Money in the Time of Coronavirus
J. McAndrews, Derivative Failures

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March 22, 2020

James McAndrews, TNB USA Inc. and Wharton Financial Institutions Center

In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

Walter Bagehot, Lombard Street

One failure makes many, wrote Bagehot, the dean of financial crisis analysts. When economies are in wild alarm, as in the fall of 2008, a failure, like the Lehman Bros. failure, can reverberate throughout the financial system, causing a wave of rescue efforts and other failures.

Our current crisis and its anxiety are borne of a different cause. Large parts of the economy have been shuttered, not because of financial stringency or economic insufficiency. Instead, conscious decisions have been made that to save lives it is necessary to close shop.

Bagehot’s words have a different interpretation now: the best way to overcome the crisis is to arrest the spread of Covid-19, the primary failure. Surely, arresting the spread of Covid-19 through means other than social distancing remains many months away. We are left with the question of how best to prevent, or, if unsuccessful in prevention, to cope with the derivative failures.

That reduced economic activity is a derivative failure of the spread of Covid-19 demands different reactions from policy makers from more familiar recession scenarios, often caused by excessively tight monetary policy. Further, with policy rates in many advanced economies near or below zero, the room for a several percentage point drop in policy rates doesn’t exist. What steps are crucial to counter the deepening social distancing recession?

First, we must support, protect, and direct resources to the health sector to maintain and even increase its capacity. Second, outside of the health care sector, much economic activity need not be stimulated at present; instead it needs to continue to be suppressed. Third, we must work in every dimension to prevent hardship to those who are suffering—those who have or will lose their employment or income, who are isolated from necessary support, or are laboring in difficult circumstances. Finally, it is important now to preserve the knowledge and capital, much of it human capital, in society in general and also in firms.

The two elements of assisting those who have lost employment and income and preserving society’s ability to recover once the primary failure is arrested, have been the subject of many essays in this series and elsewhere. There are many laudable suggestions. In the remainder of this essay, I’ll discuss how governments might best preserve the ability of firms to survive the crisis.

As Dan Awrey pointed out in his essay, the Federal Reserve’s recent expansion of lending is welcome in that it is designed to “prevent dislocation within private money markets from triggering the failure of otherwise healthy banks and other financial institutions, along with the consequent withdrawal of lending, deposit-taking, and other key financial services.” These recent actions by the Federal Reserve are important building blocks in preserving the financial services that all modern economies rely on.

The Fed’s actions alone cannot preserve the ability of many nonfinancial firms to survive a long period of inactivity. The Federal Reserve’s lending is based on counterparties delivering collateral to the Fed. That collateral consists of loans to firms, but for the firms to receive the loans in the first place, the lender must be confident in the firm’s ability to repay. In the current crisis and as the slowdown continues, that confidence to lend will disappear. To maintain the confidence of lenders, there is an urgent need for Congress to provide assistance with pandemic insurance, in a fashion similar to the Terrorism Risk Insurance Act in 2002. Many lenders will refrain from lending if borrowers don’t have insurance for business interruptions caused by pandemics, but we’ll need the federal government to provide reinsurance to private insurers.

Some adjustments to the Fed’s programs can improve their efficacy during this slowdown. The joint U.K Treasury and Bank of England program for lending to firms, the Covid Corporate Financing Facility, has many features worth emulating here in the U.S. It measures firms’ credit quality prior to the spread of the pandemic; it allows firms that had not before issued commercial paper to participate in the facility; it uses measures of credit quality beyond those of ratings agencies; it allows firms of relatively lower credit quality to participate in the facility; finally, it aims to match market pricing prior the economic shock from Covid. The U.K.’s CCFF is open to all firms that “make a material contribution to the U.K. economy.” Broadly inclusive features like those should be adopted by the Federal Reserve for its CPFF.

Firms also face the specter of paying interest and principal on their existing borrowing. Without the ability to refinance those borrowings and to borrow additional amounts to make interest payments, many won’t have the revenue to sustain the required principal and interest payments. Financial regulators have issued helpful guidance to banks to continue to support businesses and households Nonetheless, as the slowdown continues the confidence to lend will surely be drained from the circular flow of economic activity, limiting the efficacy of the Fed’s lending programs and guidance.

Consequently, much more must be done to preserve firms in the face of the slowdown. Simply providing funds to specific firms now, as is currently being discussed in Congress with respect to the airlines, is not likely to be effective. We have little idea how long the slowdown will persist, and we have not assessed which firms are crucial to any anticipated recovery. Spending resources injudiciously now may prevent us from applying those same resources in more effective ways in just a few months.

Some principles can assist us in determining which firms should be a priority for extraordinary government assistance. Like the auto firms in the wake of the global financial crisis, firms that have both significant employment and high capital intensity are vital to preserve. Firms with high capital intensity are difficult to replicate, and this is true for firms that employ highly skilled workers, that is, firms that have high human capital intensity. A second principle is that firms that provide inputs to others are likely more systemic in their operation than those that provide final goods. For example, a computer chip manufacturer is likely more systemic than a computer manufacturer. Finally, extraordinary assistance should only be considered if broad-based, widely available facilities to help most firms are already in place.

It is difficult to make the determination of where to focus resources as such triage decisions are most excruciating. But the government will make such decision according to some principles. It is vital that the government should make its principles explicit, so that people can understand the reasons the government is acting and can better forecast future interventions. In general, society needs to examine, through democratic methods in Congress, which firms are harder to replace than others, and which are more systemic in their effects on other firms and focus its preservation efforts on those firms.

Notwithstanding how difficult it was to replace the auto firms given their importance to the economy, the auto firms were put through bankruptcy in 2008-2014 and continued to operate. That approach was possible, in part, because many other firms were not also in the same straits as the auto firms. New policies to reorganize the finances of systemically important firms that cannot service their debt will have to be considered.

The current crisis will strain our finances, but it may strain our imaginations even further. How to deal with the derivative failures caused by an extended shutdown of the economy without impairing the ability of the economy to recover is one such challenge. We should avoid a rush to throw money at industries randomly. Instead a pledge to preserve the economy, to direct resources at particular industries and firms, and to do so in a deliberative and democratic way, is likely to be more effective in addressing the failures that will result from this abrupt recession.