Former Fed President offers exclusive, optimistic look at the COVID-19 contraction
In times of crisis, people seek answers. On April 7, just three weeks after the university was thrust into an entirely online teaching environment, the VCU School of Business stepped into a community leadership role by hosting the first in a series of virtual business conversations on “The Economy and COVID-19.”
More than 160 donors, c-suite executives, business leaders and alumni logged in for a conversation between Dean Ed Grier and Jeff Lacker, a renowned economist and former president of the Federal Reserve Bank of Richmond. Since 2018, Lacker has served as a distinguished professor in the department of economics at VCU where he has earned a reputation as an outstanding educator and mentor to his students and colleagues.
Over the course of the 45-minute dialogue, facilitated by Zoom video conferencing, Lacker provided historic and mostly optimistic perspectives on the pandemic before fielding questions (some submitted in advance) from participants. These highlights have been edited and condensed for clarity:
Economist, not an epidemiologist: “My expertise is in economics, not virology or medicine,” Lacker explained. “I, like many others, have been forced to be a consumer of medical analysis and predictions. I’m not in a position to weigh in on the merits of various epidemiological projections, so I’ll try to stick to the economics of this downturn. Economic downturns are something I’ve been following for over 40 years, and we’re certainly in the midst of one.”
Comparisons to the 2008 – 2009 recession
An instantaneous and deep contraction: “We are in the midst of a contraction. It is extremely compressed – almost instantaneous. A typical economic downturn unfolds over several months, maybe several quarters, as weakness in one sector spills over. For example, in 2008-2009 recession, the contraction phase took 18 months.
Simultaneous reduction in economic activity: “We are getting contraction in essentially two months right now. It’s a virtually simultaneous reduction in economic activity across a broad range of sectors. The result has been a record-breaking pace of decline. It’s also the case that we are going to get a contraction that is very, very deep.”
Lacker cited the first employment report to reflect the effects of COVID-19 showing massive job loss as well as other reports showing more than 10 million initial unemployment claims filed by people who are newly unemployed.
Indications suggest instantaneous contraction: “To put that into perspective, in the 2008-09 recession, it took about 16 months for the flow of initial claims for unemployment insurance to accumulate to the same number we see today.” Lacker said broader measures and reports related to retail sales and industrial production are weeks away. The measure of economy activity for the second quarter will not come out until late July, but some forecasters are projecting between 20-25 percent lower economic activity in April, May and possibly into June.
Prospects good for contraction not getting much deeper: “This is a sizable contraction. It’s going to be deep, but I think prospects are good for it not getting deeper after the level it reaches in the next month or two.”
How long will this contraction last? “I think the major question about this contraction is how long it’s going to last,” Lacker conceded. “I think Dr. Fauci [director of the National Institute of Allergy and Infectious Diseases since 1984] said it right that ‘[We] don’t make the timeline, the virus makes the timeline.’”
“It depends on when we can lift the social distancing guidelines that are keeping economic activity depressed. I don’t want to get stuck in a partisan tarpit on this, but if the main purpose of social distancing is to flatten curve in order to stretch out the utilization of hospital resources, then a substantial relaxation is probably not likely before there’s relative confidence that we’ve passed the peak in utilization and are headed down the other side. That’s the criteria I’m looking for. There are various forecasts ranging from the end of May to the beginning of the fall and they all seem reasonable to me, given my understanding of the epidemiology.”
The case for a V-shaped recovery: “In the last recession, the discussion was ‘Is it going to be a V-shaped or L-shaped recovery?’” Lacker recalled. “It ended up looking like a check mark. Activity fell and then began growing again at a steady rate, steadily climbing out at trend economic growth rates – about two percent per year for GDP. It didn’t snap back to where it would have been had we not had a recession, to meet a trend line through the previous expansion. But growth did return.”
“A case could be made now that a sharper V-shaped recovery is plausible [because] most recessions involve some economic activity that we don’t want to do after the recession. We built a lot of houses going into the last recession. The recession basically was the revelation that we didn’t need all the houses we built, so it was clear we weren’t going to build as many houses in the future as we had in the past. We needed to shift resources – capital and labor – out of housing construction into something else.”
Anticipate a return to normal with some caveats: “Here, that probably isn’t going to be the case. Anything that was economically logical in January will – when the virus is well enough contained that we can go back to normal – be just as economically logical as it was just a couple of months ago. In theory, we can just all get back to what we were doing.”
“There are some caveats to that: We are all going to run down some savings in the meantime. We may throttle back on consumer spending until we build our savings back up. The other caveat has to do with whether there are any changes that are of a permanent nature in the way we go about our business. You can imagine things like less airline travel, fewer hotel stays, less going out due to fear of virus. But that is a behavioral factor that’s hard to get a handle on. And that could happen and yet not have a large effect on overall growth and employment.”
