Economic Fragility: Implications for Recovery from the Pandemic
October 8, 2020
Marburg Memorial Lecture
Marquette University Economics Department
Key takeaways from Boston Fed President Eric Rosengren’s Oct. 8 remarks
- Takeaway: The state of the economy as it encounters a shock or downturn – and the health of the financial system – can play important roles in recessionary dynamics, and how the recessionary burden is spread across the economy.
Excerpt: “Highly levered firms and excessive concentrations of commercial real estate lending at some institutions would make the economy more vulnerable to a variety of disruptions, including a pandemic or other shock.”
- Takeaway: Many firms increased their leverage as the prevailing low-interest-rate environment provided more capacity to take on debt. This leverage magnifies returns in good times, and losses in bad times.
Excerpt: “In an economic downturn, greater leverage – with its principal and interest repayment demands – may prove problematic for firms, or by extension the economy.”
- Takeaway: Increased risk-taking in the low-interest-rate environment that preceded the current economic downturn will likely make the recovery from the pandemic more difficult.
Excerpt: “Abnormally low rates for a long period during times when economic slack is no longer a concern can result in excessive risk-taking, as businesses and firms take on additional debt and accumulate more risky assets in search of better returns – potentially bidding up asset prices to unsustainable levels. The financial pressures associated with such behavior build gradually, and only become clear in the next economic downturn.”
- Takeaway: Losses due to financial shocks adversely affect a wide range of stakeholders – notably, workers; including those who are least able to endure an economic downturn. A wave of unnecessary bankruptcies resulting from such shocks can cause a spike in job loss and significant scarring of the labor market.
Excerpt: “If the costs for taking on the extra risk were borne only by investors knowingly taking that risk, it might not be so problematic. … [But] a leveraged business is more likely to declare bankruptcy, permanently severing its many formal and informal contracts with customers, suppliers, and employees. … Excessive leverage can exacerbate job losses from temporary demand shocks, and make the recovery process slower and more painful than it would have been without the leverage.”
- Takeaway: An important mechanism that plays a role in recessionary dynamics is the tightening of credit terms and credit availability during an economic downturn.
Excerpt: “In part, the importance of this channel is amplified by a low interest rate environment during the preceding economic expansion when households and firms accumulated loans, oftentimes in real estate. A prime example in the current downturn is commercial real estate, where the high leverage build-up before the crisis and the severe hit from the crisis have led to a noticeable tightening in credit conditions.”
- Takeaway: In the years preceding the pandemic, Rosengren and others raised questions about the need for accommodative interest rates when the economy was doing well, and emphasized the need to take more precautions against financial stability risks.
Excerpt: “In the United States, we do not have a cohesive set of regulatory and supervisory tools to moderate risk build-ups. And while we do have the Financial Stability Oversight Council, we do not have a regulatory and supervisory body endowed with tools and structures that can be deployed to limit financial stability risks.”