Due to continued intervention by central banks and governments over the past decade, free markets were already on life support before the Wuhan virus struck. The current crisis has given authorities an excuse, to shed any restraint and take full control of large parts of the economy. Nowadays, exchanges don’t function as places of true price discovery. Instead they display prices, that are heavily manipulated by central banks. Governments are launching far-reaching loan and bailout programs for companies, that will allow them, and not market forces, to pick winners and losers. Our nations have become centrally managed economies, where politician and unelected central bank officials control most business activity. We are on the way to replicate the Soviet Union, where all power and wealth was usurped by a small group of apparatchiks, while the rest of the population suffered.
Why did we get there? Was it the sole responsibility of selfish politicians, power-hungry bureaucrats or the boundless greed of a few capitalist billionaires? To some extent yes. But the main reason, why the current situation could unfold, is us.
From the end of World War II until the early 2000s, Western economies grew steadily and our societies reached a level of wealth unheard-of before. Salaries grew steadily, consumer goods were affordable and readily available, and in case of unemployment or sickness, an excellent social welfare system provided ample support. Especially in Europe, but also in other parts of the Western world, people developed a perception of entitlement and expected the state to intervene every time that a slight problem emerged. When serious cracks in the ‘all is well’ narrative appeared during the Great Financial Crisis of 2007-09, the population called on politicians and bureaucrats to do ‘whatever it takes’ to solve the crisis and ensure an even higher standard of living than before.
There have always been political and economic crisis throughout history and, despite of what some politicians and central bankers are telling us, there will be more in the future. Financial prudence demands, that you maintain enough cash to cover expenses for 3-6 months (1 year is even better). Part-time workers, low wage employees, the unemployed and young people at the beginning of their career, will of course not be able to save that much money or any money at all. But a middle-class employee, who is older than 35 years, should have been able to create a sufficient emergency fund by consuming less and saving more.
What applies to individuals, also applies to companies. They too should have secured enough cash, to survive for 3-6 months without becoming insolvent. But instead of saving money, many Western companies have preferred to use the low interest environment of recent years to increase their borrowing. If all the money had been invested in R&D or profitable projects, this would be forgivable. Unfortunately, a lot of the borrowed money has been used to buy back own shares, pay high dividends, grant excessive senior management compensations, and invest in questionable M&A deals at inflated prices. As a result, not only stock prices went up, but also the debt ratio. To satisfy their greed, senior management and shareholders have been willing to sacrifice the long-term success of a company for short-term gains.
To deal with the current crisis, middle- and upper-class individuals should respond by slashing their monthly spending. But as this might entail moving to a cheaper house or apartment, selling the expensive car and curtailing discretionary spending, most are not willing to do so. Companies should enter a major restructuring program and sell new shares to boost capital. But the former requires a lot of work and determination, and the latter would cause a crash in the stock price. Shareholders as well as senior management, whose stock options would become worthless, are not willing to accept the resulting losses. Therefore, everyone is crying for government help.
The current crisis is severe. Even after most of the economy is opened again, people will not immediately return to their old spending habits. Some will avoid going out or travelling due to health concerns. Others will reduce their spending, as they are uncertain about their future income. And those, who have lost their jobs, won’t have any money to spend. Don’t expect a V-shaped recovery. Get prepared to accept, that most companies will experience sizeable losses in revenue compared to pre-crisis level and some will go out of business.
A severe downturn is inevitable and it is just a question of whether it will be a recession or a depression. Can governments and central banks stop it? No. Can they delay it? Yes. Would they be justified in delaying it? No. Postponing the inevitable requires governments to substantially increase debt, and central banks to create trillions of new money ex nihilo. Instead of solving the crisis, they would make the future collapse even worse. If there had been a proper reset in 2007-09, we would be in a much stronger position to deal with the current challenge.
Is it justified to bail out struggling companies? No. Most companies got into a precarious position, because senior management behaved recklessly and shareholders did not interfere or even promoted bad behavior. Bailing them out now, gives a strong incentive to future management teams to behave in the same way. If you support free markets, you also have to accept bankruptcies. Otherwise profits are privatized and losses socialized. Don’t worry too much about the employees. In Western countries we have well-established welfare systems that will take care of them. And the more corrupt companies will exit the market, the more new-entrants with great business models will emerge to create many new jobs. It’s the government’s task to cushion the transition for employees, not to protect ill-managed businesses.
