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Whether a black swan or a scapegoat, Covid-19 is an extraordinary event. Declared by the WHO as a pandemic, Covid-19 has given birth to the concept of the economic “sudden stop.” We need extraordinary measures to contain it.
Initially referred to as the novel coronavirus 2019, the coronavirus disease (Covid-19) originated late in 2019 in Wuhan, China and was first reported to the World Health Organization (WHO) Country Office in China on 31 December 2019. Rapidly becoming an endemic, it was declared by the WHO a “Public Health Emergency of International Concern” on 30 January 2020.
Covid-19, now present in more than 100 countries, has been declared a pandemic by the WHO. However, the global financial markets had declared it a pandemic in the week that started on Monday, 24 February 2020, by overwhelmingly vouching for pandemic. They did this through the fastest equity market correction of all time that took place in about six to seven days, where a correction is defined as at least a 10% drop from the peak. There remains a second question which still is debated, and it is about whether Covid-19 is a swan or a goat.
While the origin of the concept of goat (specifically, scapegoat) is Chapter 16 of Leviticus, one of the early books of the Bible, the origin of the concept of swan in the current context is from Black Swan. There is also the white swan, which originated in Crisis Economics: A Crash Course in the Future of Finance. A scapegoat is a person or an event blamed for the wrongdoings, mistakes, or faults of others, especially for reasons of expediency. As for the two swans, a black swan, as defined by Taleb (2007), is an unpredictable outlier event with an extreme impact, and a white swan, as defined by Roubini and Mihm (2010), is the same as a black swan except that it is predictable.
Although, in a recent essay, Roubini (2020) identified several white swans for 2020 that “could trigger severe economic, financial, political, and geopolitical disturbances,” such as the escalation of the ongoing cold war between the United States (US) and China to a near hot war, and the potentially catastrophic effects of climate change, even he did not refer to Covid-19 as a white swan as it was an undeniably unpredictable event. So the real debate is whether Covid-19 is a black swan or a scapegoat.
Although we could not have predicted it, Covid-19 was not the reason, but just the trigger for the ongoing financial crash as all we needed was the proverbial straw to break the finance sector’s back (Öncü 2015). With asset price bubbles everywhere and the total global debt over 322% of the world gross domestic product in the third quarter of 2019 (IIF 2020), something had to trigger what is happening now.
But Covid-19 was not just any trigger as it gave birth to the concept of the economic “sudden stop.” When the global equity markets dropped on 31 January 2020 following the WHO declaration of the Public Health Emergency of International Concern, El-Erian (2020) warned the investors on 2 February 2020 that they should snap out of the “buy the dip” mentality. Pointing out two vulnerabilities, namely structurally weak global growth and less effective central banks, he introduced the concept of “sudden stop” economic dynamics.
Although El-Erian is yet to define what exactly an “economic sudden stop” is, I take it as an abrupt onset of a deep recession. In the case of Covid-19, it is a sudden stop of economic activity resulting in supply and demand shocks to the global economy as major cities in infected countries, more than 100 and counting, are put on lockdown. And, add to that the deepening oil price war between Russia and Saudi Arabia.
Shortly after 6 pm on 8 March 2020 in New York, the futures markets opened and oil futures (both Brent and WTI) are trading about 21% down, gold is above $1,700 per ounce, and all United States (US) equity index futures are trading about 4% down. What is worse is that with the long-term US Treasury yields at their historical lows (10-year yield below 0.5% and 30-year yield below 1% as I write), the capital markets are frozen (not to mention many oil projects that will go bust at these prices).
Building on the International Monetary Fund (IMF) Global Debt Database (GDD) comprising debts of the public and private non-financial sectors for 190 countries dating back to 1950, Mbaye et al (2018) identify a recurring pattern where households and firms are forced to deleverage in the face of a debt overhang, dampening growth, eliciting the injection of public money to kick-start the economy.
They observe that this substitution of public for private debt takes place whether or not the private debt deleveraging concludes with a financial crisis, and deduce that this is not just a crisis story but a more prevalent phenomenon that affects countries of various stages of financial and economic development. They also find that whenever the non-financial private sector is caught in a debt overhang and needs to deleverage, governments come to the rescue through a countercyclical rise in government defi cit and debt. If the non-financial private sector deleveraging concludes with a financial crisis, "this other form of bailout, not the bank rescue packages, should bear most of the blame for the increasing debt levels in advanced economies."
Lastly, Mbaye et al (2018) note that their results suggest that private debt deleveraging happens before one can see it in the non-financial private debt to gross domestic product (GDP) ratio.
