Policy Analysis Through The Lens Of Phase Transitions

Getting back to a steady-state growth equilibrium

Blu Putnam, Chief Economist, CME Group
Originally published in the April | May 2020 issue

The US Federal Government and the Federal Reserve (Fed) moved swiftly to provide massive support to the US economy amid the Covid-19 global pandemic. Governments around the world are helping workers and companies, while central banks bolster financial institutions and fixed-income markets. The US Congress has passed, and the President signed into law, a record-breaking $2 trillion economic support package, while the Fed added almost $2 trillion to its balance sheet in the month of March 2020, ramping it up to $6 trillion (or 30% of GDP) and headed higher. The programs are unprecedented in their scale. They are complex with many different moving parts. They have been put together quickly. Adjustments and new programs undoubtedly will follow.

To understand how these fiscal and monetary programs will work to support the economy, we need to first understand the nature of the economic damage the world is experiencing due to the Covid-19 virus and the emergency containment measures being taken. The US and other economies around the globe have abruptly shifted from a steady-state growth equilibrium to a state that might be best characterized as “far from equilibrium.” Getting back to a steady-state growth equilibrium may involve three distinct phase transitions, with each phase having strikingly different implications for policy initiatives.

First, there is the phase of cascading network collapse. Our economic system is a myriad of interconnected parts. We have disruptions in supply chains, transportation, consumer demand, etc., that feed on themselves. Worker layoffs might come thick and fast in unprecedented magnitude. After the virus containment measures are relaxed and the economy starts to go back to work, we enter the second phase: financial distress and restructuring. Consumers, businesses, and governments assess the financial damage from the cascading network collapse phase, and they try to develop strategies to go forward in an altered economic environment of severely limited resources. There likely will be defaults and bankruptcies. The third phase is network rebuilding. Consumer and business behavior has been changed, in some cases for the very long term. Consumers are likely to spend what they can, but many may aim to save more to restore their financial positions. Businesses are expected to gear up cautiously, preserving their precious cash resources and prioritizing accordingly. Expect the network rebuilding phase to be long and drawn out with many difficult financial challenges to be overcome.

Policy Analysis I: Cascading network collapse phase

Most of the economic support provided or announced in March 2020 by the Fed and the US Federal Government is aimed at containing the damage during the first phase of the cascading network collapse. These are highly important monetary and fiscal policy programs as they seek to mitigate the damage and put a higher floor under the economy than might otherwise have occurred without this assistance.

The economic support programs from the central bank are focused on maintaining the smooth functioning of financial markets so there is not a banking system failure, as there was in the financial panic of September 2008 that led to the Great Recession. Measures have included support for money-market funds and primary dealers, as well as Treasury bill purchases and repo (collateralized repurchase transactions) to support the overnight and short-term money markets on whose smooth functioning the financial system depends.

Fiscal policy efforts are aimed at helping consumers and businesses survive financially and to get them to the other side of the crisis. Fiscal policy initiatives in this category include 1) providing income to workers with paycheck replacement and expanded unemployment insurance programs and (2) making loans to companies to keep them in business. 

What is critical to appreciate is that support programs aimed at limiting the damage from the phase transition of the cascading network collapse, while essential to putting a floor under the damage, these monetary and fiscal emergency programs do not assist the economy in dealing with long-term financial distress or in accelerating the pace of economic recovery. Importantly though, the economy resets from a higher level of activity than if the cascading network collapse had not been mitigated, at least to some extent.

The Economic Applications of the Physics of Phase Transitions

The term “far from equilibrium” was coined by Dr. John Rutledge, my former professor, colleague, and friend. Dr. Rutledge argues that economies are in a major phase transition, just as physicists analyze a state change, say going from a liquid to a gas. In phase transitions, all the action and turbulence is at the boundary line. Think of a pot of water boiling and the bubbles forming in a chaotic manner on the surface of the liquid as they move into their new gaseous state. Analyzing phase transitions relies on complexity theory and dynamic systems analysis and has little to do with the comparative equilibrium economics taught in universities.

Policy Analysis II: Financial distress and restructuring phase

After the network failure has been arrested, the economy will remain far from equilibrium as it stabilizes at a lower level of output and experiences severe financial distress. Essentially, this is a phase of financial distress and restructuring. Companies and individuals will be sorting out the damage from the cascading network collapse phase. This new phase includes the potential for defaults, bankruptcies, and significant corporate restructuring.

Some individuals will not be able to pay rent, utilities, insurance premiums, car loans, mortgages, etc. As individuals work through their newly diminished financial situation, it is nearly certain that spending in the economy will be materially below what it was before the crisis. This means that many businesses will simply not bounce back quickly, or at all, because their customers are financially impaired and cannot resume consumption patterns at the previous pace. 

Many businesses will have similar challenges with cash flow to make monthly payments for wages, rents, insurance, loans, etc. We expect some defaults and bankruptcies despite the fiscal policy support measures, as well as suspended or cut dividend payments. Credit rating agencies may downgrade some ‘BBB’ investment grade bonds into the ‘BB’ category, which is below investment grade and may trigger some selling pressure in the high-yield debt markets.

