Evaluating trade-offs of economic responses to the COVID-19 pandemic

Originally published April 15, 2020 on Medium.

Should we let companies affected by COVID-19 fail and go through bankruptcy, as was recently proposed by Social Capital CEO Chamath Palihapitiya in this exchange on CNBC? If not, what is the best economic solution to this pandemic? This post was sparked by these questions, and while I don’t see it as a direct response to Chamath’s out-of-the-box approach, his exchange did, however, catalyze some of my scattered thinking from the past few weeks as the Federal Reserve has expanded its open market operations, much to the outcry of Twitter economists (Mises this and Money Printer that) — and, more curiously, motivated me to write.

I want to focus on what Chamath suggests in his exchange, my issues with that response given the catalyst of this economic crisis, and more broadly what the Fed and the government (this is at least as much a fiscal problem as a monetary one) should have done in response to the COVID-19 induced economic meltdown. In essence, I will argue that the optimal solution to our current economic crisis is not bankruptcies, nor is it the more traditional ballooning of the Fed’s balance sheet, but rather a mix of decisive fiscal policy stimulus paired with public health and monetary policy.

So what does Chamath suggest? Let’s take one representative example: the Social Capital CEO thinks we should let airline companies fail and go through bankruptcy rather than “bailing them out”. Chamath argues that bankruptcy is the best solution for the companies themselves and their employees, and we shouldn’t be too concerned if, as a byproduct, rich CEOs and institutional investors get wiped out:

“This is a lie that’s been purported by Wall Street. When a company fails, it does not fire their employees; it goes through packaged bankruptcy. If anything, what happens is, the people who have pensions inside those companies, the employees of these companies, end up owning more of the company. The people that get wiped out are the speculators that own the unsecured tranches of debt or the folks that own the equity”

Let’s dig into that. In a Chapter 11 bankruptcy, creditors are paid — and assets divided — in the following order:

1. Secured creditors — bondholders, typically banks
2. Unsecured creditors — generally including the company’s suppliers, employees, and banks.
3. Shareholders — any owner of the company’s stock, with further distinction between preferred (paid first) and common stockholders

The first takeaway here is that secured lenders (ie. banks) will get their money back first. This is, after all, core to bankruptcy in the first place and why stocks (particularly common) are a riskier investment than bonds.

Next in line are unsecured creditors, and it’s here things get tricky — employees are entitled to their salaries, wages, and contributions to employee benefits plans earned in the 180 days prior to filing, up to $10,000. And maybe certain unsecured bank lenders get wiped before employees obtain these claims, but it’s not necessarily clear to me that employees end up better in relative terms. More importantly, how do the employees end up faring in the long run? The record is murky, so it’s helpful to turn to an example or two.

Chamath mentions airlines, so perhaps an obvious example is Delta’s bankruptcy in 2005. Citing rising fuel costs, Delta filed for bankruptcy in September 2005, with debt amounting to $28B. After 19 months, the airline exited restructuring, having let go of 6,000 employees in the process — roughly 12% of its workforce. Delta has bounced back tremendously to become the leading US airline, and was by all measures thriving until the pandemic. However, is the cost to employees in terms of jobs lost worth it now given the context of the coronavirus?

Take another prominent example: GM filed for bankruptcy in June 2009, in the fourth largest bankruptcy in US history, with $95B of debt on its balance sheet at the time of filing. While it’s difficult to ascertain exactly the impact on personnel (some likely stayed on as part of the sale of certain assets; others likely lost their jobs as brands like Hummer and Saturn died), GM came out of the restructuring with 68,500 employees out of the original 91,000, or a 25% reduction. Again, is GM a stronger company today than it was in early 2009? Yes, undoubtedly. Yet are the airline companies today facing the same types of challenges that Delta was facing in 2005 or GM in 2009? Are the costs of those reorganizations reasonable to bear in today’s crisis?

Last on the list of priorities are stockholders, with preferred shareholders having preference over common stock owners (who of course include employees). Chamath mentions that employees end up owning more of the company at the end of a bankruptcy. I find that this is not necessarily substantiated (employees own a fraction of the company in the form of common shares). From the SEC:

“Although a company may emerge from bankruptcy as a viable entity, generally, the creditors and the bondholders become the new owners of the shares. In most instances, the company’s plan of reorganization will cancel the existing equity shares. This happens in bankruptcy cases because secured and unsecured creditors are paid from the company’s assets before common stockholders. And in situations where shareholders do participate in the plan, their shares are usually subject to substantial dilution.”