Recent data released by the International Institute of Finance (IIF) indicate that debt overhang of the non-financial private sector is worse in 2019 than it was in 2007. According to the IIF, after reaching an all-time peak of about $248 trillion in the first quarter of 2018, despite contraction in the rest of 2018, and encouraged by falling interest rates, global debt rose by $3 trillion in the first quarter of 2019, reaching to about $246 trillion. Of this $246 trillion, while about $60 trillion is financial debt and about $67 trillion is government debt, about $73 trillion is non-financial corporate debt and about $47 trillion is household debt. Thus, at a total of about $120 trillion, the non-financial private sector dwarfs others in terms of its over-indebtedness.
Furthermore, these numbers are based mainly on bank loans and debt securities. The IMF GDD all instruments data available for 45 of the 190 countries imply that these numbers grossly underestimate the actual non-financial private debt. Given that the world GDP was about $85 trillion in 2018, the global non-financial private sector debt to GDP ratio must be way above 150%. In light of history, a global non-financial private debt deleveraging is therefore inevitable, and the coming round may be worse than the previous round that started in 2007.
At this level of global non-financial debt overhang, the non-financial private sector will deleverage, and in the absence of other mechanisms, the two “bailouts” that Mbaye et al (2018) mentioned will come.
As the former chief economist of the Bank for International Settlements (BIS) William R White said in an interview in 2016 (Evans-Pritchard 2016):
“The situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up ... It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something ... The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly."
It is with this question in mind that I now turn to the German Currency Reform of 1948. A few years after the end of World War II, three of the Allied powers occupying the western zones of Germany, the United States (US), the United Kingdom, and France had started a currency reform in their zones in 1948.
At the insistence of the US, they set up a decentralised central banking system consisting of independent state (land) central banks in the 11 states in their zone, and a joint subsidiary of the Land Central Banks, the Bank deutscher Länder (BdL), much like the Federal Reserve System in the US.
The original plan consisted of: (i) conversion of currency and debts at a ratio of 10 Reichsmarks (RMs) for one Deutschemark (DM); and (ii) a fund built with a capital levy for the equalisation of burdens (Lastenausgleich), which would correct part of the inequity between owners of debt, and owners of real assets and shares of corporations (Kindleberger 1984).
The DMs printed in the US were flown, and the reform began on 20 July 1948. To avoid moral hazard problems, the conversion laws from RM to DM were announced to be published a week later, on 27 July 1948. However, hardly does any project get implemented as planned. The announced conversion laws included provisions to cancel all accounts and securities issued by the Reich so that barring a future radical Lastenausgleich, the reform imposed the burden of war almost entirely on holders of paper claims against the Reich (Hughes 1998).
The first step in the currency change provided only for the surrender of the old RMs, which were thereafter valueless, merely enough new money for each individual and firm to meet their essential needs for about two weeks (Bennet 1950). Each individual received 60 DM in two instalments (40 DM–20 DM). Firms and tradesmen received 60 DM per employee. The recurring RM payments, including wages, rents, taxes, and social insurance benefits, as well as prices other than those of debt securities, were fixed at a conversion rate of 1:1. While the remaining debts were written down to 100:10, in the course of a few months, currency and deposits had been written down to 100:6.5, effectively.
The result was that about 93.5% of the pre-1948 savings of West Germans in their accounts were abolished. Since the less affluent had kept their savings in savings accounts mostly while the more affluent in mortgages and bonds, the less affluent paid more for the war burdens than the more affluent. Furthermore, real property holders fortunate enough to avoid war damages had escaped unscathed as the tax system spared profits to encourage self-financing, and corporations preserved about 96% of their real assets (Hughes 1998).
Although the notion can be traced back to 1943, the Lastenausgleich Law was passed after the establishment of the Federal Republic of Germany on 23 May 1949. Enacted on 18 July 1952, and effective from 1 September 1952, it increased compensation of the savers by an additional 13.5% so that their loss was reduced to 80% (Hughes 2014). The law also imposed a nominal 50% capital levy on capital gains, but allowed payment in instalments over 30 years, making the levies merely an additional property tax (Hughes 1998).
