Total disconnect

Living in Ankara, I usually have to endure several tiring flights to participate in the events of universities, think tanks and international institutes. That is why the recent shift to virtual events has been a welcome development for me. Last week Fed Chairman Jerome H. Powel participated in one such virtual event at the Peterson Institute for International Economics in DC. He was saying that monetization was not that bad this time around. “The virus is the cause, not the usual suspects — something worth keeping in mind as we respond,” he said. I find this particularly important.

Powel was talking about the real economy. Yet when it comes to the financial markets, it’s still not the virus, but the “usual suspects” that seem to be driving prices. Why is there this disconnect between markets and the real economy?

Financial markets exist to improve resource allocation in the real economy, but here we have a situation where the real economy has taken a deep plunge, with nothing similar happening in financial markets at the outset. That’s what I call a total disconnect. It’s as if “markets are in one universe and the real economy is in the other,” as Muhammed El-Erain, an Egyptian-American analyst, noted in a Bloomberg interview this last week. This is the first time anything like this is happening. In economics, we don’t have a coherent framework to think about a situation like this virus. We are all caught unaware, totally unprepared.

I think that it’s related to the nature of the “sudden stop” the pandemic has caused. We have had sudden stops in the real economy before, yet in all those cases, from the Latin American to the East Asian crises, it started with the financial markets. Not in this time. This time it began in the physical realm, with COVID-19-related social distancing measures putting an artificially forceful stop to the real economy across the world. With nothing to compare the current situation to, portfolio managers seem to have decided that they will dance on in the deafening silence.

Now think about a portfolio manager analyzing the situation with regard to individual countries, such as Turkey or Brazil. They might be looking at a situation like this: Tourism revenues and industrial (or natural resource) exports rapidly declining due to the virus, no hard currency earning capacity at all, debts coming due. Oh, and no reserves to speak of. The portfolio managers have danced past the silence, and are now moving their hips to the sound of the alarm bells and blinking red lights.

That’s where we need to go back to Powel’s words once more. We have to keep in mind that it’s the virus, “not the usual suspects” right now. It’s not that insolvency is becoming obvious with virus induced illiquidity, it’s the virus induced illiquidity making everybody, from Turkey to Brazil, insolvent. That’s what we have to keep in mind. That’s why dollar liquidity provision by the Fed, through Fed swap lines, is of utmost importance to sustain our current international monetary arrangements. Otherwise, we have an environment where authorities everywhere are postponing all payments just to protect livelihoods and buy time. Who then cares about international payment obligations?

It’s all about this total disconnect between markets and the real economy leading to bad valuations and gyrations in exchange rates, I’m afraid. What we urgently need is an international lender of last resort to provide global dollar liquidity to central banks. Now or never.