Anatomy of the COVID-19 financial crisis

A financial crisis is approaching. This one will be a typical one driven by business cycles.

To stop the crisis, governments should have subsidized jobs until enterprises start their activities. While interest rates are low, this is not a big deal as long as politics allows.

The US Treasury could have financed income losses through debt. However, the fiscal packages have mainly focused on providing liquidity to firms. While millions are jobless, there will not be enough demand enabling firms to sell their products.

For those countries with record high levels of unemployment, COVID-19 is becoming an economic and financial crisis as well as a health issue.

A financial crisis is approaching. This one will be a typical one driven by business cycles. Whether it will be a global one depends on the US economy. If the US financial sector cannot recover from its COVID-19 losses, this will have crucial consequences for the world economy.

Business cycles shape the decision-making behavior of lenders. While the economy is growing, lenders lend extensively by raising their leverages. In such an environment, risky borrowers can find funding opportunities since they are expected to pay their debts due to their growing disposable income and rising asset prices (Igan & Kang 2011). Yet, this mechanism is reversed in bust times. As the economy slows down, the disposable income of some borrowers declines, driving them to spend less, so they can pay back their credit installments (Mian et. al.). The decline of disposable income of some borrowers leads to a contraction in consumption. Meanwhile, borrowers become short of equity due to falling asset prices caused by the economic downturn (Igan & Kang 2011). Borrowers, who cannot cut expenditures adequately, default on their credits. Due to the falling collateral prices, they cannot compensate the full amount of debt. Increasing defaults exacerbate the default burden on financial institutions and jeopardize their capital. The effects of the crisis amplify when financial institutions tighten credits in order to preserve their current capital levels. A credit contraction further pulls gross expenditures down and deepens the crisis.

Economies are currently at the first stage of a financial crisis. Letting the unemployment rate spike has been a vital mistake of governments. If the fall in disposable income of borrowers cannot be restored, the next stage will begin. Financial agencies will cut risky credits worrying to loose their equities. Credit rationing will cause a further fall in expenditure and pull the economy into a deeper depression.

To stop the crisis mechanism, governments should not have subsidized jobs until enterprises start their activities. As interest rates are low, this is not a big deal as long as politics allows. The US Treasury could have financed the income losses via borrowing. However, the fiscal packages have mainly focused on providing liquidity to firms. While millions are jobless, there will not be enough demand enabling firms to sell their products. For those countries with record high levels of unemployment, COVID-19 is becoming an economic and financial crisis as well as a health issue.