Is it justified to bail out shareholders and bondholders? No. If you invest in shares and bonds, you do so to earn money. You must be aware of the risk of losing part or all of your money. It shows lack of character to collect all the profit, but ask for state support when threatened with potential losses. The government should only provide relief to poor and lower middle-class people, who were talked into buying risky bonds and stocks by dubious sales guys.
Is it justified to bail out struggling individuals? Depends. Middle-class and rich people who have accumulated a lot of debt, because they were careless or living well above their means, should suffer the consequences. However, people who have fallen below the poverty line for whatever reason, deserve public support. The public welfare system should provide payments just above poverty level. This ensures, that nobody falls off the cliff, but also provides an incentive to become self-reliant again.
Government bail outs distort markets and usually only provide short-term relief. They also tend to favor the Rich and thereby adding to inequality in our society. There are plenty of other options available that
- interfere less with free markets
- help to prevent mass defaults by providing urgently needed liquidity to all companies (and not just the big corporations)
- give relief to the poor and unemployed, while putting a heavier burden on the Rich
Below we present several potential measures. We don’t claim that they are perfect and that there are no better solutions. But they are in our opinion superior to providing cheap loans and subsidies to political cronies, which is currently widespread in most Western countries.
Suspension of income tax advances
Companies and some individuals need to make advance tax payments. At a time, when cash is king, such tax payments can cause a major drain on liquidity. Why doesn’t the government forgo such pre-payments and reimburse payments already done this year? That doesn’t mean that no tax needs to be paid. Companies and individuals would still be required to file their tax statements next year and pay income tax. But the assessed tax amount will likely be lower than the sum of prepayments, as the latter was based on far too optimistic expectations for this year.
Central banks could offer governments a zero-interest bridge credit for this year’s tax deficit, to be paid back upon receiving actual tax payments in the following years. We are not in favor of government debt monetization by central banks, but in this case, it would be justified as this is a special emergency and the money must be paid back in full.
No VAT for essential goods
Value-added tax (VAT), Good and Services Tax (GST) or sales tax increase the price of goods and thereby reduce the amount of traded goods. In addition, they particularly affect the Poor, who spend a higher percentage of their wages on taxable goods than the Rich, who have a much higher investment and savings rate.
Especially in Europe VAT rates are very high ranging between 17% and an insane 27%, tough reduced rates might be as low as 5% and some exemptions might apply. By slashing the rates for food and other essential items to zero, governments could improve the plight of the Poor and unemployed. Of course, checks must be in place to ensure, that shops don’t pocket the tax saving by keeping sales prices unchanged
Companies that are closed by the authorities, should enjoy a payment suspension for the time of their closure. In this case, they would not have to make interest and principle payments to banks, settle with suppliers, transfer rents or pay employees as long as the lockdown lasts. Once it’s over, they would resume the respective payments.
The pay-back period of a bank loan would be extended by the duration of the closure. Therefore, the debt would be paid back in full. Suppliers would just have to wait a little longer for their money. Staff would receive unemployment benefits from the state. Only landlords might suffer an actual loss. For their own mortgage payments, they could be equally granted a temporary payment freeze. But for the fully owned part of the property, they would suffer a temporary loss in income. This is not fair, but most landlords should be able to deal with it.
Similar solutions could be found for companies, that have experienced a significant fall in revenue due to government-imposed restrictions.
Solidarity pay cuts
In the current crisis, it is important to avoid the lay-off of too many employees at the same time. One way to avoid this is to pass an emergency law in parliament, which would require companies to first implement a ‘solidarity pay cut’, before they can terminate employment contracts. In this case all salaries above a specific amount would be cut, including bonuses and stock options.
The cut-off amount should be set high enough, as not to affect low- and mid-income staff.
