Society after Coronavirus essay #8: the relentless contraction of the economy

This is the eighth in a series of essays exploring the economic, social and cultural effects upon the daily lives of persons living in the United States, western Europe and more broadly around the world, as we emerge from the global Covid-19 lockdown pandemic.

 Suggested Reading Collaborate GCCT

By Matthew Parish

The work done by commercial lawyers, and the nature of commercial law itself, are changing dramatically as a result of the Covid crisis. This is one of the most extraordinary features of the pandemic. Markets are altering so rapidly that conventional legal models of how contracts work are having to be rewritten. Lawyers are suddenly doing new jobs.

To illustrate this, consider what has happened to the airline industry in the midst of the global coronavirus crisis. Far fewer people are flying anywhere, both through fear that flying spreads disease and by reason that government regulation has increased the cost of international travel. For example, the obligation to self-quarantine when arriving from another country places a substantial cost upon international travel, depending upon whether the obligation is enforced or just observed in practice. The airline industry has responded through dramatic contraction.

So-called aircraft boneyards, enormous tarmac yards where unwanted aeroplanes are left when not wanted by airlines, have grown in size as airlines have reduced their schedules and handed their excess aircraft back to the aircraft leasing companies. Airline and airport staff have been furloughed and ultimately will be made redundant. The aeroplanes that still fly, after some abrupt changes, remain fairly full as there is still a much-reduced core of passengers who wish to fly.

But airlines offer less flexibility on routes to their customers, and those routes they do still fly are reduced in frequency. Along with contraction in service there has been substantial stepped (not gradual) price deflation, almost unheard of in history in the absence of a dramatic oil price drop. The cause of price deflation is surely the fact that amongst the remaining kernel of passengers willing to fly, there is much increased price elasticity of demand compared to prior market conditions. Given the increased perceived risk of disease associated with the close proximity of people involved in the use of commercial aircraft, putative passengers are wondering ever more whether they need or want to fly; in consequence they are becoming more price sensitive. We don’t need that foreign vacation anymore; therefore the question of whether we take it is more dependent upon the price of the transaction. In this way, increased price elasticity of demand drives price depression.

Why are the aircraft leasing companies, to whom airlines have committed with long-term leases and upon which there are inevitably cross-enforcement provisions for aeroplanes and flights (aircraft leasing agreements provide that the revenues from one route or aircraft may be enforced against in respect of unpaid debts relating to another aircraft or route), letting the airlines get away with it? The answer is that they don’t have any choice, because the courts have (surely intentionally) stopped enforcing contracts with sufficient speed and vigour for the enforcement process to be economically useful. The role of the litigation lawyer has thereby changed, from being the enforcer of contracts before the judiciary to being the breaker and remodeller of long-term contractual arrangements in the face of the judiciary’s reluctance effectively to enforce contracts. The rule of law is thereby breaking down gradually but inexorably.

One might almost eye the change in the approach to the law of long-term contracts as though there is an industry-wide expansion of the judicial doctrine of frustration, whereby contracts can be rewritten in the face of unexpected events that change the economic consequences of performing the originally conceived contract so dramatically. Those familiar with long-term hydrocarbon production contracts will recall the existence of so-called ‘Qatar clauses’, which permitted renegotiation of such contracts in the event of a substantial change in the economic circumstances pertinent to the profitability of the contract (typically the price of crude oil but also in the face of war).

Everything now must be renegotiated in these new ways, by reason of the massive falls in capacity and prices necessary in the airline industry in order that there be an airline industry left at all. All of the airline leasing companies, the banks and the investment funds that stand behind them, the courts, the judiciary, and the lawyers involved, understand the need essentially to rewrite all the long-term contracts involved in the airline industry to cope with the unprecedented contraction we are experiencing. At every stage in the complex contractual matrix of long-term transactional arrangements underpinning the operation of the airline industry, lawyers are serving as facilitators of a complete restructuring of the legal relationships involved. Airlines are handing back their aeroplanes to leasing companies who are thereby declining to pay revenues to their financiers; and even if the courts could and would enforce the underlying long-term contracts being broken thereby, the net result would just be to destroy everybody.

