In every acute financial crisis, aspects of the financial markets break in different and sometimes deeply perverse ways. The “smart” money is often not rewarded, but spanked. And in the current financial crisis, the markets are spectacularly and incomprehensibly broken thanks to destructive state and local government policy that no one except some insider-trading lawmakers and business executives could predict.
They could have taken action to isolate the most vulnerable populations – perhaps had the state seize nursing homes and legally quarantine those who still live independently, activated the National Guard to deliver necessary supplies and do welfare checks. Instead, they quarantined the healthy, and the elderly and medically vulnerable now have to be exposed to crowds at six grocery stores just to find household essentials thanks to panic hoarding and the tragedy of the commons. In the gated community in Florida where I live, the seniors are throwing raging pool parties because they can’t use the amenities and continuing on with their outdoors activities. Even they don’t take the draconian policies intended to help them seriously. (This isn’t just a story about Zoomers on Spring Break, guys.)
Current policy is stupid. It’s insane. It will do the opposite of what they intend in terms of spreading the virus and it has thrown us into a depression, not merely a recession, economically. It should be revised immediately. But policymakers have taken a public position now – and public positions can never be reversed in the age of social media and the society of the spectacle, no matter how stupid – so they are committed to driving us off a cliff with no brakes. We live in an era where bad ideas are path-dependent and our demise is instant.
The Traditional Advice Financial Advisors Give Their Clients
Let’s suppose, hypothetically, that you are a retiree in a pre-coronavirus world. You walk into your financial advisor – who is going to collect a percentage of your assets under management in exchange for her on-going advice, even in a financial crisis – and tell her that you would like to move to a more conservative portfolio because you cannot afford to lose your money after retiring.
That advisor is going show you a bunch of generic charts about the value of diversification produced by their financial institution’s marketing department, but will eventually end up recommending that you move a larger percentage of your money to bonds rather than stocks. Corporate bonds are higher in the capital structure, she will explain, which means that in the event of a bankruptcy, bondholders will at least get paid something and equity (i.e. shareholders) will likely be wiped out. She won’t mention that “getting paid something” part won’t happen until after years of nasty court battles and white-shoe sabotage, but I digress.
And then she will sell you on municipal bonds – the debt vehicles that state and local governments use to finance the construction of infrastructure and public buildings, like school facilities and courthouses and water treatment plants. Your advisor will explain to you that state and local governments have rarely defaulted on their debt historically. Although some big names have defaulted lately, like Puerto Rico and Detroit, you have to go all the way back to the Great Depression to find systemic municipal defaults. These are the investment vehicles that are mostly “safe,” she says.
Except in a financial crisis – and most especially this one – that advice does not seem to be true.
How Financial Crises Actually Play Out – Not That Straightforward
The stock market (which is a gauge of what corporate earnings look like going forward) always rebounds after the federal government and Federal Reserve get to where they provide sufficient fiscal and monetary stimulus to cancel out the forces that caused the market puke.
The recovery in the current crisis has the potential to be more rapid than the 2008 Financial Crisis because the government response has been more rapid and more intelligent. And by intelligent, I mean less willing to reward corporate greed than provide a lifeline to desperate households, who are ultimately the driver of the economy with their spending. The best thing we have going for us right now is we have a populist president.
In the 2008 Financial Crisis, it took a decade to recover for two reasons. First, the fiscal stimulus that did happen was insufficient and poorly structured. George W. Bush was an idiot and tried to dump a lot of taxpayer dollars on the banks on his way out of office. Barack Obama was an idiot and poured nearly a trillion dollars into deeply unwise public works, prioritizing “green” and “shovel-ready” projects. (A lot of highways got repaved and money went to politically-connected solar farm entrepreneurs, for example. But ordinary Americans got to see their houses get foreclosed on.) And then Obama bailed out Government Motors, who eventually sent their manufacturing operations to other countries anyway.
None of this money went to the people who needed it. That doesn’t seem to be happening this time. The American people are going to get paid this time. That is smart and will probably help the economy recover at lightning speed after what will probably be the largest decline in economic output in American history, even during the Great Depression.