An encouraging “bottom line”
Concluding his formal remarks, Lacker laid out his bottom line: “This is an exceptionally rapid contraction by historic standards. We’ve never seen anything like it. It’s deep, but finite, and likely to hit a bottom in terms of the level of activity within a month or two – at least that’s the modal outlook. There will be an uncertain duration. A relatively brisk recovery is plausible, but a range of possibilities are out there.”
“Every downturn has unique features. This one does too. But two centuries of economic growth and downturns suggest that we are going to get back to a place where economic activity returns, is vibrant, and we are moving ahead.”
Lacker fields questions from the community
On the COVID-19 economic relief package: “The aim of the bill is not stimulus, in the sense of trying to increase economic activity. We want economic activity to be lower now. That’s kind of the whole point. I think of the bill and relief measures essentially as relief, providing some support to the sectors and people we’ve asked to take a big hit on behalf of all of us. Without any other measures, they might have to suffer a lot while others are working from home and doing okay. What we want is to share the burden of adjustment. Imagine a closed agricultural village where 20 percent of the farmers get their crop wiped out. What you would like is everyone else eats 20 percent less. That’s kind of where we are headed, to avoid the loss of income for some people, causing them to have to reduce their spending and their well-being by more than warranted. That’s how I think of it.”
Can we afford the debt and deficit? “The deficit was large when we came into this. Federal debt was rising as a percentage of GDP. It was on track to be very large, five or ten years down the road. Whether that is sustainable or not is a good question. The flag you would see is interest rates on U.S. Treasury debt in the marketplace. Those have been exceptionally low, which is a sign that the demand for U.S. Treasury debt is so large that we now are not near a danger zone yet in terms of issuing too much debt and running too big a deficit. Could that happen? Yes. Is inflation a worry? Yes, it’s always a worry for me… but I think there are gaps in our understanding of monetary policy transmission process. What we know suggests that it’s conceivable down the road that inflation pressures could emerge, but I put them a couple years down the road and view them as secondary to getting through this crisis with enough measures to help all of the people we’ve asked to make sacrifices for everyone’s benefit.”
Misconceptions of this economic crisis as well as fiscal and monetary policy? “The Fed has entered market with some credit programs where they essentially print money and lend money to businesses, buy corporate debt, buy other securities from money market funds, commercial paper and the like. Those are often described as flooding market with funds or the like. That’s a kind of a misnomer. In some sense the Fed could have bought treasuries instead. (They are also buying treasuries.) So, to some extent, you should think of it as government securities backing those investments. What Fed is really doing there is propping up some asset prices in order to prevent credit spreads widening more than they think is justified. That’s one misconception.
“What the Fed can do is kind of limited in this crisis. Today what we have is a real shock. It’s a shock to real economic activity. The financial sector over here is just feeling the effects of it. So, it’s not a shock to the way the financial system provides services to the rest of the economy. There isn’t really a problem in the financial sector to fix, as I see it. The problem is the real economy and what’s going on there.
Can the U.S. help the world recover? “The cooperation between central banks ramped up substantially in 2008 and the Fed has tapped those relationships to ramp up cooperation again. The chief form that takes is that, around the globe, central banks and governments and other official institutions like to keep their liquid assets in the United States vested in dollars. In addition, all foreign banks that are active globally are active in the United States as well. So, when some institutions have trouble accessing funding and their central bank wants to help them, the U.S. central bank, the Fed, can help that foreign central bank by lending that central bank dollars that they can use to help their institutions acquire dollars. So, there is an established network of lending arrangements between central banks in Europe and Japan and the like.
“Recently, last week, the Fed announced a broad extension of that to emerging markets and this is important because the virus has not yet hit places like Africa and Latin America, and it’s likely to hit with a lot of force and they are much less prepared than the developed world is and the adjustments there could be ferociously costly. A few months down the road, they are going to feel it. So, unlike in 2008, the U.S. has extended these reciprocal ‘central bank to central bank’ lending arrangements to emerging markets.
How will commercial real estate will be impacted? “There could be permanent shifts in behavior. The movement from brick and mortar retail toward online ordering is certainly getting a big turbo charge in this episode. Whether it snaps back to the trend it was on or it’s been given a permanent boost is an open question. As far as commercial real estate office buildings and working from home. My opinion is that firms won’t be as productive if all their people are ‘Zooming’ in. There is still a role for face-to-face.”
Impact on banking financial services industry short and long term: “The banking industry came into this exceptionally well capitalized with strong positions thanks to a decade of work. In addition, their systems – their risk management and information processing systems – are top notch. I think the financial system is much more resilient than it used to be.
“Having said that, the Fed has intervened in a couple of markets that it never intervened in before. So, going into the corporate debt market, buying investment grade corporate debt, and being active in the commercial paper market again – those are going to set expectations that have the potential to tilt incentives going forward. In the past, I would trust the corporate debt market to manage itself and generally keep an eye on excesses. There were losses here and there, there’s always something that goes wrong from time to time. But, whereas in the past I would trust that it could manage itself, now I’m less certain.
