Business in Times of Corona: The Dangerous Fruit of the Magic Money Tree

27 Mar, 2020

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In one of life’s little ironies, it was not the senator from Vermont but the billionaire businessman from New York who brought social democracy to the United States. The massive federal aid package now working its way through Congress is set to vastly expand and profoundly alter the role of government in the affairs of corporate America. Laissez fair is no more.

In return for offering $2 trillion in life support to households and privately-owned businesses affected by the corona pandemic, the federal government essentially gets a ‘golden share’ that allows it to set the rules and predetermine outcomes. After spending decades denouncing Europe’s addiction to social democracy, and state aid for troubled industries, as toxic and outdated, the US is now using the same prescription to protect society from the worst excesses of the free market. Corporations that accept federal money may no longer fire workers at will, offshore or outsource jobs, and must limit executive pay and stop dividend pay-outs and stock buyback programmes.

It took a virus less than a month to corner a Republican administration into accepting that corporate America has a responsibility that reaches beyond the next quarter and includes others than just shareholders. Though Treasury Secretary Steven Mnuchin, a former hedge fund manager, may repeat, almost ad nauseam, that the federal government is not in the business of running private business, his actions – however reluctantly taken and at odds with his personal convictions – prove otherwise.

Boeing CEO David Calhoun smells a rat and is having none of it: Earlier this week, he vowed to look elsewhere for support for his beleaguered company. Mr Calhoun said that Boeing does not want an equity partner but needs a cash injection to tide the company over. Though the rescue package does not mention Boeing by name, it has tagged some $17 billion for support to aeronautics manufacturers and corporations deemed critical to national defence. On Fox News, Mr Calhoun assured that he has plenty of other options to explore before taking government cash with strings attached.

The size and scope of the intervention is nothing short of phenomenal and can draw on no historical parallels, with the sole exception of the wartime economy. Contrary to popular belief, the US did not become the ‘arsenal of democracy’ by rallying private enterprise, but by commanding it. The number presently being touted – $2 trillion – is only the beginning of a much larger effort to support industry. The rescue package includes $500 billion to shore up larger corporates. Of this money, $454 billion is set aside as a backstop for lending programmes administered by the US Federal Reserve. Considering the usual loan-to-capital ratio of 10 to 1, aka the ‘magic money tree’, this means that the Fed’s total firepower has just been upped by a staggering $4.5 trillion dollars.

Even most economists on the fiscally conservative side of the debate agree that ‘going in big’ is the way to go and may help preserve the broad tax base that will be needed post-corona to rebalance the national accounts. The Congressional Budget Office expects the federal deficit to balloon to $1.1 trillion, or 4.9 percent of GDP. According to William Foster, lead US analyst at Moody’s, that forecast is wildly optimistic: He expects the fiscal deficit to exceed 10 percent whilst his colleague at Fitch Ratings considers 13 percent closer to the mark.

However, the national debt rising in tandem with the deficit should not necessarily pose a problem. Its absolute number is less important than the total cost of servicing the debt. Since the US government can easily tap capital markets without the need to pay a premium to lenders, the debt servicing cost is only expected to rise modestly. Last Thursday, the US Treasury was able to place its 30-year bond at 1.44% interest whereupon Fitch duly reaffirmed the country’s AAA rating, clarifying that recent market illiquidity for T-bills reflect ‘exceptional market conditions only’ and do not signal heightened concern over credit risk. In fact, the US government will always be able to pays its debt since it controls the mint.

That seems to hold true in Europe as well. On Thursday, the European Central Bank (ECB) shook off its last scruples and bravely declared that it will henceforward buy up a limitless amount of government bonds, ditching the proverbial bazooka and deploying its nukes. The bank also ditched its own rules which determine that it can only hold up to one-third of any given Eurozone member’s debt. The bank must also observe proportionality when buying-up government bonds. Since the ECB already could only buy another €10 billion or so of Dutch government debt before reaching its statutory limit, the bank was unable to acquire any additional bonds issued by the hard-pressed governments of Italy and Spain. By binning the rule book all limits have now been removed.

That was the ECB’s response to the refusal of the Dutch prime minister and the German chancellor to greenlight the issue of Eurobonds during an emergency video conference of EU leaders on Thursday. That virtual meeting saw a hard clash between Italian Prime Minister Guiseppe Conte, who pressed for more financial support, and his Dutch counterpart Mark Rutte who was backed by Chancellor Angela Merkel as he flatly refused to discuss the topic. Mr Conte was infuriated that both leaders also shot down his suggestion to relax the rules that govern the €410 billion European Stability Mechanism (ESM). Money from this fund is only disbursed to countries willing to implement often painful reforms.

President Klaas Knot of De Nederlandsche Bank (DNB), the Dutch central bank, and his colleague Jens Weidmann over at the Deutsche Bundesbank – two peas in a pot – expressed fear that removing all restrictions would also remove the last impediments to an uncontrollable spending spree. Both also reminded that earlier in the week the European Commission had already scrapped its European Stability and Growth Pact which limited government debt to 60 percent of GDP and spending deficits to 3 percent. Though they received the support of their Austrian and Finnish counterparts, Messrs Knot and Weidman were outgunned as the ECB rolled out its ultimate weapon.

As caution is thrown to the wind, new questions arise: How will the genie be put back in its bottle once the virus scare has abated, and will inflation be kept at bay? The previous reality dictated that quantitative easing was unable to stoke inflation, leading economists to speculate that perhaps the link between money supply and prices had somehow been broken.

However, those efforts to spur inflation involved hundreds of billions – not the untold trillions currently being pumped into slumped economies. Also, should the beast finally awaken – not so much a question of if, but rather a more ominous when – how will the surplus cash be removed without inflicting considerable pain? Though almost nobody disputes the need to intervene forcefully to prop up businesses and governments as they deal with a crisis that is not of their making, an important truism is being overlooked: There is no such thing as a free lunch. What Messrs Knot and Weidman fear is that they will be asked to pay the bill when it comes due – as it eventually must.