John Heasley

John Heasley
TBA General Counsel

All big businesses are now too big to fail

For the first time, the Fed was directed to get into the lending business due to the CARES Act mandate.

During the last eight months, the federal budget deficit climbed to $1.8 trillion, larger than any annual shortfalls in U.S. history. This amount was double the $738.6 billion over the same time period last year. The projected annual deficit for this year is $3.7 trillion, twice the previous record set in 2009 during the financial crisis.

The national debt, already at record highs, will exceed $20 trillion. These figures do not include the interventions by the Federal Reserve with an ever-increasing portfolio of over $6 trillion.

In 2008, there was an appropriation of $700 billion to prop up the largest banks. These TARP funds were used to inject capital into the largest financial institutions in order to stabilize the financial markets during a crisis they helped cause.

After propping up one broker dealer, Hank Paulson’s Treasury Department allowed Lehman Brothers to fail with the goal of putting discipline back into the financial market sector. The markets expected a federal backstop and when that did not happen, inter-bank activity ceased, the markets plunged and Paulson was forced to ask Congress for the $700 billion.

Up to that time, it was always presumed that the largest banks and broker dealers were too big to fail (Citi had been bailed out before); Paulson’s actions codified the doctrine.

Where is most of this new spending going? To a variety of large businesses. The $2.1 trillion CARES Act provided for PPP loan support, but it also has $50 billion for airlines and $17 billion for national security businesses. This is mainly targeted at Boeing, the aerospace and military giant.

For the first time, the Fed was directed to get into the lending business due to the CARES Act mandate and over $450 billion in appropriations to cover any loan losses.

The Federal Reserve has also been active in what could be called off-balance sheet interventions. In a reprise of what it did a decade ago, the Fed has again bought billions of dollars’ worth of U.S. Treasury bonds and government-insured mortgage bonds.

The Fed has also announced it is going to start to buy exchange-traded funds that hold a diversified portfolio of corporate bonds. The Fed is now buttressing the $9 trillion corporate bond market.

Fed Chairman Jay Powell has indicated that he will pull out all of the stops to support the economy. The central bank does not have to function like a typical financial institution; it has the bottomless ability to buy assets and print money.

When this pandemic is contained, how do we get ourselves out of this fiscal mess? Victor Davis Hanson at the Hoover Institution at Stanford suggests that we will have a number of difficult choices to make:

  • Americans will be forced to live with extremely low (or negative) interest rates. Savers will be punished and there will be little interest paid on the federal debt. The U.S. is the safest haven for international money. We honor our bonds. But we could end up becoming a permanent debtor state paying very little to those that lend us money. This works well until it doesn’t. The Chinese and the EU are desirous of replacing the dollar and American debt as the preferred instruments of investments and international trade. If these countries come out of the COVID crisis in better shape than the U.S., expect them to try to dominate the financial markets. If they are successful, we will have to pay an increasing share of our GDP for debt service.
  • Taxes will have to be raised — more in a Biden administration than in a second Trump administration, but they will still go up. Biden initially proposed a $1.4 trillion tax increase and subsequently raised it to $4 trillion. He offers nothing in deficit reduction and wants the funds to be used for projects such as the Green New Deal.
  • There will have to be extreme cuts in spending on entitlement programs and defense. Social Security and Medicare are sacred cows and most politicians will realize that they will not stay in office long if they cut these programs. And, in a world threatened by China, Russia, Iran and North Korea, it would be foolish to cut defense spending.
  • The U.S. government could return to the inflationary 1970s: Print more money, let inflation rise and pay off our debts with funny money.
  • The policies of more deregulation and tax incentives could spur GDP growth by 3% a year and allow us to grow our way out of deficits. This has been attempted before, but it has not resulted in deficit reduction. If the White House changes hands, this will not be on the table.

Finally, policymakers may have to deal with the potential for a falling dollar. There is a growing chorus of economists, led by Stephen Roach of Yale, that believe the dollar could fall in value by as much as 35%.

They cite our low savings rate and the need for the U.S, over the last 40 years, to rely on surplus savings from abroad. They believe that when you combine fiscal challenges with trade deficits and trade wars, the underpinnings of the dollar as the world’s primary reserve currency are threatened.

How we approach the economic challenges of this crisis depends in many ways on what happens in the November presidential election. You may feel like I do (and as I did in 2016) that in a vibrant democracy of 320 million people we deserve better choices than the two we have.