This article fist appeared on the World Economic Forum Blog on June 22, 2020.
- We need governments to develop policies focused more on equity than debt.
- They could co-invest with private sector funds or subsidize investments.
- Government-led pandemic insurance could lessen the cost of future bailouts.
The events leading to the Great Recession that started in 2007 are often referred to as a credit crisis. But that is true only in a narrow way. The recession was driven primarily by the bursting of a housing bubble and the related impacts on the financial system. The real credit crisis of our lifetime is turning out to be the coronavirus recession.
What we face today is both more widespread and more worrisome: households and companies of all sizes, already highly indebted, are taking on massive levels of new debt just to survive.
To be sure, this is the right course for now. By working together, governments and the financial system are keeping good businesses alive and helping to speed the economic recovery. Many companies desperately need this cash to get through the economic reopening period unfolding now.
But governments need to supplement this effort as soon as possible with policies that focus more on the ownership side of the balance sheet and less on the debt side. Unlike debt, ownership stakes, known as equity or stock, don’t need to be repaid, and therefore are a much more stable source of financing over the long run.
The clock is ticking. Numerous companies soon will find themselves with too much debt for their long-term health. They will either die when the cash injections stop or will limp along as “zombie companies” that will hold back the future economic recovery. The spillover effects will weaken the banks and governments.
Fortunately, there are a number of ways for governments to encourage more equity investment.
First, now would be an excellent time for nations to remove long-standing obstacles to equity, such as laws or regulations that make it expensive to issue stock, as well as tax advantages favouring debt over equity.
Second, governments could co-invest with private sector funds, both to inject more equity into the economy and to encourage more private sector equity investment.
Many countries probably already have enough equity funding overall. But mid-sized companies and certain segments of the economy could face hurdles in obtaining it. Here, governments can provide judicious assistance in a couple of ways.
One is to simply subsidize investments, such as by providing a dividend of a few percent a year for a limited period of time to make it more attractive to invest despite a high level of uncertainty.
A second approach would be to tackle the uncertainty directly by providing government insurance to new equity investment in these parts of the economy to protect against extreme macroeconomic results. For example, the government could make a payment to these equity investors if GDP for 2020 drops by more than 10%. By eliminating the extreme risks, investors could be made comfortable with investing without demanding fire-sale prices.
Even after these measures, of course, some companies could be pushed to the brink. Unfortunately, the economic hit from COVID-19 and the shutting down of much of the economy will mean that many otherwise viable companies can’t support their debt levels and aren’t attractive to equity investors.
Some nations, including the US, are lucky to have a bankruptcy system that is well designed to keep companies alive that are structurally healthy but have gotten in over their heads with debt. We would be better off if other governments could work with their private sectors to design a simplified, voluntary form of debt restructuring that could be activated swiftly when it becomes clear that a viable company is in serious danger of bankruptcy. They may need to add subsidies to encourage quick acceptance, reducing the losses for creditors and allowing businesses to continue to operate and to retain at least some of their employees. Even the US may need such an approach to head off a wave of bankruptcies that could overload our courts.
Finally, with an eye to the medium and long-term, we need government-supported business interruption insurance for pandemic risks. If businesses had gone into this crisis with such protection, there would be far less need for government intervention on such an unprecedented scale.
Private insurers can’t provide this on their own, because the risk is too large and would be impossible to diversify since it hits the whole world more or less at once. Governments could charge premiums to help offset the rare year when they would have to pay out. Premiums that are acceptable for businesses are likely too low to cover the full cost, but the reduction in future bailout costs should more than cover the difference.
Yes, massive government credit programmes are necessary right now. But there are numerous ways governments can help reduce the painful hangover likely to arise in the future from indulging in so much debt.