The shutdown decision is a fundamental economic principle. A firm should continue to operate if it can generate sufficient revenue to cover its variable costs. A firm should shut down if it didn’t make at least enough revenue to meet its variable costs. Because of government restrictions put in place to reduce the spread of COVID-19, whole swathes of the economy need to shutdown.
Many politicians are talking about the bridge to the other side. Unfortunately, many businesses have already decided to shut down. Some did not even engage with the possible support avenues because they knew there was no chance the bank would lend them more money or their landlord cut them some slack on their lease obligations.
The evidence of this is in the enormous unemployment claim numbers around the world. The queues outside social security offices are happening even in countries where a wage subsidy policy now exists because of COVID-19. I don’t think the blame game is helpful at this point, but some empathy with people who are the collateral damage from the public health actions exists.
The public health crisis itself is playing out differently in each country. It’s not clear yet what the real impact of COVID-19 will be – modelling is uncertain, and each country will have its factors that either make their outcomes worse or better. It is silly to think that the only problem here is the health crisis. The social consequences of a 2nd Great Depression due to the sudden stop of economic activity will be just as awful for the world.
A simple thought experiment can help us understand the likely decisions of business owners. If revenue has gone to zero, for an unknown period, there are several ways to pay costs that are still being incurred by the business. It can use its cash reserves, borrow more from the bank, raise more equity from shareholders or use government support packages.
Every business owner will know what their break-even point is. They will also be acutely aware of their ability to support the business. If they have a year’s worth of bills in the business cheque account, this isn’t an issue for them. They will be fine, assuming there is a resumption of regular economic activity on the other side of the bridge.
However, if they are already running a low cash balance or using debt to meet operating expenses, they will not be able to proceed with zero revenue for longer than a month or two. Putting businesses into hibernation doesn’t work because every contractual arrangement they have entered into has to be put into hibernation on reasonable terms at the same time.
The recent drop in asset prices due to uncertainty around COVID-19 impacts and already recognised economic losses such as travel and hospitality shutting down, mean that the fair value of any small business is lower. There are unlikely to be any buyers at present. Incurring too much debt through a crisis impairs the value of the company on the other side.
This reality is affecting large businesses too. Unlike the public sector, a private company can hit “hard limits” of what is possible. Resource constraints exist, their bank will tell them they can’t borrow more, and the government will restrict their operations. Their employees may choose to quit instead of coming into work and being put at risk. Their landlord will refuse to cut a deal on rent.
This health crisis is a society-wide coordination problem. Without the government imposing a lockdown on all, the decentralised decision-making of many actors leads to businesses putting people at risk because other companies in their industry are still operating, so they feel like they have to as well. It’s crazy.
One of the issues with specific bailouts is that at this stage of the collapse, it’s likely putting good money after bad. Equity owners and debt owners receive a risk premium to incur risk. If every time a crisis occurs, they get bailed out, with no consequences, the people don’t like it.
The irony is that if people thought the response of populism to the Global Financial Crisis and its fallout was terrible, just wait until the second wave of populism and nationalism arrives after a global pandemic accelerated by the free movement of people and goods across borders.
It will be even worse when banks and large corporations get bailouts when at the same time, many households can’t access welfare. The losses will be borne by those who are unable to negotiate their bailouts with their creditors and landlords because they don’t owe them enough. Because of the uncertainty, many businesses will merely shut down because their balance sheets can’t sustain six months of no revenue.
The government is trying its best under considerable uncertainty. The lesson of this particular crisis so far is that looking to the government for financial support in an emergency is a dangerous path to take. On the other side of the bridge, expect a lot of debt aversion and laser focus on lean operating models where only the critical expenditures to deliver value to customers happen.
The current operating model for many businesses has grown over time to include a lot of unnecessary expenditure. There will be a focus on crucial value streams – what is the bare minimum required to deliver an excellent experience for customers? Product and service catalogues will need to be simplified. Entire categories will disappear because they will seem frivolous in more austere times.
Many firms are already replaying their GFC playbook. This playbook means cancelling projects, standing down staff, offboarding contractors and consultants, and eliminating discretionary spending wherever they can.
Unfortunately, this is the last thing the economy needs. When businesses tighten their belts, the drop in demand from public health restrictions accelerates further. The carnage from further reductions in economic activity will be just as awful as the health crisis happening in the hospitals.
A pandemic of this nature is going to change our way of life for decades to come. The health and economic scarring will be worse than the Great Depression because other than those directly impacted by the GFC, many in the developed countries have not known adversity on this scale their entire lives.
Hopefully, random acts of kindness and humanitarian response from governments to help their people in crisis can prevent a complete collapse of social order. This COVID-19 pandemic is a crisis on many fronts, and the worse the health crisis becomes, the worse everything else becomes. The other side of the bridge mightn’t be one we want to cross in the end.