We should also keep in mind that while common stock is held in large part by institutional investors, a large portion of these assets end up in mutual funds and pension funds that ultimately make up the savings of “regular people.” Take a look at who owns Delta, for example:

You’ll no doubt notice the big names, like Berkshire Hathaway and BlackRock and State Street (SSgA Funds Management) — and don’t get me wrong, institutions certainly own a large chunk of these assets and would suffer from a stock price collapse. However, we should keep in mind that these are large mutual funds that ultimately serve as investment products for 401ks and other pensions plans. Vanguard, for example, is the second largest shareholder of Delta (or was on April 9, 2020), and as you’ll notice below, it (and other firms like it!) makes up a non-insignificant portion of very popular Vanguard ETFs and Funds.

A significant decrease in Delta’s share price will undoubtedly have negative effects on these Funds, and ultimately impacts the holders of these Funds. It’s difficult to estimate exactly what impact it has on the average pensioner relative to hedge funds or other institutionals — indeed, it’s likely that hedge funds suffer relatively more in financial terms, but does that matter if at the end of the day the average pension or savings account takes a big hit in absolute terms?

So where do we stand? Basically, there is not enough evidence to suggest bankruptcies benefit employees. And, as always, these are complex, nuanced questions — there very well might be some companies that should go through bankruptcy. But this raises the question of why companies go through bankruptcy in the first place. Bankruptcy is defined as the legal proceeding involving a person or business that is unable to repay outstanding debts. Thus, we are very much talking about a debt problem and a solution to avoiding debt-induced insolvency. Returning to the GM example, this was very much the case — they had nearly $100B of debt. Given this context, why are we considering bankruptcy in the case of airlines?

When asked why anybody deserves to get wiped out from a global pandemic, Chamath replies “My point is employees don’t [get wiped out]. Who are we talking about? We’re talking about a bunch of hedge funds that serve billionaire family offices; who cares?”

Effectively, Chamath is making the argument that these companies, and their institutional investors, should be wiped out because they can. And I suppose that’s not incorrect, but it’s quite different from suggesting the airlines, say, mismanaged their businesses into massive piles of debt. And further, is it really the right solution to the problem we are facing? In fact, are we even talking about the right problem? Maybe this is a better place to start.

Let’s remember, the current economic crisis is a direct result of the global pandemic. It did not originate in the financial sector and then contaminate the real economy; rather, it started in the real economy, which itself was impacted directly by the COVID-19 virus and by new laws and regulations imposed by governmental actors (from Federal to local levels). This isn’t a story about stock buybacks and securitized lending causing defaults and unemployment in the millions. [1] Airlines are failing because no one can travel, not because they took on too much debt. Restaurants are closing shop because no one can go out to eat. It is ludicrous to suggest that businesses should operate with the expectation that their customers will drop by 75–100% from one day to the next.

What we are facing today is an extreme but temporary shock to the economy caused by the COVID-19 virus, which is manifesting in entire sectors of the economy effectively shutting down — this itself is naturally having spillover effects to other parts of the economy, and inevitably this impacts the financial sector. Given the nature of the shock, what we needed at the outset was a correspondingly intensive and temporary response of a dual nature — that is, with monetary and fiscal policy. Such a response would have allowed us to bridge the economic gap created by the pandemic.

(Now, I can already hear the furious clatter of Twitter armies typing their posts decrying the temporary nature of this shock and in fact explaining that nothing will ever be the same — but please, bear with me — I’ll address that shortly. Remember, this is meant to address what we *should *have done at the very start of the pandemic, when the early warning signs from China were clear enough for many on Twitter, including of course Balaji, to draw serious conclusions and enact counter-measures.)

Let’s start with the basics: what are the goals of the response?

1. First and foremost, we should remember that we need to enable people to maintain their livelihoods with an eye to the long run. That is, people need to have enough money to pay rent, make mortgage payments, buy food, etc. And it’s not enough to simply give people a one-time check covering two months of sustenance; the goal should be to optimize for the longer term (ie. post COVID-19), including making sure we can restart the economy swiftly.
2. Secondly, we need to prevent a debt crisis, which could have much more long-term implications for the real economy, creating an economic climate similar to the Great Recession of 2008–09. If companies can no longer pay back their debt, and lenders are hit by loan defaults on the one hand, and deposit calls on the other, there is only one outcome: collapse. If banks fail, people’s savings are wiped, more companies collapse, growth is throttled, and the cycle repeats.
3. Third, we want to make sure not to create any egregiously bad precedents out of this crisis — let’s not forget that we were coming into this period at all time highs for the S&P and unfettered global government spending via debt monetization. We need to avoid coming out of this recession with a lingering policy hangover.

