Helping Businesses — The Right Way

9/19/20

In the 1940s, Joseph Schumpeter, an Austrian economist who immigrated to America and joined the faculty at Harvard, coined the phrase “creative destruction,” which describes the process by which outdated businesses fail, paving the way for new businesses to develop. Schumpeter saw this process as being critical to essence of capitalism. It leads the way to innovation and, ultimately, to a higher level of output.

I’m reminded about this concept because the Covid-19 pandemic has changed the world. As hard as it is for those who work in certain industries — in particular, travel, hospitality, food services, and some retail establishments — many firms are facing reduced demand for their services. The new normal is, and will continue to be, a scaled down version of what was before. The CARES Act and any subsequent federal interventions may likely forestall some business failures, but a shakeout is all but inevitable. In the end, after failing firms shut down for good, remaining businesses will come to operate with profits that approach or even exceed the pre-Coronavirus levels. It may take some time, but it’ll happen.

That’s the way capitalism is supposed to work. The implicit contract for any business is that the owner (read shareholder) is entitled to a return on capital in the form of profits. But risk is an important component of the compact; and part of the bargain is that the invested capital is in no way guaranteed. Under capitalism, business losses are private losses, not subsidized by the taxpaying public. That said, in the past, at various critical junctures, the federal government has taken steps to aid severely distressed companies in danger of failing, with the hopes of stemming crises and keeping them contained. We seem to be at one of those critical junctures now.

For the most part, prior support initiatives came in the form of government loans — loans that the government expected, or at least hoped, would be repaid. Financial firms have been the primary beneficiaries of this assistance, but occasionally it went to non-financial companies, as well, such as Ford, GM, and Chrysler. Moreover, under the Payroll Protection Program (PPP), started after the onset of the Coronavirus, federal monies have and are still being used to aid small businesses, with the expectation that most PPP loans will be forgiven. Thus, as a practical matter, the vast majority of these “loans” will end up being grants.

One other type of federal assistance came into being in the 2008–2009 recession, with the advent of the Troubled Asset Relief Program (TARP), under which the federal government bought financial assets from distressed financial firms, thereby enabling them to satisfy demands for cash by their counterparties. Many believed that failure to provide this kind of intervention would have risked a cascading effect with the prospect of crippling the entire financial system. TARP funds were also used to acquire equity interests in a variety of failing companies.

With the exception of the PPP grants, the term “bailout,” is kind of a misnomer in this context. These assistance programs have been set up with the government expecting to recoup the outlays, albeit with some risk. Thus, a critical ingredient for prudent management of these efforts has been trying to ensure that the prospects of payback are promising. I believe this same ethic is appropriate today, in considering any prospective assistance to the business community. We should look toward a loan-based assistance program, as opposed to one that is grant-based.

Earlier this year, the Federal Reserve rolled out its Main Street Lending program, designed to encourage lending to small and medium sized businesses. By design, this program encourages banks to make loans to businesses that are credit worthy, notwithstanding the effects of the pandemic. Originating banks earn a fee, paid by the Fed, with the express purpose of incentivizing the bank for participating in the program and, incidentally, mitigating the credit risk on the loan (effectively augmenting the interest rate paid by the borrowing firm). The Fed also acquires the loans from originating banks, save a haircut, assuring that some portion of the loan is kept on the originating bank’s balance sheet. This skin-in-the-game provision assures that the banks handle their credit quality assessments with due diligence.

By way of comparison, as of August 31, the Fed reported to Congress that $68 billion of loans/grants had been extended under PPP. In contrast, only $1 billion has been loaned under the Main Street Lending Program. Something’s wrong with this picture, and it’s discouraging. Schumpeter’s creative destruction concept has merit. Businesses that can’t operate profitably deserve to cease operations, and prolonging their lives is counterproductive. But equally valid is idea that in a time like this, where the pandemic has inflicted considerable damage on the economy that is totally independent of normal market considerations, firms with longer-term viability deserve help getting through it.

Distinguishing those who should get this help and those who shouldn’t is a difficult issue, but it’s one that our policy makers should be considering. Under the Mainstreet Lending Program, the bankers are charged with making exactly this judgment. The analysts may not always get it right, but at least the intent is to impose a rational discipline in the allocation process. On the other hand, under the PPP, we’re essentially rationing on the basis of first-come-first-served, without regard to the longer-run prospects for the prospective recipients.

Ready access to credit is critical to our eventual recovery, but it should be directed to businesses that can demonstrate their capacity to survive. Aggressively expanding the Main Street Lending Program would serve this purpose.