By nature, economic shocks – such as the one seen in the aftermath of COVID-19 –– are unpredictable. However, we undoubtedly know that another shock will happen in the future. Yet, once again, our economic systems are depending on widespread government and central bank intervention for survival.
To create greater resiliency in the long term, governments should readjust incentives for companies and focus spending on supporting individuals.
Government Intervention, Moral Hazard and Allocation of Resources
In their classic function, central banks act as “lenders of last resort” to provide liquidity to financial markets. However, since the global financial crisis, they have also operated as “market-makers of last resort” and “lenders of last resort to the non-financial sector.”
Since the outbreak of COVID-19, five of the leading central banks combined have injected over $5 trillion into markets. With little to no say over how additional liquidity is allocated, governments are left hoping that credit trickles down to SMEs and citizens. These extraordinary monetary interventions have helped international equity markets recover most of the losses suffered in February and March – even though widespread unemployment and elevated bankruptcies remain the reality for much of society.
Such loose monetary policy is part of a multi-decade trend that has culminated in today’s zero interest rate in most of the developed world. However, since the great financial crisis, interventions of this magnitude have created a sense that recklessness is institutionalized and even rewarded when organizations are too big to fail. These measures have had severe negative long-term consequences on potential growth and society, including fostering moral hazard.
Another serious consequence of such moral hazard is the significant rise in the number of so-called “zombie firms.” These are companies that can only generate sufficient funds to cover interest payments but not the principal. Since 2008, the number of such organizations has significantly increased in the developed world. Keeping companies from failing prevents the efficient allocation of resources into more productive and growing parts of the economy.
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Lemon Socialism: Privatizing Profits and Socializing Losses
One could expect that companies would have prioritized corporate resilience following the significant injection of public money to prevent the near collapse of the financial system and to rescue many industries during the global financial crisis. In reality, what we have seen in the past few years is an acceleration of a multi-decade trend, a continued increase in shareholder returns and buybacks, corporate indebtedness and a significant reduction in productive investment and R&D. While governments have carried the burden of events such as COVID-19, companies have fundamentally spent the past 40 years returning capital to shareholders.
Some justify such an obvious departure from free-market economics as a mechanism to prevent systemic failure and further damage to the economy. In reality, this is lemon socialism, a political and economic system where profits are strictly the property of shareholders, and catastrophic losses are an externality to society. In essence, misaligned incentives have made numerous companies “too big to fail.” These organizations failed to build the resiliency in the good times that could help them weather the inevitable downtimes to come.
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Rebuilding Incentives: Clear Regulation and Cost Internalization
Companies around the globe have continued on a path of short-termism and reckless behaviour for near-term investor returns in detriment of long-term value and societal prosperity. We need to redress corporate incentives to ensure that vast sums of government support are not once again used in vain. If we continue to intervene through monetary and fiscal support without appropriate adjustments to incentives, we will amplify distortions and lay the groundwork for further systemic instability in the future.
To rebalance incentives, mitigate moral hazard and adjust economic systems away from lemon socialism, we need to implement critical regulatory and tax reforms. V. V. Chari and Patrick J. Kehoe propose regulating company leverage and taxing size to achieve a sustainably efficient outcome. Company leverage, they suggest, should have a debt-equity ratio limit, while in parallel, a Pigouvian on company size should eliminate distortions and correct the externalities of “too-big-to-fail.”
As we embark on the Great Reset, we must build entirely new foundations for our economic and social systems. Those foundations require market incentives that guarantee firms operate with society’s best interests in mind.
Governments have for too-long ignored the consequences of monetary and fiscal intervention on long-term prosperity and society in general. It is time we rebalance incentives so companies operate in a way that benefits stakeholders and society. Instead of focusing on saving jobs by subsidizing and bailing out inefficient organizations, governments should spend on social protection systems that support individuals and alleviate the economic and social consequences of recessions.