credit economy Markets

‘Capitalism Was Lost Long Before COVID-19’

Earlier this week, in the course of summarizing the main points from the latest missive by SocGen’s incorrigible (yet exceedingly affable) bear, Albert Edwards, I mentioned that my own view of the Fed’s foray into corporate bond purchases is relatively sanguine.

It’s not that I don’t appreciate the moral hazard critique. Rather, it’s that the genie left the bottle some years ago.

When the Fed cut rates to zero and embarked on what, in the pre-COVID world, counted as “large-scale” asset purchases, the effect was to push investors out the risk curve and down the quality ladder. One explicit goal was to lower corporate borrowing costs.

Read more: Albert Edwards Predicts Zombie Apocalypse

This hunt for yield intensified as time went on, creating voracious appetite for anything that offered any semblance of yield in a world were the global stock of negative-yielding debt eventually topped $17 trillion (figure below).

In Europe, things became so surreal that entire corporate curves went negative at one point last year. Those companies could effectively mint “assets”.

Of course, outright purchases of corporate bonds have been going on in other locales for some time, and the ECB’s presence in the market is one reason why the € debt market long ago became a funhouse mirror.

The point is that in a world where capital can go where it pleases, and central banks are engaged in competitive easing (a “race to the bottom”, as it were) there will be a perpetual bid for anything that offers yield pickup. Corporate borrowers in the US benefited from this, as evidenced by persistently low yields and rising leverage across virtually the entire post-financial crisis era.

Indeed, “zombie” companies (whose debt servicing costs exceeds profits) in the US and Europe have been on the rise for a decade. There is nothing uniquely “COVID” about the notion of central banks buying corporate bonds and otherwise facilitating “zombie” dynamics.

The deluge of borrowing from panicked corporates in the first half of 2020 means it is highly likely that the percentage of companies counted among the “undead” will rise going forward, especially in the event the recovery proves to be less robust than optimists anticipate.

In the US, investment grade and high yield issuance during the second quarter broke records. That borrowing was enabled by the Fed’s backstop, despite the fact that Jerome Powell didn’t buy any corporate debt until early May (ETFs) and purchased no individual corporate bonds until last month.

The red bars in the figure (below) give you some context for the deluge of blue-chip debt issuance witnessed from March through June.

So, while the problem is likely to worsen, let’s not pretend like a dozen years of easy monetary policy (turbocharged in the US in late 2017 with the Trump tax cuts) hasn’t amounted to a giant, rolling corporate bailout.

I suppose you could argue that in the period between 2009 and 2019 (i.e., between the GFC and the pandemic) “bonanza” is a better word than “bailout”. Credit market stress has been subdued in the post-GFC world, so it’s been a windfall more than a godsend. But that begs the question. That is, of course market conditions have been benign. The Fed and its counterparts across the globe have deliberately prolonged the cycle, compressed spreads, suppressed default rates, and stamped out price discovery. So who’s to say whether it’s a “bailout” or a “bonanza” — a helping hand or an unnecessary handout? We don’t know, because in a world characterized by an increasingly desperate hunt for yield, virtually anybody can borrow.

“Capitalism was lost long before COVID-19”, Deutsche Bank’s Jim Reid writes, describing the following visual, which encapsulates many of the points made above and puts the pandemic response in a historical context.

What I would gently (and quickly) note is that capitalism may be “lost” in the sense that policymakers have no appetite for creative destruction, but it’s certainly still working its “magic” when it comes to perpetuating inequality of all sorts, ironically helped along by loose monetary policy.

In any event, you could argue that the borrowing associated with the pandemic is infinitely easier to forgive (figuratively and, perhaps, literally) considering it wasn’t motivated by a desire to, for example, fund share buybacks with debt, but rather by survival concerns.

Suppressing default rates from here will presumably require an even more concerted effort to keep real yields low.

As Harley Bassman likes to say, “there are only two avenues out of a debt crisis – default or inflate, and inflation is simply a slow-motion default”.

There is another avenue — namely, blockbuster growth. But as Bassman wrote last month, “I think COVID-19 has closed off that possibility”.


11 comments on “‘Capitalism Was Lost Long Before COVID-19’

  1. George says:

    OK ,,,,, so now we have determined the Pendulum is swinging ( like I assumed all along ) This is a good post , by the way , but the question becomes does anything ever revert to a norm or do we venture into the deep blue sea of a new (perhaps tragic ) adventure…I’m game don’t know about everyone else though ….!!!

  2. Your article was very thoughtful. I thinking that real problem is the philosophy that Powell is going by. In order for him to get the job he has to say that he will do anything necessary to support the economy. He is doing what he said he would do, but that is the problem.
    The issue is Keyes is wrong about how money and credit work. We are supposed to live in a capitalistic economy. We haven’t lived in a capitalistic society since 2008, some would say 1913 , but I don’t think that.

    The Federal Reserve is supposed to stabilize the economy but in raising the debt level as high as it has it has reached a point of insanity. The government is directly funding zombie companies to keep them a float.
    I am glad you address this in many of your articles.

  3. lorbarr says:

    So how DID we get here? Greenspan started this low-interest rate regime with his series of insurance cuts from 2001-2004, which overheated the economy and led to the housing boom / bust. That jibes with the chart above – it was then that the zombie curve really takes off. And since the Great Financial Crisis, central bankers will (understandably) do anything to prevent a depression. So it seems to me that we can lay this at the feet of “the Maestro”. And Bernanke’s QE, the ultimate financial can-kicking mechanism, saved the day in the short run but caused much economic dislocation and inefficiencies in the long run…

    • Joey says:

      Recall also the events of 9/11, which deepened an existing recession, and prompted a Fed response. While the US came out of that recession relatively quickly, our response to 9/11 included two very expensive wars. This increased public debt tremendously, directly affecting monetary and fiscal policy. The rising debt affected the willingness of congress to use fiscal policies to address the GFC, helping to push us into the monetary regime that ensued, and which continues today.

  4. Vlad is Mad says:

    Remember the Walter Bagehot dictum “lend freely, at a penalty rate, against good collateral.” The Fed has gone astray. Fiscal authorities, duly elected representatives, are charged with the responsibility of picking winners and losers. That is not the role of a central bank. But that is what they are doing when they backstop IG and HY, True, the moral hazard ship sailed long ago, but this intervention is something that is at another level of intervention. Capitalism only works if there are winners and losers. We have to clear out the dead wood in order for profitability to be restored which drives investment and ultimately innovation and growth. The Fed is making a mistake that offers short term benefits but long term costs.

  5. dayjob says:

    Obviously, we can’t know what the Fed would have done if this had been a “typical” downturn, but if someone invented a counterfactual machine, I’d love to see how long it would’ve taken for the bull market to end and to what levels the Fed would have gone to save zombie companies in that situation. In a way, the Fed has been saved from much harsher criticism by the pandemic (at least for now).

    Now if the Fed’s actions end up creating so much wealth inequality (and making it clear deficits don’t matter on their own) that it finally spurs action in the US to create a stronger social safety net, then maybe it’ll all have been for the better (the Fed’s actions, not the pandemic).

  6. Ria says:

    Eroded safety net- leads to recessions hurting too many by too much. Leads to unwillingness to inflict occassional pain on society of a recession. Leads to bigger bailouts and very supportive monetary policy anyway. We need, higher minimum wage- and some subsidy for lower wage workers. Universal child and health care not linked to employment. Higher levels in social goods- public health, education, infrastructure. Further support to social security and medicare trust funds. Cost is a income proportional or progressive value added tax and somewhat higher corporate tax rate. Cost of not doing this- priceless!

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