Second, the fiscal response to the Great Financial Crisis was absolutely crippled by partisan in-fighting after the two initial rounds of stimulating special interests objectively failed to do anything for the real economy. You had neo-liberal Democrats in Congress with a neo-liberal president who wanted to continue to reward their cronies. You had the Tea Party Republicans who wanted to enact austerity measures in the middle of a panic. Neither group cared much about the suffering of American families.
This meant that we were fighting the Great Financial Crisis with mostly a monetary response. And there are limits to what a purely monetary response can accomplish. This is why panics are not a time for political grandstanding. Years after the financial crisis, we were listening to Obama explain why sub-2% economic growth was the “new normal.”
This time, the government might actually provide enough stimulus to counter the deflationary hell spiral we are currently in. I would guess we are under halfway there. If I were Trump, I’d be asking to print about $4 trillion to $5 trillion dollars at this point to shower on the American people, plus I would not be postponing taxes – I would be declaring an absolute tax jubilee. I’m not playing here. I think that is what it is going to take to fix what state and local governments have done with their coronavirus response. And every day that businesses stay closed, that number is going to grow. State and local governments are not only nuking current economic activity. By forcing companies to lay people off and to avoid entering into future purchases and contracts for services, they are nuking future economic activity too.
But the government will eventually provide enough stimulus, the only question is how long they take to come to the realization of how serious its magnitude is and get it done. Without it, we are looking at an event potentially worse than the Great Depression, and that’s not an exaggeration at all.
But the “Safe” Investments Stay Broken
Let’s go back to those investments your financial advisor told you were relatively safe. “Safe” clearly does not apply in situations where the parts of the country that produce over a quarter of our GDP are told to close down substantially all commerce and “shelter in place.” This is an extreme measure that has nuked even the safest of investments. Things a lot of people who can’t afford to lose their savings are in, like the seniors who are supposedly being protected by these orders.
What do corporate bonds look like in this crisis? This is not something that has happened before. This is one of the passive investments that a lot of financial advisors put clients in. And a lot of institutional investors have large positions in. And I’m guessing it’s investment-grade in name only now, as it included a lot of borderline credits that are now quite over the border line.
The “Safest” Bonds After Treasuries Become Toxic Assets Overnight
But even worse than corporate paper are municipal bonds. The ENTIRE UNIVERSE OF MUNICIPAL BONDS just became toxic holdings overnight. State and local governments clear across the country nuked almost all of their revenues, and not for a short period of time. Those are the revenues that would otherwise be used to repay municipal bond holders, a group that traditionally includes a lot of senior citizens.
You’d be better off holding liar loan mortgages during the financial crisis than the debt of even the richest county in the United States right now, because at least liar loan mortgages have collateral other than a local government’s good word and promise to pay. Those were at least backed by a physical property somewhere that you could sell to a hedge fund’s rental portfolio. I don’t think your average investor understands that most municipal bonds are effectively secured by a handshake.
This did not even happen in the Great Depression. Many local governments in the Great Depression defaulted because most of their revenue comes from property taxes. But most state governments (funded from income and sales taxes) remained quite solvent. The only exception was Arkansas, which defaulted on highway debt that the state government had absorbed from local tax authorities. This means the state governments were still able to provide some degree of essential services. That is not the case now.
Like I said, stocks will bounce back once the federal government does what it needs to do. In a way, we are fortunate that this is happening in a high-stakes election year rather than the beginning of a new president’s term like we were at the end of 2008 / 2009. Neither side of the aisle can afford to play dirty in this context, because they risk the immediate and durable rejection of the entire American population if they do. They are turning on the fire hydrant – as they need to do, objectively, I don’t care what your non-crisis fiscal perspective dictates – rather than clamping down the nozzle.
But this event is probably going to turn a lot of the investors off of participating in the financial markets, and that’s going to have ugly long-term consequences, particularly for state and local governments who depend on investors to construct essential public works. State and local governments are going to have to emerge from this crisis with new structures and new investment vehicles.