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"Stability is Destabilizing"
Hyman Minsky
In October 2019, I wrote about how exogenous shocks and endogenous shocks impact the economy in the blog post: Financial & Economic Structures: Bridging Top-Down & Bottom-Up Approaches.
We are currently dealing with one of the biggest exogenous shocks in the world. SARS-CoV-2 is going to impact the demand in the economy and will have a second or third derivative impact on places that have nothing to do with the virus itself. It has affected the certainty of economic cash flows, and investors are worried about the impact of slowing demand on financial balance sheet of the firms in the economy. To go back to Minsky again, it is not the trade war, government intervention, political changes, geopolitical tensions, monetary intervention, or exogenous shocks such as COVID-19 that causes the financial crises. They surely are the catalyst, but the structure of the economic system determines the robustness of the system against these shocks.
So, the most crucial question is: where it ends? Are we at the onset of a Minsky moment, or can we deal with the shock to avoid such a catastrophic event? To answer that, let's illustrate the impact of exogenous changes in the economic system.
The shock, as well as the financial liabilities of domestic and foreign firms, will impact the magnitude of the effect. To understand the current state of corporate fundamentals, here is the research by IMF on corporate fundamentals in China, Europe, Japan and the US.
Large firms in most of the regions have improved their balance sheet, but SMEs and levered firms' balance sheets have deteriorated. The real uncertainty in this environment of temporary slowdown (led by COVID-19) is whether these firms can weather the storm. If not, then they will create distortions in the economy, which could lead to a Minsky moment.
To counter the impact of temporary slowdown, and a potential Minsky Moment in the economy, Policymakers have four most important tasks to deal with:
Containing spread of SARS-CoV-2
Counter the demand slowdown by a fiscal measure
Help the SMEs and levered firms meeting their contractual payments, and
Restore sentiment of investors by improving financial conditions
The Fed tried to restore the faith by coming out with a timely 50 bps interest rate cut. It should have improved the sentiment of investors, but it didn't. It is because investors believe that interest rate cuts will not be enough to save the levered firms impacted by COVID-19 slowdown. For example, financial conditions have worsened in the form of credit spreads. I do not expect that more Fed rate cuts would have any impact on the sentiment of investors, but a systematic, organized fiscal policy could. In the next few weeks, I would be closely monitoring any developments on the budgetary measures.