So let’s look at the dual response of monetary and fiscal policy, starting with the monetary response. We’ve all seen the memes of the money printer going BRRRR, and there’s certainly some truth to it in the larger context of inflationary policies targeted by the Fed and other central banks, but given the more immediate situation engendered by COVID-19, it would behoove us to look back to the Fed’s role in our financial system.

Aside from serving as banking infrastructure for all other banks in the US, the Fed has a primary dual mandate focused on promoting maximum employment and stable prices (ie. preventing deflation or excessive inflation), along with a responsibility to promote the stability of the financial system [2], which invariably influences the realization of the primary objectives. It is thus the Fed’s job to tend to our financial system when there are shocks to the economy.

How does it do that? Through the Federal Open Market Committee’s Open Market Operations — ie. the buying of securities, typically long term treasury bills (but also other assets like MBS), from its member banks. This increases the amount of money available for banks, who in turn can make sure to cover their liabilities and lend out money to debtors, which would increase the circulating money supply. In other words, the Fed is injecting liquidity into the financial system. Now, there are seemingly two primary concerns with the Fed’s actions:

1. The sheer size of its intervention. As you can see in the chart below, the Fed’s balance sheet now stands at ~$6T and the Fed on April 9th allocated up to another $2.3T in loans. This represents a significant increase from the past year, which was itself already a significant increase from the pre-2009 levels (albeit with a ~$1B reduction over the course of 2018–19).
2. The introduction of new forms of Quantitative Easing [3], including: the establishment of new corporate credit facilities for new bond and loan issuance and providing liquidity for outstanding corporate bonds; the creation of an SPV to support credit for asset-backed loans such as student and auto loans, credit cards, and Small Business Administration (SBA) loans; the creation of an SPV to buy up to $500M in municipal bonds; the creation of an SPV to buy ETFs (for now, only with exposure to corporate bonds)

Now we should evaluate these two points separately. While it’s true that the Fed has vastly increased its operations, the economic shock we’re enduring is also unprecedented in its severity and rapidity. Moreover, to date, the Fed has mostly relied on expanding Treasury purchases (rather than MBS or other assets). Theoretically, once the shock subsides, it could revert to decreasing its holdings over time, as it has done over 2018–19. Given the shape of the above chart, this is of course easier said than done — but the method is at least in line with precedent — even if the magnitude is not. The trap we should avoid is comparing the monetary expansion during this time of crisis with the inflationary monetary policy of recent times. There is no denying that at some point the massive debt bubble we have created will pop to devastating effects. However, it is during periods of relative prosperity that this should be addressed, not during a crisis — which is precisely when fiscal and monetary responses are required.

The second point is potentially far more troublesome in my view. Expanding the category of credit to lower grade assets and ETFs paves the way for a slippery slope into purchases of junk and equities, loosening the focusing restraints of the Fed — enabling it to expand the money supply at ever greater velocity and quantity, and creating a whole new set of negative behavioral externalities among the beneficiaries of these policies (what some are calling tantamount to the Fed “picking winners and losers”) [4]. One could argue this is already having spillover effects into the equity markets, with the S&P already back to early 2019 levels and with forward PE multiples at all time highs — effectively suggesting the stock market is massively overvalued.

Moreover, I can’t help but feel that these additional measures, designed to “support further credit flow to households and businesses,” [5] are a bit of a roundabout and overly complex way of achieving the basic primordial goal we outlined above — that is, to enable people to maintain their livelihoods. For these reasons, I would have prioritized a fiscal policy response with just enough monetary policy response (with the injection of liquidity) to keep banks afloat and avoid a debt crisis. The latter measure is to prevent knock-on effects of a longer term recession. A monetary response alone is moot without a decisive and aggressive fiscal policy intervention.

Remember, while the COVID-19 crisis is temporary, the fiscal response should ensure long-term economic health. The challenge with the delayed response we witnessed from Congress is that close to 16 million Americans have already lost their jobs, and some of the services businesses — in the restaurant industry for example — have shuttered with little clarity around their ability to reopen. We are in this situation today because neither the administration nor Congress acted quickly or decisively enough.

