On Monday, June 29, 2020, Arvind Krishnamurthy joined the Princeton Bendheim Center for Finance to discuss a new paper co-authored with Markus Brunnermeier on COVID credit policy.
Krishnamurthy is a Professor of Finance at the Stanford Graduate School of Business.
This crisis is different from the 2008 crisis in many ways, and a main goal of policy should be to avoid economic scarring post-pandemic. In 2008, the financial system was unable to provide liquidity and capital. One of aim of policy was to provide demand stimulus. Today, supply and demand disruptions have required that the Fed and the U.S. Treasury also prop up the corporate sector. The goal of past and future policy is to prevent scarring that extends beyond the pandemic by providing firms with insurance.
The COVID recession is straining both the sector of large corporations and the SME sector, but efforts to reduce scarring require different policy approaches. More and more firms, large and small, are in distress and moving toward bankruptcy. See chart on corporate credit spread and bankruptcy sector. But if the goal is to maximize macroeconomic benefits, we must understand that $1 injected into a large corporation has a different effect than $1 injected into an SME.
For small, owner-run enterprises, the best way to avoid scarring is to provide cheap liquidity. This will help avoid the erosion of firm value or slow scale-up post-pandemic. Without liquidity, many firms will ultimately succumb to their debt service obligations and end with Chapter 7 liquidation. This could lead to many inefficient bankruptcies where a firm of high-value post-pandemic could be liquidated during the pandemic. Even for firms that manage to avoid liquidations, high debt could be a drag on firm operation post-pandemic.
Large corporations with low bankruptcy restructuring costs, however, should not be subsidized. Some have raised the prospect of minimizing macroeconomic damage post-pandemic by subsidizing large corporations through a version of corporate bond QE. But management of large corporations, in interest of shareholders, can file for Chapter 11 to reorganize and eliminate debt overhang. By directing subsidies to large corporates, policymakers enable equity-holders to delay Chapter 11 filing longer than is socially valuable.
Instead, the Federal Reserve and the U.S. Treasury should create a facility to reduce the direct costs of bankruptcy and to shore up bank balance sheets to reduce indirect costs of bankruptcy. Subsidizing the credit financing of firms during their restructuring phase would lower Chapter 11 bankruptcy costs. Also, larger defaults might spillover to the banking sector. The Fed should act now by switching on the countercyclical buffer and asking banks to raise equity at a time when equity prices are high.