The various coronavirus relief measures announced by the U.S. government and the Federal Reserve since late March will help firms to continue paying employee salaries and stave off bankruptcies. But those efforts could use a better design to maximize their positive impacts on the U.S. economy, according to a recent research paper titled Can the COVID Bailouts Save the Economy?, written by finance professors Vadim Elenev at John Hopkins University, Tim Landvoigt at Wharton and Stijn Van Nieuwerburgh at Columbia University.
In their paper, the authors weighed four policy scenarios, including a hypothetical one where the government “does nothing.” They compared the impacts of those policy actions with those of an “idealized model” that could potentially prevent more bankruptcies and has a lower fiscal cost than existing programs.
They also offered an early glimpse of the economy’s contours after the current pandemic dies out. In that scenario, there is an “awakening” to the possibility that pandemics may be recurring events, although with small probability. But once a pandemic arrives, it may last more than one year, they noted.
In an interview with Knowledge@Wharton, Landvoigt pointed out that the paper is focused on the financial sector. It also captures “the feedback from the financial sector to the finances of the firms that are producing real output” like manufacturers of goods or services like restaurants. “When a lot of businesses fail and then banks make losses, the banks cut back on their lending business,” he said. “Then it is hard for businesses to get credit, and this can quickly spiral out of control.”
In the wake of the economic collapse triggered by the pandemic, Congress authorized four rounds of bailouts worth $3.8 trillion, and the Federal Reserve launched programs worth $2.3 trillion, the paper noted. Much of those programs aim to keep credit flowing to non-financial businesses on whose fortunes the research is focused.
Such policy interventions do help to contain the spread of corporate bankruptcies with generous programs for loans and grants, the researchers found. The relief measures also could achieve that without any additional fiscal impact since the money they disburse would have otherwise been spent on bailouts of banks and other corporations. However, these programs could lead to rising interest rates on government debt and a slow pay-down of that debt.
What if the Government Does Nothing
Essentially, the researchers attempted to predict the effectiveness of the government’s corporate loan programs, and whether those programs will be able to prevent corporate defaults and “an unraveling of the economy.”
First, they compared an economy with and without the government lending programs to provide COVID-19 support. In trying to understand what they called “the covid shock,” they drew upon their own earlier research, where corporate defaults generate a wave of bank insolvencies, which in turn create severe financial crises.
“If the government had perfect information on where its [relief] dollars had the biggest bang for the buck, then it could direct its funding support much better.” –Tim Landvoigt
The “covid shock” would cause large revenue declines among non-financial firms. That would occur because their productivity declines on average. Further, exposure to the decline varies across firms, with some firms being particularly exposed, such as restaurants, and others much less exposed, such as online retailers. The result is a much wider variation in productivity of individual firms than during normal times – something the authors call an “uncertainty shock.” “The uncertainty shock is persistent; a high-uncertainty regime is likely to last for at least another year,” they wrote.
Alongside, there are adverse impacts on labor supply, illness, child care duties, or worries about getting infected on the job. “Taken together, many firms face revenue shortfalls that are so severe that they cannot pay their employees and make other fixed payments such as rent while also servicing their debt,” the paper stated.
The authors visualized a series of cascading effects that bring about an economic collapse if the government doesn’t intervene with relief. “Absent policy, the covid shock triggers a wave of corporate defaults,” which mean losses for banks, insurance companies and even households that hold corporate debt like bond mutual funds.
Credit spreads widen and firms find it costlier to borrow, leading to a large decline in corporate investment. As banks fail and are bailed out, they strain the government’s finances, which is already seeing lower tax revenues caused by a severe recession.
The government then issues new debt at so-called “safe interest rates that makes debt servicing more expensive, while also making it more difficult for banks and other financial sector intermediaries to recapitalize themselves.
“The mutually reinforcing spirals of firm distress, financial sector distress, and government bailouts create a macro-economic disaster,” the authors warned.
“Absent policy, the economy suffers a large decline in macro-economic activity, a rise in corporate defaults, a rise in bank defaults and loss in intermediary capacity, and a spike in credit spreads which feeds back on the real economy and discourages investment,” the paper stated. The pandemic relief measures aim to prevent those outcomes.
Degrees of Damage Control
The research evaluated three government policies “aimed at short-circuiting this doom loop and limiting the economic damage.”
The first one is “a policy that buys risky corporate debt on the primary or secondary debt market, funded by issuing safe government debt,” as the paper put it. The authors called this intervention the “Corporate Credit Facility,” or CCF.
Under the CCF programs, the government would buy $850 billion worth of corporate debt, which is nearly a tenth of overall corporate debt market. The CCF comprises three programs: the Primary Market Corporate Credit Facility (PMCCF) that aims to provide liquidity to large employers; the Secondary Market Corporate Credit Facility (SMCCF), where the Federal Reserve will buy corporate bonds in the secondary markets; and the Term Asset-Backed Securities Loan Facility (TALF), where the Federal Reserve will facilitate consumer and small business loans.
The second program the paper studied is the Paycheck Protection Program (PPP), where businesses get bank loans to continue paying salaries to their employees during the pandemic. These government-guaranteed loans carry a 1% interest rate, and the principal is forgiven if it is used to pay employees. The $671 billion program is equivalent to 3.1% of GDP.