There is no doubt that the 1948 currency reform distributed the war burdens among West Germans unfairly, favouring the propertied over the property-less. However, it made the non-financial private sector consisting of households and firms of West Germany start from an almost clean slate. Further, the London Debt Agreement of 1953 erased about 51% of its foreign debt, and the remaining debt was linked to its economic growth and exports such that the debt service to export revenue ratio could not exceed 3%. Then came the economic miracle of West Germany. West Germany had moved from being a large net debtor at the end of the war to a creditor by the middle of the 1950s (Buchheim 1988), although other factors too had played a role (Eichengreen and Ritschl 2009). What caused the economic miracle of West Germany has been a topic for hot debate. While some argue for the foreign debt relief of 1953, others argue for the currency reform of 1948, and some others argue for other reasons, the debates continue.
The original reform plan was to convert currency and all debts at a ratio of 10: 1, leaving everything else intact. Had that happened, the balance sheets of all financial institutions would have remained unimpaired, assuming no bad loans. However, the conversion laws of the actualised reform were such that they required all financial institutions to remove from their balance sheets any securities of the Reich and cancel all accounts and currency holdings of the Reich, the Wehrmacht, the Nazi Party and its formations and affiliates, and certain designated public bodies. This impaired balance sheets of nearly all of the financial institutions.
The solution that the conversion laws offered was the equalisation claims. One of the provisions of the laws contained the following statement (Bennet 1950):
Financial institutions to receive state equalisation claims to restore their solvency and provide a small reserve if either or both were impaired by these measures.
The equalisation claims were interest-bearing government bonds of a then non-existing government and had no set amortisation schedules. They were just placeholders on the assets side of the balance sheets to ensure that the financial institutions looked solvent. They were just some numbers created by the Office of Military Government for Germany, US (OMGUS), headed by General Lucius Clay of the US Army. They later became bonds of the Federal Republic of Germany, established on 23 May 1949.
The OMGUS created approximately 22.2 billion DM of equalisation claims, of which 8.7 billion DM were allocated to the BdL, 7.3 billion DM to credit institutions, 5.9 billion DM to insurance companies and 66 million DM to real estate credit institutions. Interest rates on the claims allocated to the BdL, the Land Central Banks, and private credit institutions were generally 3%. Insurance companies and real-estate credit institutions received 3.5% and 4.5% respectively (van Suntum and Ilgmann 2013). These claims could only be traded among the financial institutions, and only at their face values, making them non-marketable (Michaely 1968).
Later in 1955, an agreement between the BdL and the government allowed the BdL to sell the equalisation claims at any price. After that, the equalisation claims came to also be called as the “mobilisation paper,” since the BdL “mobilised” them for open market operations. The equalisation claims were used a second time in 1990, during the German reunification, because unified Germany also faced a severe balance sheet problem in the financial sector, again resulting from an unequal conversion of assets and liabilities.
So, the equalisation claims are well tested, and historians have found no evidence that the equalisation claims imposed any long-term negative repercussions on either the viability of financial markets or economic growth (van Suntum and Ilgmann 2013).
Can we design a globally coordinated debt deleveraging mechanism using some version of equalisation claims, possibly in the form of zero-coupon perpetual bonds with no cost to anyone, so that we are able to look reality in the eye and face what is coming in an orderly fashion?
All this means that what I claimed inevitable in my column (Öncü 2019) has already started: a disorderly global non-financial private sector debt deleveraging, which is likely to lead to deep global debt deflation, followed by a recession (and possibly a depression), thereby creating financial and economic instabilities, and further tensions in international relations with dire consequences for emerging and developing countries, not to mention developed countries.
As mentioned in Öncü (2019), while in developed and high-income developing countries, the non-financial private sector is more over-indebted, in middle-income and low-income developing countries, the public sector is more over-indebted. Given that the global non-financial private sector debt deleveraging has already started, the analysis in Öncü (2019) indicates that the public sector debts of the developed and high-income developing countries will also go up and the governments’ ability to rescue their economies will also decline in these countries.Furthermore, this will severely constrain the governments’ ability to spend on climate change-related projects to addr ess the potentially catastrophic effects for many years to come, deminishing our hopes to make the necessary investments and innovations to address the now existential climate crisis on time will diminish. Last, but not least, the measures we have to take to control the spread of Covid-19 before a cure is found will further challenge the fi nancial system, as people stop earning an income and businesses go bankrupt (Keen 2020b).
