Central banks face the difficult task of helping governments to deal with the effects of Covid. At the moment, they are spending large quantities of money assisting companies to pay their workers, as due to the lockdown and lack of demand the revenues have cratered. If the situation holds for longer than a month, it will put a vast amount of SME close to the bankruptcy. This would trigger a devastating effect that destroys long-term production capacity.
The amount of money that the governments are spending to keep those businesses alive, directly by reducing taxes or helping to pay salaries to their workers is unprecedented. Consequently, the debt of states is set to increase considerably, and it entails to increase the risk of default and the interest to pay for that debt.
This situation is dramatically different from the financial crisis of 2008 when the interest rates where around 5% in Europe and the debt of countries was much lower. Now, monetary policy from central banks can ease liquidity problems, but it is not going to be as effective as it was 12 years ago.
Central Banks need to ensure that the interest rates do not increase up to the levels viewed in 2012, as the level of debt now is forecasted to be around 100% of GDP for France, 150% for Spain and 200% for Italy. High-interest rates plus those enormous amounts of debt to pay may entail the bankruptcy for those countries.
Recently, we testified the most significant coordinate action among six central banks to inject liquidity in the system via the purchase of government bonds from pension funds and insurance companies (mainly). The newly created money goes directly into the financial markets, boosting bond and stock markets and relaxing the risk premium of the countries.
What happened in the past when using QE?
One of the differences is that the last time this happened, it was a financial crisis, several banks collapsed, and the rest were in a fragile moment. When Central banks used QE in Europe, the money went directly to the banks (as the Pension Funds and Insurance companies have their deposit there) and not to the real economy, increasing only 1-2% the GDP (Bank of England)
What is happening now?
Some governments are building social policies and delivering a considerable part of this new debt directly to people, directly by giving them money (US) or helping companies to pay their inactive workers during the pandemic (UK, Spain, France Italy) to avoid the destruction of jobs.
The effects will vary massively depending on the duration of this pandemic. However, one thing is clear; the amount of debt of countries will be huge, and governments only have two tools to diminish its impact, inflation or taxes. Inflation is a critical consequence of increase broadly the monetary base because of QE. Nevertheless, it did not happen in Europe the last time it was applied six years ago. And if there is no inflation, the only alternative is higher taxes, which is probably the outcome of this crisis during the coming years in Europe.