Moreover, the provision of loans to large and small businesses by the Federal Government, even at a very low interest rate, will be a burden to the capital structure of companies, which they must consider as they assess their cash flow potential and to restart or continue their businesses. That is, loans to businesses and individuals help them to stay afloat during the crisis and get to the other side; but loans do not necessarily assist in a rapid restart of businesses. The Federal Government’s paycheck protection program for small businesses is a little different, as it starts as a loan which is potentially forgivable if the business can spend the loan on permissible expenses within a strict eight-week timetable.

Financial institutions are going to be only as healthy as their clients, and many of their clients are hurting. Again, assistance from the Fed or the Federal Government with loans mean financial institutions will remain liquid and be able to keep their doors open. But the credit quality of their loan portfolios may be severely diminished, and some borrowers, individuals and businesses will miss loan and mortgage payments. Unless new loans are guaranteed by the Federal Government, such as the paycheck protection program loans to small businesses, banks are going to be extremely cautious in extending new credit until they are sure the risk of default or client bankruptcy is very low.

Financial distress will also be felt by state and local governments, potentially acutely for some states and cities. State and local governments are generally bound by law to run a balanced budget for operating purposes, with exceptions for long-term capital projects. Income tax receipts decline as unemployment rises. Sales tax receipts decline with reduced consumption expenditures. Property tax receipts decline with a lag as property values fall. This was a big item following the Great Recession, and it is expected to be significant again in 2020-2021. In short, every major source of revenue for states and local governments is likely to experience material declines. Against the backdrop of falling revenue will be the costs for the virus containment, especially health care and unemployment insurance costs borne by state and local governments. This means that without direct grant assistance from the Federal Government, states and municipalities will be forced to cut expenses in 2021 and beyond. The third fiscal stimulus package for $2 trillion included $150 billion in grants for states and local governments. However, this appropriation is unlikely to fill the revenue gap and much more may be requested at a later date since alternative revenue sources such as tax increases are not feasible at this time.

We note that in the aftermath of the Great Recession, around 850,000 jobs were lost at the state and local government level, with the losses accumulating all the way through 2013, several years after the depths of the crisis. Our perspective is that state and local governments, indeed, will get some further assistance in the form of grants from the Federal Government, but that legislation may take a long time to wind its way through Congress. The Fed may also set up a program to purchase municipal bonds and other state and local government debt. Buying the bonds will keep interest rates low for any new issuance, but it does not address the challenge that state and local governments will have to get back to the balanced operating budgets as required by law. The bottom line here is that job losses are likely at the state and local government level in the second half of 2020, 2021, and possibly beyond. 

Policy Analysis III: Rebuilding the network

There is considerable overlap between the financial distress and restructuring phase as it evolves into the network rebuilding phase. For several reasons, the phase transition for rebuilding the network is not likely to produce the same pace of economic growth as the steady-state equilibrium that existed prior to the crisis.

Here are some of the key reasons why the network rebuilding phase may be a long and drawn out process.

  • Wage cuts. Many corporations will be in sufficient financial distress that, even after cutting dividends, they may cut worker pay as well.
  • Supply chain rebuilding is difficult. Supply chains inside the country and around the world have been severely disrupted. They are not necessarily easy to repair, and the rebuilding process can be expected to be slow.
  • Consumer savings rates rise. Consumers may choose to spend less and save more to repair their damaged balance sheets.
  • Deflationary pressure. The network collapse and the financial distress phases have seen a huge drop in global demand for goods and services. Even during the network rebuilding phase, we expect strong deflationary forces which are unlikely to fully dissipate until the second half of 2021. We also assume there will be more fiscal policy initiatives coming into play, such as infrastructure spending that can have an immediate impact on demand. There are also likely to be more fiscal and monetary policy responses as the economy enters the network rebuilding transition phase back to steady-state growth equilibrium. Some policies will work well and others may not be as effective as hoped.
  • New fiscal spending. Fiscal policies that involve new spending that would not otherwise have occurred bring the best likelihood of accelerating the pace of rebuilding. This category includes, among other things, spending on infrastructure and direct grants to state and local governments.
  • Loans. Loans from the Fed or the Federal Government are mainly useful to keep businesses and consumers afloat, so they helped in the cascading network collapse phase to get one to the other side, but they are not as useful in the rebuilding phase. Low interest rates or not, loans are a burden on the capital structure of businesses.
  • Fed asset purchases. What the Fed is buying matters a lot. Purchases of municipal bonds and corporate debt can ease strains in these markets and provide confidence to rebuild. Fed purchases of longer-term government debt securities are not likely to help the economy, although they can reduce fixed-income and equity market volatility. Unfortunately, support for the longer-term Treasuries in the period after the Great Recession encouraged a ‘search for yield’ which led to more risk taking and is one of the reasons the damage in the financial distress period was so severe in this crisis.

Appendices: Monetary and Fiscal Policy Actions