TOP 5 CONCERNS ABOUT POLICY IN THE NEW ERA - April 2020 Douglas J. Elliott - Oliver ...
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TOP 5 CONCERNS ABOUT POLICY IN THE NEW ERA April 2020 Douglas J. Elliott
Top 5 Concerns About Policy In The New Era
In the midst of the pandemic horror surrounding us, it is difficult
to focus on the economic and financial policy choices facing our
leaders. However, it is also necessary to do so, in order to reduce the
total damage.
Overall, I am comfortable with the broad shape of the economic policy
response, which combines massive quantities of fiscal stimulus with
major monetary policy actions to provide further stimulus and to ensure
acceptable levels of liquidity in the markets and the larger economy.
Regulatory and supervisory actions have been significant as well,
encouraging financial institutions to lend and invest.
Despite my strong approval of the overall policy direction, I do have a
number of major concerns that I hope will be alleviated by future policy
actions to fine tune or supplement what has been done to date.
© Oliver Wyman 2Top 5 Concerns About Policy In The New Era
TOP 5 LIST OF CONCERNS
• The risk of “start and stop” economic/health policies
• Excessive levels of financial leverage in economies around the world
• A return of the Euro Crisis and other sovereign debt problems
• The medium-term temptation to ramp up inflation
• Excessively weak credit standards and the creation of zombie companies
THE RISK OF “START AND STOP”
ECONOMIC/HEALTH POLICIES
Perhaps the most immediate danger is that overall policy on the pandemic flips back and
forth between a focus on tackling COVID-19 and restarting the economy. The right answer is
to conduct a policy that appropriately balances the health and economic dimensions while
responding to new information and changing circumstances. The risk is that we overreact to
one side, create new problems on the other, and then overreact to that. The most obvious
version would be to release the social distancing restrictions too early in an effort to reduce the
economic damage and then rush to reimpose restrictions when the infection reignites. In the
worst case, we could go through several rounds of this. It will be much better if we can design
approaches to a restart that protect the most vulnerable and hold down total infection levels
while allowing substantial amounts of economic activity to resume. There will be trade-offs, but
they should be intelligently balanced, despite the political obstacles that will doubtless exist.
Jumping from one extreme to the other would be far more harmful.
EXCESSIVE LEVELS OF FINANCIAL LEVERAGE IN
ECONOMIES AROUND THE WORLD
Throwing substantially more debt into a system with high levels to start with brings many risks.
There is probably not another option in the short run, but policy needs to shift as quickly as
possible to replacing some of this debt with equity. Paying down debt as the recovery takes hold
is also desirable, but there are strong limits on how much this can be done without undermining
the economy. Appropriate restructuring of balance sheets will be a better approach in
many cases.
© Oliver Wyman 3Top 5 Concerns About Policy In The New Era
This primarily applies to private debt-to-GDP ratio sector businesses, but there is room for
some restructuring globally in the public sector as well. In some cases, more can be done with
privatization of government-owned businesses. In a few cases, countries will simply not be able
to handle their total debt burdens and debt instruments will have to be restructured, creating
losses for debt holders, whether they be public or private.
A RETURN OF THE EURO CRISIS AND
OTHER SOVEREIGN DEBT PROBLEMS
I am specifically worried by the difficulty some nations will have, particularly within the Eurozone,
in managing even higher levels of debt. Italy has received the most attention, as an economy
that is “Too Big to Fail,” the economy has been hit horribly by COVID-19, and will face many
challenges in pulling out of the hole it is in. At the beginning of the Euro Crisis, Italy’s debt-to-
GDP ratio was about 115 percent, versus 85 percent for the Eurozone as a whole. Italy starts this
new crisis at roughly 135 percent, while the Eurozone as a whole is only up to 86 percent. So, Italy
starts in a worse debt position this time around and has even more political problems than last
time. That said, nominal interest rates are lower this time around, which reduces the running
costs of maintaining this debt level.
During my years at the Brookings Institution, I studied the Euro Crisis closely. I always believed
that the strong likelihood was that Europe would pull through, but I worried intensely about the
significant risks. In fact, Europe’s leaders walked to the edge of the cliff five times and each time
managed to look down and step back to reach the necessary compromises. Muddling through is
still my base case for any repeat of the Euro Crisis, but I think the probabilities of a bad outcome
have gone up.
Nor is Europe the only area where sovereign debt crises could blow up. Most continents have one
or more candidate countries for such problems.
THE MEDIUM-TERM TEMPTATION
TO RAMP UP INFLATION
One way out of debt problems is to inflate the currency to reduce the real economic value of
debt, making it easier to repay. This might be sensible if done on a modest basis, but can easily
get out of hand and lead to inflation levels that do real damage. Look back at the 1970s and 80s if
you wish to see how costly this can be. Even if wide economic harm is avoided, there are massive
distributional effects between savers and borrowers that must be considered.
© Oliver Wyman 4Top 5 Concerns About Policy In The New Era
I don’t see a big inflation concern in the next couple of years in the advanced economies, but
there is a real potential as we go out further. This potential is enhanced by the fact that most
countries have not seen a problem with excessive inflation in 30 or so years. Politicians may find
it easy to downplay risks that have not occurred for so many years.
EXCESSIVELY WEAK CREDIT STANDARDS AND
THE CREATION OF ZOMBIE COMPANIES
Right now, governments are making, guaranteeing, or encouraging very large sums of loans with
weak or non-existent credit underwriting. That may be the only choice at the moment, but it is
not a long-term solution. Propping up companies that cannot survive in the longer run without
continuing support becomes a real drag on an economy. Look at Japan’s “lost decade,” now
running well over a decade. We need to transition to providing liquidity support, or sometimes
equity infusions, only to companies with reasonable prospects for the future. Even in the shorter
term, there are interesting ideas such as the suggestion of Agustin Carstens (General Manager
of the Bank for International Settlements – BIS) of government loans tied to the amount of taxes
paid by a firm in previous years. This has the advantage of directing funding towards firms that
have proven they can make profits in at least the good times.
© Oliver Wyman 5Oliver Wyman is a global leader in management consulting that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. For more information please contact the marketing department by email at info-FS@oliverwyman.com or by phone at one of the following locations: Americas EMEA Asia Pacific +1 212 541 8100 +44 20 7333 8333 +65 6510 9700 AUTHOR Douglas J. Elliott Financial Services, Partner douglas.elliott@oliverwyman.com Copyright © 2020 Oliver Wyman All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. The report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. This report may not be sold without the written consent of Oliver Wyman. Oliver Wyman – A Marsh & McLennan Company www.oliverwyman.com
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