When Walter Bagehot, the Victorian economist, wanted to explain how central banks should act as lenders of last resort, he quoted a director of the Bank of England. “We lent it by every possible means and in modes we had never adopted before,” the central banker said of the BoE’s response to a financial panic.
The US Federal Reserve’s decision to include junk bonds in its latest asset purchase schemes reflects this century-old principle that when the financial sector is in trouble it is often better to hose it with cash than be too discriminating about the effects. Buying junk bonds will mean tacitly supporting some of the private equity companies that have specialised in capital engineering and loading companies up with debt.
For many this violates the fundamental basis of capitalism: badly-run businesses should go bust and speculators should expect to lose their money if bets turn bad. That includes those who did not prepare adequately for a crisis whether through overly leveraging their assets or making their companies fragile through stock buybacks. If shareholders enjoy the rewards of being less risk-averse than others so, too, should they carry the costs. Workers, many Americans point out, have been encouraged to put aside enough of their pay to cover for unforeseen circumstances; so should businesses.
Yet enforcing these principles would mean many well-run companies would become collateral damage. It is the Fed’s job to maintain orderly financial markets and the infrastructure for coping with such a large wave of bankruptcies does not exist. Uncertainty would swiftly cripple wholesale funding markets as investors tried to assess who was carrying bad assets on their books. This would further burden the economy with a financial crisis in addition to a shutdown, and put even more boosters under already rocketing rates of unemployment. In the past month there have been 22m applications for unemployment benefits in the US; potentially eradicating all job growth since 2009.
Distinguishing between those deserving and undeserving of support is difficult even in normal times. Trying to do so in the middle of a crisis is impossible. It is easy to say speculators and corporate raiders should not enjoy the same level of support as viable businesses, but drawing a line between the two is difficult. Many take ordinary corporate practices to an extreme. The Fed is wisely limiting purchases to corporate bonds that were investment-grade before the shutdown.
However, the politics of this support are terrible. Public anger accompanied bailouts for the banks during the financial crisis; supporting the junk bond market may be even more controversial. Although debt did not cause this crisis, there will have to be a reckoning once the moment of danger is passed. Corporate America should expect to run much lower levels of leverage, as well as to pay more in tax to the federal government that has preserved many of them as going concerns.
Most importantly, the Fed will need to sell these assets quickly. Such rapid action would make it clear this is an attempt to ease a temporary dollar funding squeeze and not a bailout. Congressional oversight over the scheme is vital, too; neither Fed chair Jay Powell nor Treasury secretary Steven Mnuchin are elected and many Americans worry the scheme is rewarding the politically connected.
Fighting a crisis can be a dirty business. It often requires compromise. The Fed’s actions are justified, but they will be rightly controversial: the best approach is to make them as short-term and transparent as possible.
Source: Economy - ft.com