“That goes double for airlines. I think rescuing the airlines this time becomes a serious problem. We did that after 9/11 and treated it as a one-off and now a second downturn in airline traffic generates a rescue. All these companies went through bankruptcy in the 1980s and 1990s. It didn’t disrupt airline travel. I just don’t see the rationale for it and I question whether we have a mechanism for containing the incentives airlines now have to leverage up given the rescues they’ve received. Those are the big challenges I see.”
The outlook for smaller community banks: “Small businesses have been hit really hard. They are likely to have fewer financial resources to be able to tide over employees that they have had to send home. They are less able to cover their payroll costs even if their workers are producing or getting revenue. They are real source of vulnerability.
“There is this large [Small Business Administration] program designed to funnel federal lending to small business. It opened up on Friday [April 3]. There was a huge scramble of applications. I’m guessing there will be future rounds of that down the road.
“Not all banks have invested in the expertise to do Small Business Administration lending. It’s technical. You have the get the paperwork just right and get it into the system. Getting to know federal credit programs is going to be the order of the day for community banks.
“More broadly, the number of community banks has been falling gradually over the last couple of decades – since the 1990s, when we deregulated restrictions on banks combining. I think that’s going to continue. I think a well-run bank needs to be looking ahead and thinking down the road about merger partners – whether they want to acquire or be acquired, what the future holds for them, what their scale should be, do they have a back office that makes sense and the like. So, there are continuing challenges for the community bank area.
What about healthcare? “My heart goes out to people on front line that are working in horrendous conditions, like the people in New York. Healthcare is something that has really challenged us as a country. I think we went down the wrong path in 1940s with the tax incentives that led to the wide spread of employer-based health insurance, and we are sort of digging our way out of that, but I’m not sure we’re ever going to get away from it. We are sort of patching that up.
“Health policy is another tarpit in American economic policy that I’ve watched from afar. This is going to be a wake-up call for the country about its healthcare infrastructure. I think the valiant effort and the dedication and devotion of people in healthcare systems is going to be evident as we come out of this. There are going to be a lot of stories of heroism and bravery. We’re hearing them already. Hopefully, that will provide more a sympathetic tone to discussions about ways we might want to alter healthcare provision going forward.
The most clever and effective relief programs: “The Small Business Administration program is pretty clever. It’s a loan, but down the road, if you used money and you retained your workers, you can deduct from your principal payment the payroll expenses, utilities, rent and the like. In some sense, it’s a grant packaged inside a loan that incents small business to retain workers on the payroll. That’s kind of what you want here. You want to say, ‘Let’s all take a time out.’
“The problem, of course, is that firms aren’t yielding the revenue they otherwise would. But you’d like to hold everything in place, keep employers and employees connected, ride this out for a couple of months, and then let things gradually come back to normal. I think that’s a pretty clever approach and pretty reasonable. It might flounder on this issue of small business revenue. If a restaurant doesn’t have anyone coming to buy food there, that’s going to gum up the math on that. That’s the one issue I’d point to.”
“The unemployment insurance extension is something we always do. It makes perfect sense in this situation. A lot of the state unemployment insurance systems are a little bit antiquated. Maybe this will be wakeup call on that front because it proved hard for Congress to craft something that was implementable that was more fine-tuned. …[They made a] compromise now to get it out the door fast but it probably isn’t the right way to go. So maybe there will be some resources channeled toward modernizing those systems going forward.”
Mortgages and mortgage deferrals: “Three to four percent might be the bottom feasible mortgage rate for a world where U.S. Treasury rates are 0.5 percent or more. Right now, they are 6/10ths. The mortgage rate didn’t come down as rapidly as the interest rate on U.S. Treasury securities to which it’s tied and moves pretty closely. There are various technical things behind that.
“The critical thing in the mortgage market now is forbearance. The relief bill did a good job encouraging banks to take a pause and let people delay payment in a way that doesn’t have ramifications for their reported credit histories. Some banks doing a better job than others. The idea of delaying all your payments but having to pay them all in August is a little daunting. A program that would allow a borrower to stretch out the repayment of the missed payments over time or add them on at the end of the mortgage would be a little more sensible in this time.
“I’ve been pleased by the broader extent to which landlords and lenders to landlords have been coalescing around forbearance to keep things whole. And that goes back to the fact that this really is a temporary thing. Everyone recognizes that the epidemiology is limited. Knowing how temporary this is is the thing that saves us here. It’s not because one sector ran amuck that we are in this situation. It’s because of something outside of our control. I think it’s mobilizing the better nature of a lot of economic actors which is sensible, to help each other in this situation.”
Do you share the optimism of economists like Vernon Smith? “The American economy is just brimming with creativity and innovative capacity. When we clear our way past this, we will get back to that. You can see it now. My wife was sewing masks yesterday. She was asking me for dress shirts that I’ve outgrown and was willing to sacrifice because they’ve got the tight weave needed for masks. So, I have a new pinstriped mask now. People are sharing patterns on line. Stores are putting out little [mask-making] kits and stuff. It’s just an impressive aspect of American life that that energy is there. People chomping at the bit to get back to the ordinary course of events. It will come.”