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Fight the Crisis: The Big Freeze

9 reading min.
Prof. Dr. Nick Gehrke

written by

Prof. Dr. Nick Gehrke

what can we do against the crisis - a personal statement

It’s been a while since I last attended an economics lecture. But I have always been interested in the subject. Now the threshold of the crisis has been crossed by the coronavirus, and economic upheavals are becoming apparent. What can we do against the developing economic crisis? I dare to make my proposal: The big freeze.

The Situation

The Covid-19 virus has placed us in a unique situation. The big lockdown is here. Public life has come to a standstill in order to contain of the virus. No one knows when it will be over. But what I'm concerned about are the "secondary effects" - the resulting economic effects and consequences of the standstill. Some people have said that Covid-19 is the "black swan" that is now accelerating the economic disruptions and would probably have come to light at some point in the past. As history shows, black swans always come as a surprise. Whether the Black Swan is called "Covid-19" or "Franz Ferdinand Carl Ludwig Joseph Maria von Österreich-Este" is almost irrelevant; in any case, it serves as a "trigger" event for noticeable upheavals, or even "system change".

Since about 2009, at the latest, we have had a funds rate of max. 1% in the EU. Since 2016 there has been practically no funds rate at all (see graph below).

 

funds-rate-eu

 

Due to so-called cheap money, there are a lot of "zombie companies" which are actually unprofitable and only exist because you can borrow money so cheaply. This paralyzes real economic reorientation and adaptation processes and has practically put us in a kind of mild "freeze" state for years - we just haven’t noticed it so far - everything has always stayed the same. Further consequences are low fixed interest rates for pensions etc. However, we don't want to deal with all these consequences of monetary socialism that have been going on for a decade now. What we need to do now is to look at what we can do in the current extreme situation.

 

The unconditionality of the financial system

Economists often talk about production factors in the context of the production process. The whole thing is very abstract and in economics, the production factors necessary for the production of services are usually reduced to the two production factors: "labor" and "(physical) capital".

The production factor of "labor" refers to the employees that to be paid, and the (physical) capital has to be remunerated by interest, leases, rents, and licenses.

So, what happens when a crisis occurs? Which instruments are immediately "pulled" by the government? Two critical instruments: firstly, short-time work and secondly, bridging loans.

I find the following observation interesting:

Short-time work affects the production factor "labor" and, despite short-time work compensation, ultimately leads to a low wage. As a result, this means that employees are temporarily paid less. That makes sense. You simply cut pay and thus save costs.

The remuneration of the (in-kind) capital does not seem to know "short-time work". It is common practice to serve the debt service without any reduction. Instead, companies should take out bridging loans to be able to service the debt in full. But nothing is cut, at least not without insolvency, and that would be a kind of "game-over" situation that is certainly not characteristic of short-time work.

In my opinion, this is a remarkable difference between these two factors of production. The production factor of (physical) capital is unconditional, whereas the production factor of labor can be treated conditionally. I am merely stating the facts. No transition to socialist arguments should be prepared, for instance, in the style of a possible "unjust" pre-treatment "capital before labor".

Nevertheless, this can be considered worthy of consideration, because let us be clear about one thing: if an industrial company does not get more raw materials or has less than it needs, then this restricts production. We don't need to discuss this because it makes no sense to discuss physics and engineering. It is a natural scarcity characteristic. Despite the money economy: money is a human construct. There is no scarcity of money. In the past, there was an attachment of money to precious metals. However, gold bonds haven’t existed since the early 1970s (due to the abandonment of the Bretton Woods Agreement by US President Richard Nixon). Money is thus a "mere mind game", much less rooted in the natural scarcity orientation of physics.

