Coronavirus Crisis versus Lehman bankruptcy: a preliminary comparison — GED Blog

The global economic crisis triggered by the spread of the coronavirus (COVID-19) is already the third major economic crisis of this century after the Lehman bankruptcy in 2008/09 and the bursting of the dotcom bubble in the early 2000s.

While the first two global crises can be primarily characterized as a demand crisis following a financial crisis, the current crisis is a combination of a demand and a supply crisis, which could cause a financial crisis. The diversity of challenges makes it more difficult to solve this crisis, and it will likely lead to greater economic damage than previous economic crises.

The Lehman crisis

The starting point of the global economic crisis in 2008/09 was the bursting of the US real estate bubble. When properties that were used as securities for corresponding loans failed, the credit bubble burst. Banks had to sell stock market shares to secure their liquidity. These sales triggered price declines. Private investors also sold stock market shares and other securities for fear of further price losses leading to a stock market crash.

The bursting of the speculative bubbls was transferred to the real economy through various channels (see Figure 1 and here).

The immediate effects of the financial market crisis that resulted from the Lehman bankruptcy were:

  1. An abrupt slump in demand for goods and services (Demand Crisis).
  2. A decline in lending by banks for fear that these loans cannot be repaid (Credit Market Crisis).
  3. A reduction in employment as a response to lower demand and the resulting drop in production (Employment Crisis).

Economic policy measures to combat the Lehman crisis

The economic policy response of the developed economies was a combination of interest rate cuts and government stimulus packages. The aim of these immediate measures was to rapidly combat the crisis of confidence and demand:

  • The cuts in interest rates represented an expansionary stance towards monetary policy. This served to ensure an adequate supply of credit for the entire economy. Falling interest rates made credit-financed investments by companies and purchases of goods by consumers more attractive, thereby increasing the demand for goods. Finally, this monetary policy also increased confidence in the sense that the risk of credit bottlenecks is reduced.
  • To stabilize demand, government stimulus packages were introduced to increase demand. This tool also had a confidence-increasing effect: if the state guarantees companies a higher demand for goods, companies can look more positively into the future. This increases companies’ willingness to keep employees on the payroll instead of laying them off.

The result of these measures was that most countries experienced a rapid economic recovery. If real GDP in 2007, the year before the Lehman bankruptcy, is set at 100 percent, Figure 2 shows that with the exception of Italy, all other G7 countries were able to return to pre-crisis levels more or less quickly.

However, the price for this rapid recovery was an increase in government debt as a result of the credit-financed economic stimulus packages. The global money supply continued to grow. However, this did not lead to higher inflation rates. Rather, the money flowed into the asset markets, where it led to sharp increases in asset prices.

The COVID 19 crisis

The starting point of the current economic crisis is a combination of a decline in demand and in supply, which then led to price slumps in the stock markets. As we have already shown, a rapidly spreading infectious disease such as COVID-19 causes both demand for goods and production of goods, to fall abruptly.

Above all, the standstill of public life (shutdown) means a loss of sales for companies with — at least in the short term — more or less unchanged costs. The result is a loss of profit, which manifests itself on the stock markets in the form of price slumps. The fear of possible losses accelerates the sale of shares and thus triggers a price collapse — a financial market crisis occurs in the form of a stock market crash, which also spreads to bonds. Unlike the Lehman bankruptcy, however, there is currently no mass bursting of loans.

Weeks of plant closures do imply not only losses for the affected companies, but also liquidity bottlenecks. If companies do not receive loans from their banks, there is a threat of temporary insolvency ( liquidity crisis). If the shutdown lasts longer, the liquidity crisis can even turn into an insolvency crisis: If companies lose sales — and thus also their ability to borrow. If this cycle continues, it can become so extensive that overindebtedness prevails, the companies have to stop operations and file for bankruptcy.

A long-time production stop can ultimately lead to a situation where the supply of goods and services is no longer secure. Even a lower demand for goods, which is the result of lower disposable income, will eventually exceed the supply of goods, if the supply of goods becomes ever smaller without replenishment. This results in price increases paired with simultaneous supply bottlenecks. Low-income people, in particular, find it increasingly difficult to buy essential goods and services (see Figure 3).

What are the next steps?

In order to prevent these elements from worsening, a way must be found to prevent the spread of COVID-19 and at the same time enable production processes to begin again. In the short term, five areas of action are particularly important for developed economies:

  1. Creation of additional capacities in the health sector, especially in the area of intensive care beds Only if prevention is sufficiently high, existing restrictions in social life can be eased.
  2. Liquidity support is needed to avoid corporate bankruptcies. Many instruments are possible for this purpose: the provision of low-interest or interest-free loans, state guarantees for better access to credit or deferral of state claims (e.g. taxes). The interest rate policy of the central banks is only of limited help because the key interest rates are already close to zero. On the other hand, the purchase of corporate and government bonds can have a stabilizing effect because it ensures that the national economies have sufficient liquidity. However, this widens the monetary base and enhances the probability of speculative bubbles.
  3. Liquidity assistance cannot compensate for losses. Particularly in areas with low returns on sales, it is unlikely that companies can compensate for the losses of a week- or even a month-long loss of sales. In such cases, many companies can only be rescued if the state covers these losses. In addition to direct payments to these companies, this option includes tax credits or even the the state becoming a shareholder.
  4. If many citizens are uncertain about their future income and employment situation, a reluctance to consume is to be expected. Fiscal policy is a suitable means of stabilizing demand. Higher government spending leads to an increase in demand, which stabilizes companies’ sales expectations. Government investment should focus on the socio-ecological transformation of society.
  5. Employment declines will be unavoidable even if economic activity resumes quickly. This is where labor market policy can be called in. Depending on how tightly the network of social security is in a country is, government instruments vary (unemployment benefits, continued wage payments in the situation of quarantine or short-time work benefits).

All in all, it must be clear that stabilizing the economic system and cushioning the social consequences of such a severe economic slump is linked to high levels of state-owned debt. This is an enormous challenge for most industrial nations because they are still suffering from the fiscal consequences of the Lehman bankruptcy and now have much higher debt levels than in 2007 (see Figure 4).

Nevertheless, a further increase in government debt is inevitable, as the global economy is in a situation of “ whatever it takes “.

Originally published at https://ged-project.de on April 23, 2020.

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