Sunday, April 19, 2020

Economic Sustainability and “Coronashock”

Editor’s Note: We are delighted to publish the following essay from Economics Professor Ellen Clardy of Houston Baptist University. Dr. Clardy shares thought-provoking insights about the trade-offs between social and environmental sustainability, and between short-term and long-term considerations.

Please keep in mind that the situation is evolving on a moment-to-moment basis. For instance, certain Federal government assistance programs have run short of funds, although Congress is now negotiating to replenish them.

As always, we welcome reader comments. Please contact with comments about Dr. Clardy’s post, or with suggestions about future posts.

"May you live in interesting times” is a phrase from the 20th century that is often incorrectly attributed to an ancient Chinese expression. Surely, though, it does seem to ring true today, as we are facing the coronavirus, a pandemic that originated in Wuhan, China. Barely 10 years past the Great Recession, a calamity that required unprecedented fiscal and monetary policy interventions into the economy, we are now facing the Great Cessation.[i]

This downturn is unlike any other because the decrease in aggregate demand is not originating from a pessimistic swing in animal spirits; instead, it results from government mandates to shut down or vastly curtail large segments of the economy in the name of public health. Meanwhile, the negative productivity shock is due to many in the labor force being told that they cannot go to work. Because the underlying economy was strong before the Great Cessation, we may expect a quick recovery when we restart the economy. However, we must take steps to limit the damage.

For a system that can be successful in the long term, we need policies to promote social, environmental, and economic sustainability. Needs in one area, however, will inevitably clash with those in other areas. Protecting public health has caused us to sacrifice short term economic sustainability to serve the needs of social sustainability. Putting aside the debate on the wisdom of that decision, we must now focus on policies that promote long-term economic sustainability. In times of crisis, the Federal Reserve is intended to be the lender of last resort.[ii] Originally, the Fed’s primary tool was the ability to make loans to banks, but they innovated many other tools in response to the Great Recession. They are doing so again to respond to the coronavirus shut down and to restore the economic system.

The failure of the credit markets is a primary threat. If businesses cannot access credit, and if panic spreads over their inability to do so, the ripple effect may seize up the banking system. It may even cause a depression. The first step for the Federal Reserve is lowering the Federal Funds Rate (FFR). The FFR is the interest rate that banks charge for overnight inter-bank loans. However, other rates are also influenced by its level, so mortgage rates, auto loans and the like should decrease accordingly. The usual goal of lowering the FFR is to lower the cost of borrowing and thus encourage consumption and investment. In these circumstances, though, this reduction is more about keeping credit available.

The Fed’s Federal Open Market Committee (FOMC) meets regularly to set monetary policy and issue press releases about their decisions; the Minutes of their meetings are released weeks later. As recently as their regularly scheduled January 28-29 meeting, their assessment was that “all is good.” They voted to keep the target range for the FFR at 1.5% to 1.75%, given low unemployment, low inflation, strong household spending, albeit weaker investment and export spending.[iii]

However, preemptive actions by the Fed obviated the need for the regularly scheduled March 17-18 meeting because the Fed recognized the threat that the coronavirus poses to the economy. On March 3, the Fed announced a 0.5% cut of the FFR to 1% to 1.25%.[iv] It was a dramatic move, ahead of schedule, with a cut that was double the typical 0.25% change.

Then the drama increased. On Sunday, March 15, ahead of the Asian markets opening, the Fed announced a massive cut that changed the target for the FFR to 0% to 0.25%. In its press release, it stated that the US economy is coming into this period on “a strong footing,” but it expected the coronavirus to cause problems for both the global and the domestic economies, with the energy industry facing particular stresses.[v] The FFR had last reached such depths in 2008, in reaction to the Great Recession.

Because this rate tool was also near zero and thus “maxed out” during the Great Recession, the Fed learned a lot about creating other tools at that time. Once again, it is turning to some of those tools.

Indeed, it is now time for the return of Quantitative Easing (QE), born of the Great Recession.[vi] “Normal” Fed open market operations that target the FFR involve the purchasing of short-term Treasury notes, but QE involves the buying of longer term government bonds, mortgage backed securities and other assets. The Fed thus becomes a buyer of last resort, enabling access to cash for those who need to sell such assets.

