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Anatomy of the COVID-19 financial crisis

  • Writer: Macroprudential Policy
    Macroprudential Policy
  • May 24, 2020
  • 3 min read

Updated: Aug 3


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Only the combined use of fiscal, monetary, and macroprudential tools can break the credit contraction loop and avoid a deeper global crisis.


The pandemic driven financial distress reflects a classic business cycle downturn amplified by COVID‑19 shocks.


While monetary policy stabilized financial markets, it was fiscal support that sustained aggregate demand and employment.


1. Business Cycles and the Crisis Amplification Loop


Lender behavior is cyclical:

  • Expansion phase:

    • Lenders raise leverage and expand credit aggressively.

    • Risky borrowers access funding as incomes and asset prices rise (Igan & Kang, 2011).

  • Contraction phase:

    • Falling incomes reduce consumption (Mian et al., 2013).

    • Asset prices drop, eroding collateral and equity.

    • Loan defaults rise; collateral sales fail to cover losses.


Crisis amplification mechanism:

  1. Rising defaults → Banks’ capital erodes.

  2. Banks tighten credit, curbing lending.

  3. Expenditures fall, deepening the recession.

  4. Feedback loop accelerates the downturn.


Currently, economies are in the early stage of this cycle, with high unemployment and weak consumption as early warning signs.


2. COVID‑19 and the Onset of Financial Distress


  • Lockdowns led to spiking unemployment, eroding household disposable income.

  • Without income restoration, banks will cut risky lending to protect equity.

  • Credit rationing → falling spending → risk of deeper depression.


Governments initially focused on business liquidity, but insufficient household support risks a self‑reinforcing contraction.


3. Monetary Policy Tools Employed


Major economies deployed unprecedented monetary measures to stabilize financial markets:


United States (Federal Reserve):

  • Policy interest rate cut to near-zero.

  • Quantitative Easing (QE): Purchase of Treasuries and MBS to lower long-term yields.

  • Emergency credit facilities: Commercial Paper Funding Facility (CPFF), Main Street Lending Program.

  • Swap lines with global central banks to ensure USD liquidity.


Euro Area (ECB):

  • Policy rates near zero, deposit rate negative.

  • Pandemic Emergency Purchase Programme (PEPP) for sovereign and corporate bonds.

  • Targeted Longer-Term Refinancing Operations (TLTROs) to maintain bank lending.


Japan (BoJ):

  • Yield Curve Control to keep 10-year JGBs near 0%.

  • Expanded ETF and corporate bond purchases.

  • Special funding programs for COVID‑affected firms.


Emerging Markets:

  • Rate cuts and reserve requirement reductions.

  • FX interventions to prevent capital flight.

  • Some asset purchases (e.g., Brazil, Indonesia) for the first time.


4. Fiscal Policy Tools Employed


Fiscal measures were critical for supporting aggregate demand and preventing mass defaults:


United States:

  • CARES Act (~$2.2 trillion): Direct stimulus checks, expanded unemployment benefits, and forgivable small business loans.

  • Corporate credit backstops jointly with Fed.


Euro Area:

  • Job retention schemes (Kurzarbeit in Germany) preserved incomes.

  • State guarantees for corporate loans and deferred tax obligations.

  • Next Generation EU Fund for joint recovery spending.


Japan:

  • Massive stimulus packages (>40% of GDP) including household cash transfers and SME support.

  • Government credit guarantees to prevent corporate bankruptcies.


Emerging Markets:

  • Targeted cash transfers and wage subsidies (Brazil’s Auxílio Emergencial, India’s PMGKY scheme).

  • Limited by higher borrowing costs and capital outflows.


5. Comparative Analysis of Tools


  • Monetary policy: Stabilized financial markets quickly but limited in stimulating consumption due to already low rates.

  • Fiscal policy: Directly supported incomes and demand, proving more effective for real economy recovery.

  • Country evidence:

    • Germany and Japan (aggressive fiscal + monetary) saw faster labor market recovery.

    • US delayed direct income support, causing higher initial unemployment impact.

    • Emerging markets faced policy constraints, relying more on targeted fiscal transfers.


Conclusion


The approaching financial crisis illustrates the limits of monetary policy in a low-rate environment. Fiscal stimulus and macroprudential support are essential to break the credit contraction loop. Countries combining strong fiscal and monetary actions (Germany, Japan) managed a smoother recovery, while reliance on liquidity support alone leaves economies vulnerable to a deeper downturn.


References


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