Entering Recession with Covid-19 and Deflation

Entering Recession with Covid-19 and Deflation

Epidemic models may help in assessing the impact of COVID-19 on the economy as well as to understand the market’s interpretation of the virus impact. In this respect, Shiller’s narrative economics may provide insights with wider practical implications than behavioral economics.

What About COVID-19

According to Prof. Shiller, the Kermack-McKendrick theory of disease epidemics can be considered a realistic framework for understanding the behaviors of viruses.

epidemic models covid recession deflation
The SIR model for N=100, I0=1 c=.005, r=.05

Susceptibles are healthy but vulnerable people, infectives have the disease and are spreading it, recovered are the one succesfully going through the infection. The graph above represents the situation for a virus probably 2-3 times more aggressive than COVID-19. Approximately, it takes 20 days before the infection get noticed because of its high number of patients; recovered start to steadly increase after 25 days with the virus defeated after 50 days (i.e., immunization); instead, susceptibles are quickly depleated within 30 days (i.e., pandemic).

The case above represents an uncontrolled situation; instead, we are currently experiencing extensive control (i.e., lockdown) and treatment (i.e., hospitalizations). Note that dead count is not included since the coronavirus weaken the individuals in its peculiar ways; this is a general model useful to understand its impact on the economy.

Economic Impact of COVID-19

In general, disruptions will occur after the notice of the virus and the assessment of its virality (i.e., 20 days above plus other 30 days for clinic research) from December 2nd 2019 means January 20th 2020. From this day the Chinese economy, its 80% exports towards the developed economies, and the financial markets begin to elaborate the news firing the animal spirits. Now, given the exponential decay in the number of infected, we can expect the virus to be defeated in China 80 days after its inception, by the 10th of March 2020. Then, the centralized China should re-starts its engines in a couple of months. Accordingly, we can expect a similar behavior in developed countries (maybe slightly longer because centralized economies are more efficient). As a result, Europe may recover in May 2020 and US in June 2020. However, earnings are quarterly published with the first impact of COVID-19 available to investors in Q1 and the stabilized situation in Q2; in other terms, financial markets will assess the corporate answers/reactions and the state’s stimulus in August 2020. However, interim financial results may be available earlier to reduce the impact on animal spirits.

Financial Markets

Probably the most dramatic and terrific news relatively passed unnoticed is the downturn in commodities after the Wall Street drops in February and March. On one hand, cheap commodities and strong dollar are good news; however, most asian tigers can be seriously at danger of a currency crisis like in the 1980s. Luckily, currency swaps may provide support for reciprocal aid in avoiding a global financial crisis, provided governments and central banks do not take a long cruise as in 1929.

Deflation

As long as we are not going to die of the flu, we are seriously threaten by deflation as it started a few years ago in Japan, Europe, and USA. Deflation is a monetary phenomenon affecting the distribution of wealth among the individuals in our societies favoring some industries instead of others; however, it will not increase or decrease the wealth of our societies. Substantially, it is an extensive reduction of the quantity of money (or substitutes) entailing some decline of prices. In other terms, it directly affects liquidity subtracting it from our economies and societies.

The main issue with deflation is that without liquidity our bills (i.e., taxes, mortgages, and debts in general) cannot be paid and, thus, we are all exposed to bankruptcy risk. As a result, the wealth in our societies will remain the same although it will change ownership. Thus, equality and justice will be directly measured with bankruptcy laws; in other terms, unjust laws will enrich the richer whereas just laws will allow poor to acquire distressed assets.

Recession

Should we be worried of entering into a recession with deflation and the economic impact of COVID-19 with commodities and oil at depressed prices? On one hand, deflation is not negative or positive for the overall state of the economy; indeed, previously inflationary or shock-induced recessions simply centralized wealth in the hands of a few. On the other, the social impact of COVID-19 may be even positive for developed countries finding some solidarity and commonality of intents at least in the medium term. Finally, currency swaps will depreciate the dollar (i.e., reducing US debt) and stabilize developing economies provided some sort of industrial diversification has been already devised (i.e., China but not most African and Asian countries). As a result, industrialized states will safely recover, although slowly whereas emerging countries will have to strongly increase productivity levels to achieve lower than before growth rates. Employment will be affected by an increase in disposable income (i.e., money remaining after paying the bills, food, rent, transport) allowing to prolong wages’ negotiations supporting the idea that advanced economies and developing countries with raising middle-class may sustain current consumption and debt levels. In the end, USA, advanced Europe, China, and few others centralized economies will probably go through with less efforts than in 2008 or in 2001 notwithstanding full recovery will be achieved only when all countries will have gone through.

What to Do

The average recession lasts 12-18 months with stock markets usually anticipating recovery and recession. If you are invested in US stocks, you should stay in the market and, if you can afford the risk, wait August to buy the deep; however, the conflict in MiddleEast (Syria, Iran, Israel, etc.) and the debt level in latin America are important variables considerably increasing the involved risk. With respect to US bonds, corporate will be illiquid well beyond because Treasuries are now the most safe and liquid asset to be in. China has a similar profile although its centralized economy and first taste of quasi-quantitive easing may surprise. Europe is already in recession without a clear path apart in specific cases (i.e., Germany and satellite economies). If you are extensively indebted (i.e., mortgages, credit cards, or other debts) you may consider cash rather than gold as well as liquidate the unnecessary to build a 15% cushion just in case just bankruptcy laws are not available in your country and your assets are already in the eyes of someone.

References

Shiller, R. J. (2017). Narrative Economics. Cowles Foundation Discussion Paper NO. 2069

Hulsmann, J. G. (2008). Deflation and Liberty. Ludwig von Mises Institute

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