A new tool, the Temporary Corporate and Small Business Liquidity Facility, is an innovation by which the Fed uses money from the Treasury to buy loans from banks, thereby supporting bank loans to businesses.[vii] Similarly, the Fed has announced steps to support the SBA’s Paycheck Protection Program and the Main Street Lending Program.[viii] While the Fed does not lend directly to businesses, this is a workaround to keep the credit markets functioning.

In addition, the Fed lowered the discount rate, which is the interest rate that banks pay to borrow at the discount window. Typically, banks avoid using this tool because it is perceived as a sign of bank distress. However, the actions of the Fed have encouraged banks to borrow from it without an implied stigma, and the Fed reports an increased use of it.[ix] Additionally, the Fed has established other access points to credit, including Commercial Paper,[x] Primary Dealer Credit,[xi] and the Money Markets and Mutual Funds.[xii] More may be introduced as the Fed deems necessary. Indeed, the Fed is pursuing many methods to maintain the flow of credit to households and businesses and to prevent panic in the financial markets.

Finally, the Fed is addressing the rising global demand for dollars that has been triggered by a flight to safety. It is lowering the cost of dollar liquidity swaps, thus preventing shortages of dollars by providing credit lines to foreign central banks. The Fed announced a reduction in the cost of the swaps in concert with five central banks on March 15,[xiii] and then announced additional temporary arrangements with nine other countries on March 19.[xiv]

Clearly, the Fed is taking action to ensure that the financial markets continue to function; it will continue to innovate tools as needed to support the credit markets. However, it is aware that monetary policy is a blunt instrument that cannot directly address the impact of the shut down on individuals and businesses. Government fiscal policy is the tool that must provide targeted help to people and businesses.

While it is usually slow to pass laws and slow to implement them, the federal government moved very quickly last month. The Coronavirus Aid, Relief and Economic Security (CARES) Act[xv] was signed into law on March 27. Along with two other bills that were passed earlier in the month, CARES injects money into the economy through expanded unemployment insurance, direct payments to taxpayers, and additional money for the hospital system, certain industries, and state and local governments.

However, the recovery will be delayed if many businesses fail because they cannot make payroll with little to no revenue. The Treasury Department has innovated a system to extend loans to businesses with 500 or fewer employees to cover payrolls through July. The loans are processed through the current banks of these businesses; the borrowers will be forgiven if they retain their employees. There is even talk of a fourth stimulus bill that provides for a long-discussed infrastructure package.

These extensive interventions should preserve our financial markets and help people who are hurt by the cessation, thus restoring long-term economic sustainability.[xvi] But at what cost? Obviously, our government debt will increase. And what about the increase in the money supply? In the long run, a money supply that grows faster than the real economy causes inflation, but the Fed demonstrated after the Great Recession that it can prevent excess money from flooding the real economy by adopting the Interest on Reserves tool. It pays banks to keep excess reserves at the Fed instead of lending the capital into the real economy, while still assuring the system that credit will be available if needed.

The damage from the Great Cessation is yet to be measured, but bright spots are already visible. We are now aware, for instance, that our Chinese offshore supply lines for key pharmaceutical ingredients leaves society vulnerable. Businesses and government officials are likely to initiate future moves to bring this industry back to America, along with the jobs that will follow it. Other industries may pull away from China too; for instance, the Department of Homeland Security and other Executive Branch agencies recently called for the FCC to revoke China Telecom’s authorization to provide telecommunication services in the United States.[xvii] And even though many people are losing jobs, some industries have seen demand grow and are hiring rapidly, such as grocery stores, delivery services, and warehouse distribution centers.

In addition, the amazing ingenuity of the American economy could diminish net economic damage. For example, components of the food supply chain that served restaurants froze when their customers’ dining facilities closed. But grocery store chains like Texas’ H-E-B have reached out to these food distributors to help meet increasing grocery store demand, thereby salvaging food that was trapped in the supply chain.[xviii] Restaurants, too, have shifted from serving meals to selling groceries.[xix] Albeit anecdotal, such efforts will help limit net economic damage, especially if the economy returns to life in the near future. Indeed, the innovative, hardworking people of America, working within a capitalist system, is our most valued asset that can ensure our economic sustainability.