For instance, in Germany the amount could be set at 5,000 EUR/month, which is well above the median and the average gross income. An office employee with 3,500 EUR/month income would experience no change, but a manager with 8,000 EUR/month would receive 3,000 EUR/month less and the CEO with 30,000 EUR/month would see the salary drop by 25,000 EUR/month. In addition, both the target bonus of the manager and the CEO would be cut to zero during the time of the solidarity pay cut (e.g. if the original annual target bonus of the manager was 30,000 EUR and the pay cut lasted 4 months, then the target bonus would be reduced to 20,0000 EUR). The CEO would receive no stock options for the whole year.
This is certainly not a ‘free market’ solution. It should only be applied once and only for a short period such as 3-6 months. Otherwise most skilled employees and managers would leave the country. Solidarity pay cuts are not an option that we would usually propose, but we are sick of listening to CEOs and senior managers talking about their social responsibility. Now they have an opportunity to prove it.
Preferred shares instead of company bail-outs
We generally don’t like government stakes in private companies. But we like cheap loans and subsidies by politicians to their cronies even less. Instead of throwing money away, it would be better, if the public would be able to participate in future profits of a company. Fortunately, there are preferred shares.
If the government feels obliged to give money to a listed enterprise, it should only be in exchange for preferred shares with no voting rights but a higher dividend. As we don’t want politicians and bureaucrats to interfere with the management of private enterprises, absence of voting rights for the shares is crucial. However, there should just be a veto right regarding the sale of major assets, M&A activities and management compensation, to avoid abuse by senior management. ‘Public shares’ should also have a guaranteed dividend of 2%-3% above inflation, as long as the company makes enough money to pay for it.
The additional shares would cause heavy losses for existing shareholders. They would not only face a considerable fall in share price, but also a severe reduction in future dividend payments. But this is fully justified. If shareholders did not force the management of the company to adopt prudent financial behavior in the past, they must suffer the consequences. This is ‘real capitalism’.
The state should finance the investment with 100-year interest free government bonds, to be bought directly by the central bank. This would amount to direct debt monetization, which we usually refuse. But as central banks are currently engaged in many questionable and even unlawful activities, we consider this to be only a minor violation of free markets.
All preferred shares bought by the state should be placed in a Sovereign Retirement Fund (SRF) outside of the control of the government or the central bank. Once companies achieve a turn-around and their stock prices rise considerably, the SRF can sell the shares for a nice profit. After 10-15 years, profits of the SRF could be used to prop up the failing public pension system. In this case, not only our companies but also our pensions would be saved.
Conditional bank rescue packages
Banks are essential for the economy, as they are – at least up till now – the main provider of loans and the payment infrastructure. If banks default, companies and individuals will quickly follow. Thus, it is important for governments and central banks to ensure, that not too many financial institutions become insolvent.
Unfortunately, a large number of banks especially in Europe were already in trouble before the corona virus. The current crisis will undoubtedly push many over the edge. To avoid this, politicians and central bankers have no choice but to intervene.
Instead of handing over free money to the banks, governments should make any rescue package conditional on the following conditions: 1) Partial use of existing bail-in regulations. In this case, creditors would have assets over for certain amount (e.g. 50,000 EUR or USD) converted from deposits to shares in the bank. 2) A certain percentage of new loans must be allocated to small and medium enterprises (SME), to avoid preferential treatment of more lucrative large corporations
Apart from short-term emergency measures, a complete reset of our economies is inevitable to get them back on a sustainable growth path. Respective measures are:
- Reduce government regulation
- Streamline the public sector
- Reform the social welfare system
- Simplify the tax code, slash tax deductions and reestablish tax fairness
- Overhaul the financial system (banks, financial intermediaries, etc.)
- Establish a new monetary system
We are realists and know, that the future is likely to unfold in a very different way. The widespread sense of entitlement and the unwillingness to suffer short-term hardships in our population, will push politicians to launch massive interventions that only provide short-term relief. Central banks will print huge amounts of money and governments will go on a debt-financed spending spree. Main beneficiaries will be the (Super) Rich, while the rest of the population has to pay for it through surging consumer prices and higher taxes. By not accepting a temporary reduction in their standard of living, the middle class is sowing the seeds of its own destruction
Stay healthy, for the worst is still to come.
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