The Main Street Lending Program provides bank loans to small and medium-sized businesses that were financially sound before the pandemic. These loans are not forgivable, and they carry an interest rate of 3% with the government guaranteeing 95% of the loan, while banks carry the remaining 5% risk. This $600 billion program represents 2.8% of GDP.
The main takeaway from the research is that the bridge loan programs (PPP and MSLP) are successful at preventing many corporate bankruptcies. “This prevents the pandemic from spilling over into a financial crisis. Stronger intermediaries are able to continue making loans, suffering merely a severe decline in assets and net worth rather than a major meltdown.”
The two programs will be able to contain the increase in credit spreads, borrowing costs for firms and the decline in overall investment that would have occurred in their absence. They would also help firms stave of bankruptcies, and the government-funded bailouts that would follow if those bankruptcies were to occur. The costs of operating the programs will be offset by the bailouts they prevent from occurring, the authors contended.
The study shows that in contrast to the PPP and MSLP, the CCF is much less effective. While the CCF lowers credit spreads and boosts investment that would have otherwise declined, it has “only minor effects” in preventing firm defaults, the paper argued. Other downsides to the CCF are that in order to finance its purchases of corporate debt, the government must issue Treasury debt that would grow the primary deficit to nearly 20% of GDP. That, in turn, increases interest rates and leaves financial intermediaries more fragile, the paper added.
“Debt becomes more expensive because now both banks and corporations take into account the possibility of a rare disaster event.” –Tim Landvoigt
A program that combines all three — the PPP, MSLF and CCF — increases societal welfare by 6.5% in terms of boosting consumption, compared to a do-nothing scenario. The government’s borrowing would also balloon, but not more than it would have without the policy interventions. The government must issue 17.5% of GDP in additional debt, up nearly fourfold from 4.6% of GDP in 2019 – and at higher interest rates, the paper states. “Government debt takes 20 years to come back down to pre-pandemic levels.”
Where the CBL Program Scores
Currently, “since the loans are given to all firms without conditionality, the PPP wastes resources on firms that do not need the aid,” the authors stated. The alternative policy the paper recommends has one critical difference: The “conditional bridge loan” program (CBL) they propose would give out loans only to those firms that need them. That rider would mean that “a smaller-sized program [would suffice] to prevent a lot more bankruptcies,” they pointed out. “The CBL is an idealized program,” said Landvoigt.
Under the CBL program, the size of loans would be determined by the productivity those firms achieve. However, the researchers acknowledge that the information requirements imposed on the government are more stringent. Such information would also be imperfect. “In reality, there is an issue of asymmetric information,” the paper noted. “Firms know more about their drop in revenue than the government. [There is also a] moral hazard — firms have an incentive to overstate their need.”
“If the government had perfect information on where its [relief] dollars had the biggest bang for the buck for the businesses that need the money the most, then it could direct its funding support much better and get a more efficient outcome,” said Landvoigt. The authors do not fix a size for the CBL program, but rather compute what fraction of GDP the government must spend to achieve the same reduction in the firm default rate as in the PPP.
How the Metrics Move
The effects of policy interventions can be dramatic in how they impact business investments.
Without relief programs, corporate loan defaults are set to increase sixfold from pre-pandemic levels to 11.5%, nearly 40% of banks become insolvent, investments fall by 70%, and aggregate consumption falls some 5%. The government would need to bail out troubled banks, for which it has to borrow more by issuing debt, causing the primary deficit to balloon to 16% of GDP levels before the pandemic.
The Paycheck Protection Program would contain loan defaults to a 2.9% increase, save two-thirds of the banks that would have otherwise gone under, and limit the fall in investments to 50%. The primary deficit would grow by a smaller size to 13.3% of pre-pandemic GDP. The costs of bailing out banks would also fall. “The government is saving money by spending money,” the authors pointed out. Consumption levels stay flat, though.
The Main Street Lending Program would also reduce loan defaults, even if they are not forgivable. Bank defaults, too, can be contained, and only about a sixth of them would go under. Corporate investments fall 54%, a bit more than in the PPP model. The fall in consumption is limited to 4.6% of pre-pandemic levels. All said, this model is not expensive to the government because there is no debt forgiveness feature and because most firms end up being able to pay back the loan, the paper concluded. “Yet, the program still eliminates most bank bankruptcies, and saves much of the cost of bank bailouts.”
In the CBL program, the loans would be forgivable and fully guaranteed by the government. Yet, because they are productivity-contingent loans, corporate defaults, and consequently bank defaults as well, would be almost entirely eliminated. There would be no need for the government to spend on bailouts, and therefore limit the increase in the primary deficit to about 7% of pre-pandemic GDP levels. It would also boost the welfare impact by 7% compared to a do-nothing scenario.
The New Normal
Landvoigt noted that the pandemic “wasn’t on most people’s minds,” and they were unprepared for it. “There were a few people like maybe Bill Gates who raised it as a danger to the economy,” he said. “[But] the average investor in the economy, the average consumer, did not factor that in that possibility.”
The “awakening” that pandemics could become “the new normal” leads to “a different long-run economy with less corporate debt and a smaller but more robust financial sector,” the paper stated. “[However], the economy is permanently smaller.”
The economy gets smaller because there would be less corporate debt in the new normal, “because it’s now riskier for corporations,” Landvoigt explained. “In some sense, debt becomes more expensive because now both banks and corporations take into account the possibility of a rare disaster event. They keep more cash and have less debt as a precautionary measure.”