An industry contracting so rapidly and in such substantial magnitude has no choice, if any part of it is to survive, than to undergo this painful and uncertain process. The alternative to renegotiation of long-term aircraft leasing and financing contracts underlying the airline industry is to have all of those contracts rewritten by the courts or by administrators or accountants in the course of a bankruptcy procedure. Some countries’ corporate bankruptcy laws (for example those of the United States) are more finely engineered to this task than others; most European countries’ bankruptcy laws are not up to the job and therefore renegotiation in the shadow of the otherwise inevitable colossus of mutually assured destruction has become the new normal in the context of the Covid driven contraction in the airline industry.

Airlines have been chosen for the purposes of illustrating the phenomenon this article seeks to draw to the reader’s attention just because they are a phenomenon in which these trends are transparent because of the dramatic decline in passenger numbers worldwide in a liquid industry. (What is a liquid industry? One in which assets cannot be left fallow consistently with pre-crisis contractual structures; virtually every industry is liquid where assets have been mortgaged.) But the same trends can be seen in markets as diverse as hospitality, retail and commercial property. Customer-facing businesses have lost revenue on colossal scales. As a result it has in many cases become uneconomic for them to pay the rents in respect of their commercial properties to their landlords.

In the United Kingdom, by convention such payments are scheduled for the so-called “quarter days”, and anecdotal evidence has suggested defaults as high as 70% on the two quarter days that have passed since the beginning of the Covid lockdown in March 2020. There is little value in landlords suing for eviction or liquidation of tenants’ cross-collateralised income-paying assets, even if the courts would entertain such claims assiduously within a tolerable time scale. Landlords would be destroying their own (or one-another’s) income sources by total ruination of their tenants’ businesses.

Again therefore a contractual renegotiation becomes necessary to reflect the emergent reality that commercial landlords’ typical tenants no longer have nearly so much profit from which to pay their rents, and therefore there must necessarily be a substantial yet hidden level of rent deflation. It is hidden because there are no new businesses opening and seeking new premises; were there so, landlords might rationally evict their under-performing existing tenants in favour of shiny new businesses. Such shiny new businesses do not exist in a period of recession of unprecedented proportions.

Accordingly, rack rents (the price in the window of the estate agent, if one likes) remain much the same while the negotiated deflation takes place away from the public eye. The same can be said of the various financing arrangements behind commercial property leases and mortgages; they are likewise being negotiated down behind the scenes while the facial terms of overdraft of a new business account remain the same. That is because nobody is opening new business accounts.

For the same reason, rack rents for residential leases are flatlining while actual rents are subject to depreciation pursuant to landlord-tenant negotiations. Because the number of people needing to rent property is also decreasing (not least because people are dying but also because households are concentrating, to save money – so for example more people are moving in with their parents), there are few good new tenants to rent property to. Hence landlords are being forced to find compromise arrangements with existing tenants who may have lost their jobs or other revenue sources, and the flood of once-anticipated eviction procedures has not yet come, not just because the courts are going slow but also because there is no point in evicting your poorly-paying tenant if you can’t find a well-paying replacement.

Because there are few new tenants, there is no value in reducing rack rates to attract them. It is much the same game as in April 2020, when the global markets in hydrocarbons had essentially dried up through want of demand and therefore hydrocarbon prices were little more, at best, than traders’ paper predictions of the possible direction of hydrocarbon prices once demand was invigorated. However as the economy picks up and new buyers and tenants of residential property appear, the secret rental price reduction negotiations will become more visible to the markets in public deflation of property purchase prices and residential rack rates for leases. Current prospective purchasers and renters are of course waiting for precisely this to happen, thereby elongating the flatlining period before the market catches up with itself.

