In the game of chess, the queen is the most valuable piece on the board. Protecting her is paramount, but she can’t be out of action forever. The queen must be deployed at just the right time to defeat an opponent.
In economics, the government balance sheet is the queen. Governments that squander the public purse do great harm. Unsustainable budget deficits result in debt monetization, runaway inflation and currency debasement (Zimbabwe, Argentina) or can handicap future generations with crushing debt burdens (Italy).
Yet the public balance sheet is also a powerful emergency tool that can be used to prevent bankruptcy, financial chaos, and economic depression, as well as to respond to natural disasters. Today, the coronavirus is precisely this – a major natural disaster capable of wreaking economic and financial harm on a massive scale. If ever there was a time to deploy government balance sheets appropriately, it is now. The fundamentals of modern political philosophy, rooted in the idea of a social contract whereby individuals give up certain freedoms to their government for protection, underscore this.
Government policy needs to engage immediately on three fronts.
First, as we recently outlined, targeted fiscal stimulus is the most effective tool to offset a private sector spending slump stemming from uncertainty and fear created by the pandemic. Temporary sales and payroll tax relief, as well as an extension of unemployment benefits should be instituted.
Second, when ‘acts of God’ arrive – hurricanes, floods or earthquakes – governments respond with disaster relief, including loans and grants to help stricken communities get back on their feet. The coronavirus is exactly such a natural disaster, but on a larger scale. It poses grave risks to workers and communities everywhere. Governments must be prepared to offer financial backstops to firms, large and small, that might otherwise fail through no fault of their own.
According to the International Air Transport Association (IATA) airlines collectively could lose over $100bn in passenger revenue this year as a result of falling demand for travel. Without assistance, this industry is headed for a hard financial landing, from which many companies may not survive. Last week Flybe, a small British airline, declared bankruptcy.
This is not an argument for bailouts of big business. Family-owned hotels, restaurants, theme parks, tourist destinations, ski resorts, parks, lodges and travel agencies are even more at risk. Such firms have small capital cushions and enjoy minimal access to bank or market-based forms of borrowing. In the US alone, nearly 15 million Americans work in these kinds of companies in the tourism and hospitality industries. Similarly, a range of small businesses may fail if global supply chains are severed, even temporarily, by measures designed to limit the spread of the virus.
The essential point is that jobs and incomes are at risk due to no fault of either employer or employee. This is exactly why natural disasters are always a clear justification for a government to intervene in markets to protect citizens.
In the US, the Small Business Administration provides low-interest loans when disasters are declared, and similar programs exist in other countries. All should be bolstered with additional funding, an extended list of eligible participants and clear guidelines for how affected businesses can apply for emergency financial assistance. This should be done now, before companies run into trouble, lay off workers and crash into bankruptcy.
Third, as medically contagious as the coronavirus is, it could unleash an even larger economic pandemic. The financial ‘black swan’ event on the horizon is not the virus itself, but the hugely impactful risk that credit markets freeze up.
This could happen if an unanticipated corporate default unleashes rapid selling of a company’s debt securities. Unlike stock markets, corporate credit markets are prone to collapse since underlying market liquidity is poor. This is an unfortunate legacy of the ‘Volcker Rule.’ High bank capital requirements and other post-financial crisis regulations have kept investment banks from trading inventory of corporate bonds, and a critical shock absorber has been lost that used to facilitate market adjustment in times of stress.
If a large airline, hotel or industrial company ill-equipped to handle a supply chain disruption unexpectedly careens toward bankruptcy, selling of credit funds by skittish investors could prove catastrophic. Otherwise healthy firms might not be able to roll-over their debt, leaving them unable to pay wages, suppliers or creditors. The ‘black swan’ of frozen credit markets is what would likely unleash the next great recession.
Some observers believe that deficit spending or government guarantees would be financially ruinous. This is fundamentally wrong. With long-term US Treasury yields below 1%, and yields in many other industrial countries even lower, markets can easily absorb additional government borrowing. Critically, if governments act pre-emptively to stimulate the economy, backstop the most vulnerable industries and re-assure corporate bond markets, the costs they will bear will be infinitesimal compared to what would happen if they delay.
Our recent history is instructive. No serious economist disputes that fiscal stimulus deployed during the 2008 financial crisis mitigated its economic impact, saved entire industries, staunched job losses and ameliorated stresses in the financial sector. John Maynard Keynes surely would have smiled at lessons learned and applied.
A decade ago, faced with the imminent bankruptcy of General Motors and Chrysler, the US and Canadian governments provided about $85bn in loan guarantees and equity stakes to prevent a disorderly liquidation. The bailout was estimated to have saved between 2-4 million jobs in the auto and auto parts sectors, at least $40bn in potential lost state and federal tax revenues and kept tens of thousands of families from economic ruin.
To be clear, governments should not intervene to protect companies or individuals from acts of folly. This would distort incentives and create untenable levels of ‘moral hazard’. The coronavirus, however, is a natural disaster akin to a major earthquake. As such, it is a random event, meaning that government response lessens the risk that the public purse is put at risk of systematic abuse by the private sector. Proper policy measures to mitigate the economic and financial risks of the coronavirus would only have temporary impacts on public sector borrowing.
It is commonly accepted that governments are obligated to rebuild communities following ‘acts of God,’ such as hurricanes, floods and earthquakes. In the US, the Federal Emergency Management Agency (FEMA) has an annual budget of nearly $20bn to help the victims of natural disasters. In the wake of the disastrous tsunami of 2010, the Japanese government estimated that the costs of reconstruction could top $300bn, or 6% of national income. Japan’s citizens did not object to their government picking up a sizable fraction of the tab.
In those countries and regions where central banks are legally permitted to purchase private sector securities, such as in Japan or the Eurozone, plans should be drawn up and published as to how the central banks would intervene in credit markets to prevent disorderly trading. In the US, where the Federal Reserve is only permitted to purchase federal government issued or guaranteed securities, the US Treasury should engage with Congress – with the advice of the New York Fed – to establish a special fund whose sole purpose would be to provide emergency liquidity to credit markets should they go awry. There is precedent, such as in 2008 when the US Treasury guaranteed money market mutual funds to the tune of $50bn.
Crucially, these kinds of steps should be taken soon, before a financial crisis occurs. Credibility, reinforced by a ‘big stick,’ is the most effective tool to prevent a meltdown in financial markets.
Today the coronavirus is doing significant harm to the US and world economy and poses the risk of far worse damage. It is time to deploy the US government’s queen and utilize the public sector balance sheet to checkmate the economic consequences of the pandemic.