What we should have done was pair rigid public health measures (such as a nationwide 30-day shutdown of non-essential businesses) with strong guarantees around employment and debt repayment. Keeping people employed is a better long term solution than letting businesses collapse and sustaining individuals on unemployment. Thus, if we could have contained the duration of the crisis to a minimum and maintained full employment through government programs — ie. governments directly compensating businesses for their foregone revenues — we could have bridged the crisis and come out on the other side with most of the population still employed.

This does, however, make an assumption in so far as supply chains must keep running as normal, and business owners need to keep their personnel employed. An airline applying for government programs covering its revenues must keep its personnel even if they are not flying any planes, and they must keep paying their downstream vendors and suppliers, who in turn need to keep supporting their own suppliers — and the chain goes on. Mechanically, this would likely mean a few things:

• Designating a list of economic sectors impacted by COVID-19, from which companies could apply for the government programs
• Payment distribution would happen through the banking network, as it is currently happening with the CARES Act and PPP loans. More innovative approaches exist — like stablecoins and apps like Square’s Cash App, to be sure, but given the tight timing, this seems like the likeliest method (and this doesn’t preclude Square Capital to distribute these programs directly to its vendors).
• There will inevitably be individuals who fall out of this scheme, and this is where other measures come into cover the gaps, such as enhanced unemployment benefits and debt deferral.

As a hypothetical, what would it cost the government to sustain this type of scheme for 2.5 months? (It took China 10 weeks to reopen Wuhan). Assuming 25% of the economy is impacted, and 2019 US GDP of $21.4T, that equates to ~$4.5T of government spending to maintain the economy functioning. It’s no small fry, but given the CARES Act alone amounted to $2T, and Congress is actively preparing for a new stimulus package, I wouldn’t be surprised if we ended up spending far more, over a longer period of time, to fight this economic crisis. And what’s more, we will come out on the other side with millions of Americans unemployed, which will lead to a prolonged rebooting of the economy — with potential hangover effects for many months if not years. Indeed, although I have been speaking about this pandemic as temporary, our government’s sluggishness has undoubtedly extended its effects far beyond the original time estimate.

So where does that leave us? Of course, today we find ourselves in a situation where we are likely too far into the pandemic to simply “bridge the gap” to the other side. As a result, any fiscal option focusing on maintaining individuals employed will inevitably cost more and not be relevant in many cases; but we have no choice but to get to the other side. We must now optimize for the most economically viable option that saves the most lives. Moreover, a strong fiscal response can still be effective if we invest in research and the necessary equipment to tackle this pandemic head on. We need to emulate South Korea and reach testing levels such that individuals can be tested on a daily basis, enabling us to isolate and quarantine the negative cases surgically. This is likely our quickest path to safely reopening the economy. And it’s not enough to simply quarantine negative cases; we need to actively invest in retrovirals and other treatments, address the structural problems we have faced in coordinating and executing federal policy, and make sure our preventative national organizations are well resourced. In closing, we should note that while the more aggressive fiscal response proposed here is no longer feasible for this crisis, it does serve as a lesson for the future. There will be another pandemic in our lifetimes, if not another significant global event (natural disasters, etc.). We should do well to be adequately prepared for the next one.

TL;DR — bankruptcy is an interesting option that could work in some cases but isn’t the right solution nor the right problem to address. We are in this mess because of the novel coronavirus, which is a temporary and extreme shock to our economy, which deserves an equally decisive response from the Fed and the government, primarily in the form of aggressive fiscal stimulus, accompanied by reasonable monetary expansionary policy. Injecting liquidity in times of economic distress, particularly in reaction to shocks, is a good thing and is the Fed’s job. What needs to be avoided, however, is the overextension of the Fed’s actions, such as the buying of junk bonds or equities. This sets the wrong precedent and risks causing longer term economic impacts through an overvalued stock market.

Thank you to Rina Azumi, Eli Geschwind, Dimitri Borgers, Jack Clancy, and Tanner Hoban for reviewing a draft of this post.

Notes & References

[1] As was the case in the 2009 Recession.

[2] St. Louis Fed

[3] These measures primarily refer to the outcome of FOMC meetings on March 23 and April 9.

[4] On the other hand, the Bank of Japan, for example, has been buying sizable quantities of equity ETFs since December 2010. While the effect has been mixed in terms long term economic performance, the characterization of picking winners and losers is likely not warranted.

[5] See FOMC April 9 meeting notes.