Nevertheless: debt services need to be served at all costs; the instrument of "short capital" does not exist (analogous to short-time work). On the other hand, the artificiality of money is still omnipresent: "whatever it takes" is still familiar to us from Draghi: generating money with the stroke of a pen or, the more modern equivalent, with computers (of the banking system). This seems schizophrenic: the non-banking sector is absolutely required to perform debt service, but the banking sector creates money at the stroke of a pen, without acknowledging the physics of scarcity and without recognizing natural limits. Anyone who argues that the minimum reserve is like a natural scarcity is probably deluding themselves. When it comes down to it, none of this will count, and all of these rules (including those concerning the capital adequacy of banks under Basel x) will be discarded on the way to the political bazaar.

 

The sense and nonsense of more and more credit

If a company is now up to its neck in the crisis, even more loans should help. Many companies (especially the "old economy" companies with low returns) have already had a lot of cheap money as loans on their balance sheets and are actually "zombie" companies. In the crisis, even this cheap money should not be served, and to be able to serve, even more, cheap loans should help. Can this work out? This is how the situation looks to me: there has been a decade of cheap interest rates, way too cheap. Unprofitable companies could "suck it up". Now it needs more of the cheap drug. It feels like good advice: after the party the hangover comes, and the doctor says: the best therapy is now a beer, preferably a whole case. There may be people who like that, but that is probably not normal.

 

What is the danger?

More cheap loans increase the money supply. Nevertheless, businesses and citizens will be reluctant to ration their spending. That could cause prices to fall despite the increased money supply. That is odd because a lot more money can circulate. But it is still possible because the speed of money circulation is slowed down by expenditure rationing. Economists know this connection within the (accepted) quantity theory of money. It can also lead to deflation of wealth and a deflationary shock. Such bad scenarios bring back memories of the "Great Depression" of the 1930s. The well-known economist, Irving Fisher, described the process of debt deflation in his book “The Debt-Deflation Theory of Great Depressions” (1933) as follows:

  1. Debtors try to become solvent in the short term with emergency sales (sales at very low prices).
  2. The repayment of debts leads to a reduction in the banks' creation of money and thus to a reduction in the money supply.
  3. By reducing the money supply the price level decreases.
  4. Falling price levels cause the company values to fall. The creditworthiness of companies decreases, which makes it more difficult to extend or reschedule loans.
  5. The profits of companies decrease.
  6. Companies reduce production and lay off workers.
  7. There is a general loss of confidence in the economic situation.
  8. Instead of investing, money is hoarded.
  9. Although nominal interest rates fall, the real weight of the interest burden increases due to the general decline in prices.

 

Now, it is true that in our modern times, the money supply can be increased again more quickly by the European Central Bank (ECB) than in the 1930s. However, this can only be done at the cost of further corporate indebtedness with (even) cheaper money. The ECB's powder for further interest rate cuts has actually been "shot" for years.

The situation may normalize again sometime, and the circulation speed of money may increase again, then possibly, due the extensive cheap credit, too much money supply in circulation, and it will come to exuberant inflation. Nobody knows what will happen, except that it will become volatile.

 

What is the big freeze?

Let's get down to business. What kind of measures can you imagine? This is my contribution and proposal for crisis management. It's certainly not perfect. But it is vital in a situation like the current one that we practice "thinking outside the box" to explore the space of possible solutions.

Let us start with a look into the (mythical?) past. In the Bible, Genesis 25:8-55 in the third book of the book of Leviticus, it speaks of a "jubilee year" (also: year of jubilee). "You shall count seven sabbatical years, seven times seven years; the time of seven sabbatical years shall be forty-nine years for you. In the seventh month, on the tenth day of the month, thou shalt sound the trumpet; on the day of atonement thou shalt sound the trumpet throughout all the land. … ". The Bible describes extensive measures for this 50-year cycle, including the cancellation of debts and much more. It is worth reading the passage in the Bible. Maybe it is something for (bored or annoyed) ‘inmates’ who are quarantined to working from home.

Time for reflection might not be such a bad idea in times of the Covid-19 crisis. If we take the end of the Second World War as the "zero-line", then the jubilee year is probably overdue.

