Which scenarios cause an economic collapse

"No second lockdown - without an economic collapse"

The coronavirus not only threatens health - it has also rocked the economy massively. Josef Zechner, member of the Austrian Academy of Sciences (ÖAW) and professor at the Institute for Finance, Banking and Insurance at the Vienna University of Economics and Business and spokesman for the Vienna Graduate will speak about the effects of COVID-19 on companies, financial markets and investors as well as the importance of economic aid programs School of Finance, in an interview. He is convinced: Austria can no longer afford a second, long-lasting and comprehensive lockdown "without bringing about an economic collapse."

There is a lot of discussion at the moment about a second wave. What would a second wave mean for the economy?

Josef Zechner: A second wave of COVID-19 would mean that company sales, which are only just recovering, would collapse again, although a large part of the costs would continue to arise. A current study of the Italian economy shows that the three-month lockdown that followed the first wave will mean that without rescue programs by the Italian state or the EU, around 17 percent of Italian companies will have negative equity at the end of the financial year, i.e. would be insolvent. However, around 800,000 jobs depend on these companies. In the event of a second wave, the conflict of goals between the medically sensible lockdown measures and the negative economic effects would be even sharper.

In a second wave, the conflict of objectives between the medically sensible lockdown measures and the negative economic effects would be even sharper.

So economically speaking, you can't afford a second lockdown?

Zechner: One could certainly not afford a second, longer-lasting, area-wide lockdown in autumn or winter without causing an economic collapse.

Will the COVID-19 crisis inevitably be followed by a new financial crisis - or can the economic downward spiral still be stopped?

Zechner: First of all, it should be noted that the current crisis was not caused by the financial system. At the beginning of the COVID-19 crisis, the banking system around the world was much more resilient than it was before the global financial crisis in 2007. Banks now need to have far more equity than they used to be. Of course, the answer also depends on medical developments. If the pandemic continues into the coming year and requires another far-reaching lockdown, a wave of insolvencies would be the consequence. This could put banks in trouble and thereby shake the entire financial system.

In a worst-case scenario, rising corporate and sovereign debt could lead to bankruptcies.

But: We are not currently assuming this worst-case scenario. Since the crisis is not caused endogenously by weaknesses in the economic or financial system, there should be a rapid recovery after progress on the medical front and a financial crisis would not appear.

If not averted: How will this financial crisis affect us as a society? Are all sectors of the economy equally affected?

Zechner: In a worst-case scenario, rising corporate and sovereign debt could lead to bankruptcies. Once confidence in the stability of the financial system is shaken, the economic crisis would worsen significantly. There would be waves of layoffs, especially in those industries that are hardest hit by the pandemic. The share dynamics also reflect this, as I show in a recently published study on “Disaster Resilience and Asset Prices” together with Marco Pagano and Christian Wagner. Workers in the tourism and transport sectors would be particularly affected, while workers in sectors such as online services and the pharmaceutical industry are more likely to benefit from the pandemic.

The first lockdown resulted in both production losses and a lack of demand in industries such as tourism, aviation and parts of the trade. What measures are useful here so that there are no liquidity bottlenecks?

Zechner: In response to the crisis, the European Union, national governments and central banks are making liquidity available to European companies directly and indirectly. The Austrian government issues loan guarantees, among other things, to enable companies to continue to have access to cheap bank loans. For example, federally secured working capital loans are granted to cover the short-term liquidity needs of companies due to the coronavirus crisis.

High corporate debt slows future investment and growth.

Bank lending is also massively supported by the European Central Bank (ECB). For example, it carries out so-called targeted longer-term refinancing transactions. On the one hand, these measures make sense because they cushion companies' liquidity bottlenecks. On the other hand, this liquidity aid increases the level of indebtedness of companies significantly, as the liquidity is made available almost exclusively in the form of outside capital. However, numerous theoretical and empirical research shows that high corporate debt slows down future investments and future growth. This effect is referred to in finance as the debt overhang problem.

Now it would be particularly important not only to make it easier for companies to access debt capital, but also to build up equity.

How should one counteract this?

Zechner: Now it would be particularly important not only to make it easier for companies to access debt capital, but also to build up equity. One possibility is to reduce the tax disadvantage of equity. Another possibility: to structure aid programs partly through equity-like investments of the public sector. There are also interesting proposals from the academic environment, such as the concept of a European Pandemic Equity Fund, which should also enable small and medium-sized companies to receive equity-like capital grants. The companies concerned could then repay the funds received via a temporary increase in the corporate income tax or sales tax rate.

Why is it important for governments to provide public money to businesses in times of crisis?

Zechner: Public money support can be justified when there are so-called negative externalities. That is, if, for example, the bankruptcy of a company also has negative effects on other companies or financial institutions and thereby increases the fragility of the entire economic system. This is very plausible in the event of a lockdown, as occurred as a result of COVID-19. Without public aid programs, the pandemic would very likely have shaken confidence in the stability of the financial system. Market participants would then have expected a high probability of insolvency and the financing of companies and states would only have been possible on very unfavorable terms. This would trigger the feared wave of bankruptcies, so a self-fulfilling prophecy would have come about. Resolute action by the public sector or the central banks can possibly prevent such “bad balances” by restoring confidence in the stability of the system.

Without public aid programs, the pandemic would very likely have shaken confidence in the stability of the financial system.

And what are the problems associated with it?

Zechner: If such aid programs are expected by the economy from the outset, then too high risks are taken - true to the motto: If things go well, we make profits. If things go bad, the state will save us. This problem is called moral hazard by economists. It is therefore important that the large recipients of such aid programs, i.e. large financial institutions, companies or highly indebted countries, also pay for these programs in the long term. That is the challenge that politicians and regulators will have to face once this crisis has been overcome.

 

AT A GLANCE

Josef Zechner is Professor of Finance and Investments at the Vienna University of Economics and Business. Previously, he was Professor of Finance at the University of Vienna and the University of British Columbia in Canada. Zechner has been a real member of the Austrian Academy of Sciences (ÖAW) since 2004.