it will unfold.

This recession has not been triggered by an economic or a financial shock. It’s a recession by fiat—created by government decree much like a fiat currency. The US government has decided to shut down large parts of the economy overnight, instructing workers and consumers to stay home. This was the most prudent emergency move to halt contagion, but its massive economic and human costs are quickly becoming clear.

The key difference with the GFC lies in the underlying health of the economy. In 2009, the trigger was the unraveling of an enormous multi-layered credit bubble. The financial sector seized up and credit stopped flowing. Financial companies enacted massive layoffs; non-financial companies followed; this trickled down to shrinking demand for services. The recovery faced two major challenges: (i) how to repair banks’ balance sheets and get credit flowing again; and (ii) how to revive investment, employment and productivity in the right areas after the credit bubble had caused a massive misallocation of human capital and financial resources.

This time the banking sector is in good shape—indeed the government and the Federal Reserve (Fed) are relying on it to keep the economy alive while we fight the virus. Some companies are overleveraged following an extended period of record- low interest rates, but overall the non-financial corporate sector has proved resilient to a number of other shocks, from political uncertainty to protectionism.

The key difference with the Great Depression lies in the policy response. In 1929 there was none; in fact, the Fed contributed to the depth of the recession by tightening policy further even as the economy was falling off the cliff. This time the fiscal and monetary policy responses have been immediate, forceful, and well designed—building on the recent experience of fighting the GFC. The Fed has announced unlimited quantitative easing and new facilities to keep credit flowing where it is needed. Congress approved a $2.2 trillion package to boost unemployment benefits and get cash to the households and businesses that need it—quickly, in a matter of weeks.

The devil is in the details, however, and execution is often harder than design. There will be frictions and hiccups as banks struggle to process massive numbers of new loans and government agencies struggle to channel help to a suddenly much larger number of people in need.

The latest US unemployment figures reflect the unusual nature of this recession. The number of people who reported being on temporary layoff jumped by 1 million in March, to a seasonally adjusted 1.8 million. Many employers clearly hope the shutdown will be brief, in which case it appears they intend to rehire their workers as soon as they can resume operating. Permanent job losses numbered “only” 177,000.