Government-Mandated Shutdown: Monetary & Fiscal Policy in Crisis | George Selgin March 26, 2020 “[T]o avert panic, central banks should lend early and freely, to solvent INTRODUCTION firms, against good collateral, and at 'high rates.’” — Walter Bagehot George Selgin is a senior fellow and director of the Center for Monetary and Financial Alternatives at the Cato Institute and Professor Emeritus of Economics at the University of Georgia. His research covers a broad range of topics within the field of monetary economics, including monetary history, macroeconomic theory, and the history of monetary thought. He is the author of The Theory of Free Banking (Rowman & Littlefield, 1988); Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage (University of Michigan Press, 2008); Money: Free & Unfree (The Cato Institute, 2017); Less Than Zero: The Case for a Falling Price Level in a Growing Economy (The Cato Institute, 2018) and, most recently, Floored! How a Misguided Fed Experiment Deepened and Prolonged the Great Recession (The Cato Institute, 2018). Selgin is one of the founders, with Kevin Dowd and Lawrence H. White, of the Modern Free Banking School, which draws its inspiration from the writings of F. A. Hayek on denationalization of money and choice in currency. Selgin has written for numerous scholarly journals, including the British Numismatic Journal; the Economic Journal; the Economic History Review; the Journal of Economic Literature; and the Journal of Money, Credit, and Banking; and for popular outlets such as the Christian Science Monitor, the Financial Times, and the Wall Street Journal, among others. Selgin holds a BA in economics and zoology from Drew University, and a PhD in economics from New York University. 1 FED POLICY SUMMARY The Federal Reserve has committed to unlimited purchases of US Treasuries and agency mortgage-backed securities (ABS) and set up additional lending tools to shore up struggling companies and financial markets. “The Federal Reserve is committed to using its full range of tools to support households, businesses, and the US economy overall in this challenging time,” the Fed said in a statement. “While great uncertainty remains, it has become clear that our economy will face severe disruptions. Aggressive efforts must be taken across the public and private sectors to limit the losses to jobs and incomes and to promote a swift recovery once the disruptions abate,” it said. The Fed had originally planned to purchase at least $500bn in US Treasuries and at least $200bn in agency mortgage-backed securities. In recent days it has sped up the pace of these purchases, after earlier interventions failed to address strains that had emerged in both debt markets. By Friday, it had already completed roughly half of its planned Treasury purchases, as well as about a third for the agency mortgage-backed securities. Following a meeting of the Federal Open Market Committee, its monetary policy setting committee, the US central bank is no longer putting a numerical cap on its purchases of Treasuries and mortgage-backed securities, instead signaling that it is prepared to act as much as necessary. Supporting the flow of credit to employers, consumers, and businesses by establishing new programs that, taken together, will provide up to $300 billion in new financing. The Department of the Treasury, using the Exchange Stabilization Fund (ESF), will provide $30 billion in equity to these facilities. Corporate Credit Facilities — The Fed also unveiled two new facilities—the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds—that allow it to purchase corporate bonds, including new issues. The PMCCF is open to investment grade companies and will provide bridge financing of four years. Borrowers may elect to defer interest and principal payments during the first six months of the loan, extendable at the Federal Reserve's discretion, in order to have additional cash on hand that can be used to pay employees and suppliers. The SMCCF will purchase in the secondary market corporate bonds issued by investment grade U.S. companies and U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. investment grade corporate bonds. 