Governments and central banks worldwide have responded to the Covid-19 epidemic by massive doses of monetary and fiscal stimulus. Little of the money thrown at the problem has done any good. However, the further economic distortions governments have caused will have one long-term effect: they will delay and enfeeble recovery. Ever since 1929, government actions have prolonged depressions; you would think by now they would have learned better.
When the coronavirus hit, governments worldwide resorted to the same playbook they used in 2008 and in every recession back to 1929. They dropped interest rates and resorted to more deficit spending. In the United States, they sent $1,200 checks to every taxpayer and invented a program of debt support for small business that appears to have been used by everyone but actual small businesses. They also trebled unemployment pay, adding $600 per week to it until July, thus making it unattractive for many unemployed to return to work as the economy re-opened. Meanwhile, the Fed not only reduced interest rates to zero, but began to buy bonds of “fallen angel” corporations whose debts had recently been pushed into junk status by the rating agencies.
This collection of policies follows the instincts of John Maynard Keynes, but it has one huge flaw: it delays the “creative destruction” of Joseph Schumpeter that is the only way to emerge from recession and restore a healthy economy.
Take for example the Fed’s determination to buy the bonds of “fallen angels”. These are companies that used to be considered investment grade, but have borrowed so much money or whose operations have declined in profitability so much that their capacity to service debt is now questionable. If you wanted to devise a formula for selecting companies most likely to fail in the next recession, looking for “fallen angels” would satisfy that criterion. By allocating capital to them, the Fed is deliberately pushing investment towards the least profitable and least forward-looking sectors in the economy. By this action, it is reducing the amount of capital (and other resources, most notably skilled labor and management) available for the companies of the future. Thereby it hobbles innovation, productivity and new business formation.
To give one example, Hertz Global Holdings Inc. (NYSE:HTZ) on May 22 filed for Chapter 11 bankruptcy with debts of $20.6 billion on its March 31, 2020 balance sheet. Commentators blamed its demise on the Covid-19 pandemic. Yet I looked at Hertz in early 2017, at which time it had just lost $1 billion in the previous year and concluded that its bankruptcy was unavoidable. Its business had been cannibalized by competition from Uber and Lyft, which were subsidized through endless free money from the private equity industry and no need ever to make a profit. It had indulged in over-aggressive accounting, was over-leveraged and far too exposed to the weak second-hand automobile market.
My analysis was not extreme and led me to recommend a modestly profitable purchase of the company’s put options. Yet the company lasted another three years, during which its management and staff resources were employed in an enterprise that failed to make a profit and had no long-term purpose, though we are told it paid out some juicy bonuses to management. Most important, during the same period the company’s long-term debt increased from $13.5 billion at the end of 2016 to $20.6 billion. In other words, Hertz in its death throes absorbed another $7.1 billion of other people’s money that could much more usefully have been devoted to some other purpose, ideally to funding the growing companies of tomorrow.
Hertz’s unnecessarily prolonged and expensive decline illustrates the problem: if creative destruction takes years longer than it should and absorbs billions more in outside resources than it should, then economic recovery will be correspondingly delayed and made more expensive. Low interest rates and easy money are not the key to economic recovery, they are the greatest barrier to it.
As Walter Bagehot said in 1873, in a financial crisis the central bank should make money freely available, but only at a very high rate of interest. By lending at a high rate, the central bank ensures that only those borrowers that truly have a viable plan for long-term survival will borrow more money; the others will simply fold, liberating their assets and people. By making money cheap, the central bank is destroying the discipline by which markets function properly and recessions are brought to a swift end.
You can see Begehot’s principle at work in the history of past financial crises. In 1825, a major banking crisis was met with no additional lending by Lord Liverpool’s government, and the British economy recovered within a year. In 1921, neither the U.S. Federal Reserve nor Treasury Secretary Andrew Mellon indulged in Keynesian “stimulus” remedies and so that exceptionally deep recession was over within eighteen months.
Horrible mistakes were made in the next recession, that following the Wall Street Crash of 1929. Once recession hit, President Hoover arm-twisted major corporations not to reduce the wages they paid. By doing so he eliminated their profitability and forced them to lay off additional workers rather than balancing their books through pay cuts, at a time when consumer prices had sharply declined. Then he increased government spending through Reconstruction Finance Corporation loans to politically favored projects, putting the government in the business of “picking winners” and increasing the pressure on small businesses that lacked government connections. Then he made matters worse through two tax increases: the Smoot-Hawley Tariff, which collapsed international trade and the Revenue Act of 1932, increasing the top income tax rate from 25% to 63%, which collapsed the domestic economy.
Hoover rightly lost the 1932 election, after which FDR by increased regulation and meddling made matters worse, so that the U.S. economy did not recover until after the mid-term elections of 1938, which produced a conservative majority in Congress and stopped the New Deal in its tracks. By the combined efforts of Hoover and FDR, the U.S. Great Depression lasted a decade. In Britain, where the free-market Neville Chamberlain became Chancellor of the Exchequer in September 1931, cut government spending and ended Britain’s unilateral free trade policy, the quinquennium 1932-37 saw the fastest growth Britain has ever seen.
In the recession of 2008, the same mistakes were made. When Lehman Brothers declared bankruptcy, the authorities panicked and bailed everybody out, from the moribund General Motors through the ineffably foolish Citigroup to the utterly underserving Goldman Sachs’s AIG positions. Then money remained cheap for most of the next decade, while the U.S. budget was pushed into permanent deficit through pointless “stimulus.” As a result, unemployment remained very high far longer than it should have, while productivity growth disappeared altogether (a blizzard of new pointless regulations by the Obama administration did not help here). Only after January 2017 did deregulation by the new Trump administration combine with a much-delayed ultra-hesitant rise in interest rates by the Fed to produce a robust rise in productivity growth and living standards. Internationally, even worse monetary policies had produced the same productivity malaise and the same interminable delay in economic recovery.
In this recession, which differs from past ones in having been produced by the global supply-side shock of the COVID-19 epidemic and the shut-down of most world economies, policymakers have resorted once again to the tired Keynesian monetary and fiscal remedies, throwing public money at the problem. To be fair, some of the problem did warrant money-throwing; modestly-waged people who lost their jobs through the shutdown did indeed deserve help, economically as well as morally. Yet the restraints on policy from fiscal and monetary norms have been even weaker this time around than in previous recessions. There is thus no reason to expect that the results will be any better, as international bankruptcy and debt default approach ever closer.
If policymakers do the right thing now, economic recovery can be swift. The COVID-19 pandemic has destroyed few productive resources, so only the over-borrowing that existed before the pandemic needs to be written off. Unfortunately, the correct policy, pushing interest rates above the level of inflation and cutting back public expenditure sharply, is very unlikely to be pursued. It worked well for Neville Chamberlain in 1930s Britain, and for Poland and Latvia in the 2008-10 downturn, but it is very unlikely indeed to be tried now. Which is an enormous pity, because it would work, producing a rapid recovery followed by solid growth.
As it is, we are likely to get a “square-root-shaped” recession – a quick but partial recovery from the pit, as economies are reopened, followed by stagnation as governments throw unnecessary money at the remaining problem, making debt and mal-investment malignancies worse. Thus, the recovery-quelling influence of Maynard Keynes’ false doctrines will blight the futures of yet another young generation.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)