In a noteworthy parallelism of the airline industry, hotel chains are mothballing hotels – hotel boneyards, if you like – and maintaining full use of a smaller number of hotels again with lower prices due to increased price elasticity of demand. Vacationing and travel have come to seen to be more optional amidst a medical and economic crisis. Landlords of hotel premises have no choice but to take hotels back when they are given to them, and then to renegotiate with their financiers up the chain. For the same reasons as airlines, the notion of enforcing the terms of a cross-collateralised lease agreement covering multiple hotels (so that failure to pay the rent on one hotel might be enforced through measures to seize the revenues of others) has been largely abandoned.

Because there are no new hoteliers in the business setting up new hotels to cater for increased or varied demand – the market purely contracting, not transforming (aside, perhaps, from transformation towards lower quality by reason of price depression – hotel chains will give customers, where they can, less for less money), the entire financial system has had to bear the pain of the contraction of the hotel industry in just the same way as it has the pain of contraction of the aviation industry.

In this way, massive and unprecedented recession is a process being managed through complex multi-layered renegotiation of legal agreements between every level of financing, service or production in the financial system. In substantial part, government is taking up the pressure by printing money to keep industries alive at least in some form. While this has not happened so significantly in the airline industry, it has happened in the hospitality sector as staff have been furloughed (paid for not going to work) using government budgets. It has also, most notably, taken place in the rail transport sector across Europe, in which railway services have not substantially been cut and prices are now at rock bottom.  The levels of price deflation in rail travel within Europe have been as high as 80%. This is occurring even though the trains no longer have nearly as many customers. This is the result of government subsidies amounting to very substantial majorities of the budgets of railway networks.

The prospect of inflation might be thought to rear Its head as government now prints money to pay subsidies or lend money that it has no hope of recovering; but for the fact that firstly every developed economy is doing the same thing, so currencies cannot inflate one against the other if the same macroeconomic policies are being followed in equal measure; and secondly the price deflation caused by consumer-driven increased price elasticity of demand means that in practice very little is actually likely to go up in price: quite the opposite. Hence inflation is being held back, at least for now, in the face of recent history’s most dramatic economic contractions and the extraordinary price deflations that will result.

In this new world, lawyers become mediators rather than fighters and the rule of law is undermined to the extent that nobody is any longer held to contracts. The lawyers’ replacement goal is to find new equilibria in a world in which, in objective terms, there is a less economic activity. Stimulus programmes may eventually put us back on the right track. But while governments continue to dictate lockdown programmes amidst waves of increasing Covid infection said to be sweeping continents, we will be faced with the economics of continued dramatic contraction rather than Keynesian stimulus. The government can bury all the bottles of money it wants (Keynes’s revealing example of how arbitrary a government stimulus programme may be and yet still be effective); but nobody will bid on the contracts to dig them up while the economy continues so dramatically to contract in real terms in consequence of fear of disease and the long, chilling arm of government regulation of our daily lives, telling us what and with whom we can do things as straightforward as going to work, passing our social times and engaging in devotional activities.

The economies of the developed world persist in indefinite freewill while our governments’ Covid policies remain of this kind.

The effective lawyers amidst this free-fall will remain as mediators, or crisis managers rewriting into law and contracts sharing agreements in respect of the pain of endlessly contracting economies, for as long as government-inspired regulation and scaremongering continues to reduce the real level of economic activity in the societies of which each of us is part. Economic recovery can only begin to be thought about once government stops regulating what we are doing, and everybody loses the fear of God and starts instead to see Covid as a routine hazard of life. In these grim times, this seems a long way off.

But economics kills people just as much as disease. The problem we have at the current time is that nobody is counting how much economic contraction is hurting us, and hence our governments’ regulatory policies to prevent the spread of Covid are not being measured against anything as they should be. Let us pray that we find our collective common sense sooner rather than later. When economic activity continues to spiral vertically in real terms, eventually people starve. That is what we will face if we do not change course.

Matthew Parish is an international lawyer and scholar of international relations based in Geneva, Switzerland. He is an Honorary Professor at the University of Leicester; was elected as a Young Global Leader of the World Economic Forum; and has been named as one of the three hundred most influential people in Switzerland. An expert in UN reform, he is the author of several books and over three hundred articles.

The views expressed in this article do not necessarily reflect those of TransConflict.

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