2 Consumer & Business Credit — The revival of the Term Asset-Backed Securities Loan Facility (TALF) “will enable the issuance of asset-backed securities (ABS) backed by student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration (SBA), and certain other assets.” (i.e. gives the Fed the ability to buy these securities ) Under the TALF, the Federal Reserve will lend on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. The Fed also said it would soon announce a “Main Street Business Lending Programme” to lend directly to small businesses, “complementing efforts by the SBA.” Municipal Credit — In order to facilitate the flow of credit to municipalities the Fed is “expanding the Money Market Mutual Fund Liquidity Facility (MMLF) to include a wider range of securities, including municipal variable rate demand notes (VRDNs) and bank certificates of deposit.” Likewise, the Fed is “facilitating the flow of credit to municipalities by expanding the Commercial Paper Funding Facility (CPFF) to include high-quality, tax-exempt commercial paper as eligible securities. In addition, the pricing of the facility has been reduced.” The CPFF was a system created by the United States Federal Reserve Board during the Global financial crisis of 2008 for the official purpose of improving liquidity in the short-term funding markets. This program lent out a total $738 billion before it was closed. 45 out 81 of the companies participating in this program were foreign firms. These actions augment the measures taken by the Federal Reserve over the past week to support the flow of credit to households and businesses. These include: • The establishment of the CPFF, the MMLF, and the Primary Dealer Credit Facility; • The expansion of central bank liquidity swap lines; • Steps to enhance the availability and ease terms for borrowing at the discount window; • The elimination of reserve requirements; • Guidance encouraging banks to be flexible with customers experiencing financial challenges related to the coronavirus and to utilize their liquidity and capital buffers in doing so; • Statements encouraging the use of daylight credit at the Federal Reserve. 3 CORPORATE BOND MARKET SUMMARY US junk bonds have lost nearly 19% this month, a deeper dive than even at the peak of the financial crisis in 2008. Even investment-grade US corporate bonds have lost more than 10%, as investors fret that the coming recession will hurt even more creditworthy companies. Companies have gorged on cheap debt for a decade, sending the global outstanding stock of non-financial corporate bonds to an all-time high of $13.5tn by the end of last year, according to the OECD, or double where it stood in December 2008 in real terms. More than $320bn of US debt sitting on the lowest rung of the investment grade ladder now yields more than 5%, according to Ice Data Services figures, previously a rate attached to much riskier companies. Restructuring experts, according to the FT, said investors scanning for vulnerability should watch those companies with largely fixed capacity and high costs which would be hard hit by a significant drop in demand. Almost $840bn of bonds rated triple B or below in the US are set to come due this year and roughly $270bn of US bonds now trade below 90 cents on the dollar. Many companies have already been locked out of refinancing or selling new debt. The consequences showed up most vividly this week in the oil and gas sector as a price war between Riyadh and Moscow compounded the market’s coronavirus concerns, plunging almost $110bn of US energy company bonds into distressed territory. Bonds in WeWork have dropped from about 90 cents on the dollar to 68 cents and market swings are also changing the calculus on M&A. Data group HFR’s index of merger-arbitrage funds has tumbled 17.5 per cent so far in March, 4 putting it on course for its worst month since at least 1997. Large hedge funds such as Millennium and more specialised groups such as Westchester Capital Management have been hit by bets on frozen deals, according to industry specialists. Big banks were likely to focus on the largest corporate clients, putting smaller companies “well back in the queue … These small and medium-sized firms are often crucial links in the supply chain. If these links are broken, it will be much more difficult to recover from a recession.” — Campbell Harvey, finance professor at Duke University “Even if they only last for a short period of time, the effects of this earnings evaporation on a company’s capital structure and liquidity are significant and will in turn have consequences for the broader ecosystem in which that company operates.” — Alan Waxman, Sixth Street Partners “We’ll have up to $4 trillion of liquidity that we can use to support the economy." — Steve Mnuchin “If, for whatever reason, you know, 10 weeks from now, this virus, we haven’t won this, we’ll go back to Congress again.” — Steve Mnuchin ECONOMIC DATA & FORECASTS Economists have predicted a dramatic slowdown in economic activity in the coming weeks. J.P. Morgan released estimates Wednesday that predicted a 14% contraction in second-quarter U.S. growth. Goldman Sachs has forecast a 24% drop in US gross domestic product in the second quarter and Morgan Stanley has predicted a 30% contraction.