William Poole
March 12, 2020
There are several aspects of the crisis that deserve separate attention. Many will seem obvious but nonetheless need to be made explicit to yield a thorough analysis.
Oil prices
The Saudi decision to cut its price for oil appears first and foremost an attempt to punish Putin for not agreeing to a reduction in production coordinated with OPEC. The decline in world oil demand created by the depressing economic effects of the coronavirus precipitated the Saudi action. Reduction in world demand must be met by a reduction in world supply, as there is no adequate way to store a huge volume of oil already produced. I assume that the Saudis will price oil so that all Saudi production is sold. That will necessarily mean that some oil produced elsewhere is not sold. The non-Saudi producers will be forced to reduce production. Those producers will face reduced revenues from both lower volume and lower prices.
The reduced price of oil to buyers will provide some offset to the negative effects of the virus on the economy. For example, American workers faced with reduced income from reduced overtime hours will pay less at the pump for gasoline. There will be many offsets of this kind throughout the economy. For another example, airlines are grounding some aircraft and cutting schedules. Their reduced revenues will be offset to some degree by reduced fuel costs.
American oil producers will see a fall in revenues. Some producers of shale oil using fracking technology are reported to be heavily indebted. They may not be able to service their required bond payments and may have to file for bankruptcy. Most of these firms, if forced into bankruptcy, will be reorganized as existing equity holders are wiped out and bond holders become equity holders. The firms will continue to produce oil whenever the value of the oil exceeds operating costs. Exploration and development of new fields will stop.
On the same calculus, oil production from the Gulf of Mexico and other conventional fields will continue. The costs are sunk and will not have a bearing on whether to continue production. Production will continue as long as revenues from production exceed marginal production costs. Obviously, new exploration and development of new fields will stop until it is reasonable to project higher oil prices in the future.
As of this writing [on 3/9/12], globex futures are trading at $31.00 for the April 2020 contract, and $35.69 for the December 2020 contract. In principle, U.S. producers might want to leave oil in the ground rather than sell at today’s price. However, turning production on and off is not that easy. A possibility that should be watched is that some equipment may be shut down for routine maintenance. My guess is that most production will continue because it is better to get some revenue from sunk costs than no revenue.
The non-oil economy
As of today, it seems reasonable to state that the coronavirus effects on the economy are unprecedented, or almost unprecedented in modern history. The shock is surely larger than 9/11. The 2001 terrorist attacks led people and their governments to engage in a variety of protective actions. These steps were logical and easy to understand.
A framework for thinking about the situation today looks something like this. We have aggregate supply and demand curves (functions in more complete analyses). The demand curve has shifted to the left as people reduce bookings on cruise ships, airplanes, hotels and the like. There may be fewer trips to restaurants. However, the demand curve shifts to the right as individuals substitute one type of outlay for another. The family that does not take a cruise may instead invest in home improvements or a new car. Aggregate expenditure may decline—saving may increase—but that should not be assumed.
The decline in demand is unlikely to be permanent as we will adjust to the new reality. The decline in demand will leave households with the cash to spend on something else. As discussed so far, the demand shift will be a shift of relative demands, from some goods to others, and not a shift in aggregate demand.
There is also a supply shock to account for. Especially in China, some workplaces have been shut down to contain the virus. We can think of the virus effect on supply as if it idled machines because they ran out of lubricating oil. The issue is how to get the machines cranked up again. Here we have a direct loss of output without a corresponding increase somewhere else. Nor can future output offset the lost output; hours not worked are gone forever. However, in time the machines will be restored to normal functioning, perhaps with new controls to prevent some workers from infecting others. Perhaps in time everyone will be tested when entering the workplace, just as we are all screened at the airport. Whatever is necessary to restore production will happen; get used to it.
With negative demand and supply shocks, output will be lower than it otherwise would have been. However, the machinery has not been destroyed as it is in war. The lost output is gone forever, but the capital is not gone. And, for the most part, the human capital is not gone either. Some workers are dying but most are not.
The virus is different from previous shocks such as 9/11 because it has created enormous uncertainty and fear of a sort not experienced before. Even the December 7, 1941 attack on Pearl Harbor did not produce widespread fear. The United States declared war and got to work building a war machine. Unlike England, the United States did not fear attacks by German bombers. The average citizen could understand the danger of submarine attacks on merchant-ships, but those attacks did not reach those on land. Citizens today, even if very well-informed, do not know how to react to the virus threat. The uncertainty and fear of the unknown is unprecedented in modern America.
That same uncertainty has a grip on the entire world.
In time, the public-health establishment will provide the firepower to deal with the virus. How long it will take to provide a vaccine is unknown. But it seems reasonably certain that in time there will be a vaccine and/or an anti-viral agent that can be administered to ill people. We are already adjusting, just as we did to inspections at airports after 9/11. As I observed at a conference in New York this past Friday, the normal greeting has become an elbow bump instead of a handshake.
We are quarantining potentially infected people. We will learn what is necessary to contain the virus and necessary to treat those who are sick. We are ramping up production of test kits. I assume that in time there will be kits that can be used at home. With research, we changed behavior as AIDS struck down otherwise healthy people in the 1980s. Then we developed AIDS treatments. Few people die of AIDS anymore.
In time, life will return to pre-covid-19 levels but with improved understanding of how to prevent the spread of this new disease. To believe otherwise is to ignore history.
Financial markets and monetary policy
The financial markets are a barometer of fear. Around the world there is a flight to the safety of sovereign debt. Central banks ought to follow long rates down by reducing policy rates. If they do not, they will unavoidably be pulling funds from the market as they must do to maintain policy rates above market rates.
As Fed Chairman Powell stated last week, monetary policy cannot invent the vaccine needed to counter the virus. What the Fed can do is to maintain orderly conditions in the money markets so that the private sector can borrow and lend as needed to deal with the effects of the virus on economic activity. It is simply a mistake to think of Fed rate cuts as providing stimulus in the usual way we think of “stimulus.”
Summary
The analyst working to understand the current economy will have to figure out where the offsets discussed above are material. The essential point is that there are offsets to the negative effects of the virus on the current economy. The negative effects are important; no doubt about that. To neglect possible offsets is to make an analytical mistake.
William Poole
Dr. Poole is Distinguished Scholar in Residence at the University of Delaware and Senior Economic Adviser to Merk Investments. Dr. Poole retired as President and CEO of the Federal Reserve Bank of St. Louis in March 2008.
