The Federal Reserve and the Treasury have poured an enormous amount of credit and liquidity into an economy that has been severely damaged by the global COVID-19 pandemic. They are now poised to venture into uncharted waters for our modern economy by considering capping the interest rates that Treasury debt would pay. Presumably, this action could fill the financial void until the country’s economic productivity improves. Nevertheless, it sounds like the Fed is prudently preparing for even more significant economic trouble ahead and is willing to print as much money as it takes to get the job done. Its challenge is to do enough to support the economy without creating long-term damage to it.
The Fed and the Treasury deserve credit for their efforts over the last four months, and it is critical that they be prepared for even more severe downturns driven by the virus. But let’s hope that the economic triage they are administering is tethered to exit strategies to limit the economic distortion and unintended consequences that usually follow. Our post-2008 experience suggests otherwise. Indeed, Fed Chairman Jerome Powell said last week that the Fed has “crossed a lot of red lines that had not been crossed before” and has created a situation in which “you figure it out afterward.”
History indicates that this view may be short-sighted. The aftermath of the 2008 crisis screams it. Among other things, Fannie Mae and Freddie Mac are shockingly still in conservatorship, the Fed still had more than $1.5 trillion of mortgage backed securities on its balance sheet from that crisis before this one started, and rules meant to deal with the inadequate bank capital and liquidity in 2008 have negatively impacted the functioning of today’s repurchase agreement funding markets.
The Fed has had to intervene several times to adjust adjustments it made in the 2008 crisis. Increasing management of the economy always causes some financial dominoes to begin careening off each other, making additional intervention necessary. It is hard to argue that the economy will not again be massively impacted by the government’s financial response to the virus. Consider the aftermath of government’s response to the Great Depression. Between 1930 and 1940, the national debt increased by 170 percent.
The Federal Reserve’s balance sheet has grown from $4 trillion in mid-February to more than $7 trillion today. Some economists have projected that it will swell to between $8 trillion and $11 trillion. With some $20 trillion of Treasury securities in the market, the potential impact of the sum of the Fed’s actions could be breathtaking and the longer-term consequences massive. From a global perspective, if Treasury rates are effectively capped, some investors might be induced to sell Treasuries in expectation of a weakened dollar due to the potential inflationary impact of large monetary injections, necessitating the Fed to purchase even more. The economy could be heading toward a period of deflation followed by a deep, historic recession, which then could sink into stagflation or hyperinflation.
The enlargement of the Federal Reserve’s role has been necessary to cushion a faltering economy. But each additional step that the Fed takes beyond the bounds of economic normality, such as managing the Treasury yield curve, will have an impact on how markets behave and risk is priced. We are already in an economy that often incentivizes some to assume enormous amounts of risk because they believe that the government will inevitably bail the economy and them out, creating the classic moral hazard problem. “Capitalism without bankruptcy is like Catholicism without hell,” Howard Marks, director of investment fund Oaktree Capital Management LP, said in his April 2020 letter to shareholders. “Markets work best when participants have a healthy fear of loss.”
Today, the country faces a financial challenge of enormous proportions. Too little intervention in the financial market risks catastrophic collapse, while too much will lead to unintended consequences that will not be easily or quickly unwound. But each time some additional facet of the economy is managed by well-intentioned government action, it creates market distortions that can have unintended consequences that may be difficult to avoid or reverse. Government interventions, including capping Treasury rates, should be tethered as much as possible to strategies that are intended to minimize unintended consequences and identify a time and manner to reverse the action. Many temporary government programs and financial subsidies were not able to be reversed after the Depression, creating permanent new costs and social programs. A crisis is rarely the backdrop that provides a sound basis to make those kinds of permanent changes.
The government should arm itself with state-of-the-art technology to supplement human judgments and facilitate optimal implementation and exist strategies. The use of artificial intelligence and big data analytics used by the private sector would provide it with more predictive macroeconomic information to inform its long-term decisions and limit market distortion. The alternatives are dangerous. As General Colin Powell articulated in his Pottery Barn Doctrine: “if you break it, you own it.” That’s a problem when it comes to the economy.
Thomas P. Vartanian is the executive director and professor of law at Scalia Law School’s Program on Financial Regulation & Technology. He is a former bank regulator and private practitioner whose book on financial crises in America will be published in early 2021.