Daughter: “Mom, can you tell me a bedtime story?”
Mom: “Of course. Do you know the story of the people and their economy of the last two decades?”
Daughter: “Is it scary?”
Once upon a time, there was a recovering economy that was finally growing after the 2008 financial meltdown. But then, a scary virus jumped from exotic wild animals to human beings and spread over many continents. In this moment of fear, people reduced their level of consumption leading to a contraction in the overall demand. As the demand contracted, so did the GDP. This contraction scared many investors all around the world, from London to Tokyo, from Zurich to Milan and up to Wall Street. A scared investor goes ‘short’, (a nice word to explain the liquidation of shares). This led to a huge drop in share prices, reflected in a drop of more than 7% of various stock indexes such as the Dow Jones and Nasdaq.
To makes things worse, the virus hit the transportation industry very hard: airplanes were grounded, people were confined at home and so did not need to use public transport. There was a huge contraction in oil demand leading to a drop in the oil price. To contrast the fall in oil revenue, caused by both the drop in the quantity sold and in the price, OPEC decided to call a meeting to set up a new price. Game theory at its best. The idea was quite simple: Oil demand is currently very rigid/Who is doing the traveling right now?/People who really need to?/Thus, not price sensitive.
However, as with every colluding game, it is often convenient to cheat, to deviate from the agreed (or even not agreed) course of action and to take advantage of the first mover. Once again, game theory at its best. This time, the winner was Saudi Arabia who beat Russia. Saudi Arabia, one of the biggest producers of oil, decided to expand production aiming to contrast the drop in total revenue by expanding the quantity while the price was still high. This caused a further fall in the oil price.
Back on the stock exchange, investors saw a drop in the oil price which is never a good sign (raising the flag of deflation) and sold their positions more aggressively, pushing down the stock price.
At this moment, the bear showed up as a result of the growing coronavirus, and the bull threatened to leave the room.
The bull kills with upward movement of its horns. A bull market is a raising market. The bear instead kills with a downward movement of its paw. A bear market is a market in recession. The bear said “Hello everyone, I’m back again! Shame, it only felt like yesterday that the economy had started to recover, sorry to ruin the game”. Investors feared that the bear was going to hang around, causing dramatic consequences for an already weak recovering economy with low interest rates. In fact, to contrast the bear, the central banks had to stimulate the economy by lowering interest rates.
But how could they do this with the interest rate already close to zero and, in certain economies, even negative? This could lead to a liquidity trap in which the central bank cannot stimulate the economy. If we look the Keynesian recipe, we might think to ask for the coordinated intervention of governments. But they are already facing huge debt in many cases (Europe and US) since the last financial crises, whilst also trying to fight a deadly virus. Not looking very rosy, eh? Moreover, pension funds, already put under pression by the low interest rate will have to expect further years with low or even negative interest rate.
Daughter: “What about the wolf? Surely there’s a wolf in this story!”
Mom: “Here it comes! Do you remember the story of the boy who cried wolf? There once was a boy who shouted for help because of an imaginary wolf, but the second time he cried wolf nobody listened to him even though the wolf was actually there. Now, the wolf in this story is the idea of hope. Hope that tomorrow will be better. There are reasons to believe that tomorrow’s economy will be better. Reason number one: The banks, unlike in 2008, have liquidity and are not over exposed. They are not part of the problem but rather part of the solution and are able to provide the system the liquidity needed. Reason number two: If the oil price falls, the mark-up also falls. According to some economists, (see the Blanchard model), a drop in the oil price leads to a drop in the natural unemployment level which eventually causes an increase in the potential GDP. There is hope that the future will be better off. However, this hope was already advocated ten years ago and the promise seems only half fulfilled. Should the economy people of 2020 believe it again? Now here’s a kiss and goodnight!”
Daughter: “Mom, can you leave the door open so the light can come in?”
Mom: “Just a little”.