In this column last year, I looked at the German Currency Reform (GCR) of 1948 as a modern example of debt restructuring to see if it could be adapted for use now (Öncü 2019). Recall that the original plan of the GCR consisted of (i) conversion of currency and debts at a ratio of 10 reichsmarks for one deutschemark, and (ii) a fund built with a capital levy for the equalisation of burdens (Lastenausgleich) to correct part of the inequity between owners of debt, and owners of real assets and shares of corporations. As the actual GCR deviated from the planned GCR in that it required all financial institutions to remove from their balance sheets any securities of the Reich and cancel all accounts and currency holdings of the Reich, it impaired the balance sheets of nearly all of the financial institutions. The equalisation claims were the solution, which were interest-bearing government bonds of a then non-existing government and had no set amortisation schedules. They later became bonds of the Federal Republic of Germany, established on 23 May 1949.
In his two Patreon posts, Keen (2020a, 2020b) proposed several extraordinary measures including the “Modern Debt Jubilee” (MDJ) of Keen (2017) that the governments, central banks and financial regulators should take now to stop the health effects of Covid-19 triggering a financial crisis that could in turn make Covid-19 worse. Supporting these immediate measures wholeheartedly, I add a globally coordinated deleveraging framework to be considered later that Ahmet Öncü and I have proposed in Öncü and Öncü (2020a, 2020b). Our proposal is a blend of the MDJ and the GCR.
In our framework, there would be three authorities to maintain a deposit account at the central bank in each country: a deleveraging authority for leverage reduction, Lastenausgleich authority for capital levies, and a climate authority for financing needs in developing national climate plans. These national authorities should be globally coordinated through the appropriate United Nations agencies.
The Lastenausgleich authority would be under the finance ministry, whereas the deleveraging and climate authorities would be not-for-profit corporations promoted by the government. The government would capitalise the deleveraging and climate authorities by the Treasury-issued zero-coupon perpetual bonds, that is, our proposed equalisation claims. The deleveraging authority would then sell its equalisation claims to the central bank in exchange for an increased balance in its deposit account at the bank, while the climate authority would wait until the deleveraging concludes. Further, the climate authority would not be allowed to open deposit accounts to its borrowers to ensure that it would be a pure financial intermediary, not a bank.
Assuming that a globally agreed-upon debt reduction percentage that would bring the global non-financial sector leverage well under 100% is determined, and that all countries agree to act simultaneously, the framework is as follows (i) the financial institutions comprising the banks and non-bank financial institutions (NBFIs) write down all the loans and debt securities on both sides of their balance sheets by the required percentage; (ii) the deleveraging authority compensates the banks and NBFIs for the loss if any; and (iii) the deleveraging authority pays each qualified resident their allocated amount less than the debt relief if any. If an NBFI gains after the above debt reduction, it should owe equalisation liabilities to the deleveraging authority of its jurisdiction. Note that as all debts mean all debts, public sector debts will also be written down by the same percentage except the official debts of the sovereigns that fall out of the scope of our proposed framework and should be handled by other means.
After deleveraging the balance of the deleveraging authority account at the central bank goes down whereas the total balance of the bank accounts (reserves) at the central bank goes up by the total payment made by the deleveraging authority. Hence, the base money goes up by the total payment of the deleveraging authority. Since NBFIs and residents cannot maintain deposit accounts at the central bank, they have to be paid through a bank which creates deposits for the NBFIs and residents against reserves. Hence, the broad money goes up by the amount of the payment to the NBFIs and residents.
One issue is that in many countries, the bank and NBFI balance sheets are multi-currency balance sheets. However, the deleveraging authority payments are in domestic currency, which may create currency risk for some banks and NBFIs. Backed by the central banks, the globally coordinated national deleveraging authorities should stand ready to intervene to avoid potential crises.
The authorities would require their domestic banks and other financial institutions to spend an internationally agreed-upon percentage of their newly found money, if any, after the deleveraging on the interest-bearing, finite-maturity bonds the national climate authorities would issue. Since the promoter of the climate authority is the government, the bonds of the climate authority would have the same credit with the government bonds, and the central bank would accept the climate authority bonds in its open market operations. Therefore, the climate authority bonds would be the main tool to manage the reserves and deposits created through the equalisation claims. In addition, the climate authority bonds could be used for the greening of the financial system through the investment of foreign exchange reserves of the central banks proposed by the Bank of International Settlements (BIS 2019).
Lastly, equipped with a “globally coordinated wealth registry” (Stiglitz et al 2019), the Lastenausgleich authorities would collect progressive wealth taxes from the owners of real and non-debt financial assets for the equalisation of burdens. While a part of these taxes could be used to retire some of the equalisation claims and the corresponding reserves and deposits created in the deleveraging process, another part could be transferred to the climate authorities, and the rest could be spent in the interests of the society.