But I think that in the sense of modern economics, this serves only as an anecdote for now. And the cancellation of all debts (today it would be called “debt-cutting”) would be too extreme a measure.

So, what is the "big freeze"? The idea is that in a crisis, the velocity of money in circulation is decreasing. As a result, companies can no longer service their loans because they lack turnover. Everything becomes tougher and slower. The real economy is freezing.

Now the credit economy has to be frozen - that is the "big freeze" - until the situation has normalized. As a result, the "big freeze" is a temporary deferral of large-scale loan repayments. Ultimately, the production factor of (physical) capital always refers back to credit. For example, if a company builds a building and finances it with a loan, this is immediately apparent. But even if a building is rented, then in the end, as a rule, a loan must be serviced. Even if the tenant does not directly service the loan, the landlord has to do it with the income from the rent. In the end, all money amounts are the result of a credit relationship (money creation through credit).

The big freeze must now be regulated. When may which debtor bring which repayment into the deferral mode? And when may which tenant or leaseholder reduce the rent or lease payments and in what amount? And what do the banks do if the repayments are suspended?

A package of measures could look as follows once the "big freeze" is declared. Of course, the regulations of the "big freeze" are only intended to have a temporary effect e.g. until the "lock down" clears up again. When the "big freeze" mode is lifted by the government, everything will be back to normal as far as debt service is concerned.

  • Whenever a borrower suspends repayment (which is lawful under the “big freeze” rule), the central bank steps in to repay (with a certain discount, if necessary, since the commercial bank always bears the risk of default and this is taken into account by the central bank in a lump-sum repayment).
  • If the borrower suspends repayment, a corresponding mortgage loan in favor of the central bank is registered.
  • The borrower can only suspend the repayment, not the interest.
  • The borrower can only suspend repayment if he/she does not receive the full rent from the tenant or lessee.
  • The tenant can only reduce the rent or lease payments if he/she also takes savings measures in the other production factors. Thus, if he/she applies short-time working to his/her workforce. The "Big Freeze" measure of the tenant (concerning the factor of production (physical) capital) is linked to measures concerning the factor of production labor so that no arbitrary rent or lease reductions occur.
  • The rent or lease can be reduced to a maximum of the amount of depreciation plus the landlord's interest. The landlord then has "zero profit" from the rented asset, because depreciation plus interest and reduced rent cancel each other out in the landlord's income statement.
  • If the rented object is already out of the depreciation period, imputed depreciation is assumed as the lower limit. This depreciation must be exempt from income tax so that the "invoice" of the landlord is zero in this case as well.
  • If the borrowers have to repay normally again after the "big freeze", the repayments are initially made to the commercial bank until the latter has received the loan in full. Subsequently, the borrower ultimately pays the central bank for the period of suspension of repayments during the "big freeze".

 

There is a kind of "credit moratorium" during the Big Freeze. The motto is, so to speak, "Better to stretch credit than stack credit".

The advantage is that the volume of additional bridging loans does not have to increase that much. If the "big freeze" is ended by the government, then, of course, the loans have to be repaid as usual. The "big freeze" is something like a "pause" button for our credit system.

 

What happens after big freeze?

It will be an interesting time. Various people will certainly be asking the "system question" of whether the current financial system can continue to exist as it is. By the way, the "system question" has always existed, even during or after the Great Depression in the 1930s. It just doesn't seem to be too well known. I don't mean any planned economy system alternatives (which do not get us anywhere, because we still have to boost our still-strong personal initiative). But take the Chicago Plan as an example, which was aimed at commercial banks no longer being able to create money "out of nothing", but needing a 100% minimum reserve. Incidentally, the liberal Swiss have voted on something similar in the recent past: the full money initiative. But this was rejected (link leads to German-speaking content).

But one thing the vernacular has always known in any case: "The jug goes to the well until it breaks!"

What are your thoughts about crisis management or the "big freeze"? Please leave a comment!

Stay healthy,
Nick Gehrke

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