A protracted economic shock could put more capital in the hands of weak businesses, especially if the Fed expands its drastic mitigation measures.
Warren Buffet lives for financial turmoil. The so-called Oracle of Omaha famously took large positions in Goldman Sachs and General Electric during the 2008 financial crisis, and went on a buying spree during the turbulent recovery. “A climate of fear is our best friend,” he explained in his 2010 investor letter, because market turmoil can lead to the undervaluation of strong companies. When everyone is selling, even the best stocks fall precipitously. Investors should capitalize on these rare opportunities, Buffet believes: “When it’s raining gold, reach for a bucket, not a thimble.”
But during the massive sell-off in March, Buffet sat on the sideline. While investors waited for the familiar headline announcing a blockbuster Berkshire Hathaway deal, the investment firm sold more stock than it purchased, building up $137 billion in cash. Berkshire’s inactivity is a result of the Federal Reserve’s emergency-lending programs, which propped up asset markets and precluded the kind of undervaluation that Buffet seeks out. “There was a period right before the Fed acted” when companies asked Buffet for capital, he said, but “after the Fed acted, a number of them were able to get money in the public market frankly at terms we wouldn’t have given.”
The Fed’s programs staved off a severe collapse, and turned the shortest bear market in history into a rally. Buffet praised Fed chair Jay Powell on Saturday for his forceful action, ranking him alongside Paul Volcker as one of the best central-bank helmsmen in modern history.
But Powell’s actions come with downside. Lending to corporations could lead to the emergence of “zombie” firms — inefficient companies relying on cheap credit as life support. The Fed’s lending facilities allow some risky firms to fund their operations even if they’re losing money. That’s bad news for the economy, because zombies eat up capital and workers that should go to better businesses.
The “zombie” phenomenon emerged after the 1992 Japanese financial crisis. In the 1980s, Japan appeared poised to overtake the U.S. as the world’s largest economy. So rapid was the rise of its high-tech manufacturing sector that economists called it the “Japanese miracle.” Thinking the country’s sky-high growth rates would last forever, investors piled in Japanese assets, prodded by Japan’s state-managed banking system. In the early ’90s, the house of cards came crashing down: Stocks fell by 60 percent, with real estate suffering similar losses.
This financial collapse impaired the collateral held by Japanese banks, corporations, and households, threatening the foundation of the country’s economy. Though the bursting of the bubble represented a return to reasonable valuations, Japanese authorities had their hands tied: If they didn’t intervene to bolster the financial system, economic catastrophe would follow. They thus pushed banks to roll-over nonperforming loans in order to fend off “public criticism that banks were worsening the recession by denying credit to needy corporations,” as Takeo Hoshi and Anil Kashyap explained in a 2006 paper. Regulators “encouraged the banks to increase their lending to small and medium sized firms to ease the apparent ‘credit crunch.’” These policy decisions led to the ensuing “lost decades” of near-zero economic growth in Japan.
Now, in response to the coronavirus, the Fed has followed Japan’s lead. By backing corporate-credit markets, the Fed incentivized investors to capitalize companies suffering from the global economic collapse. Boeing, which had negotiated a $60 billion congressional rescue package in March, ended up raising $25 billion from the private markets and withdrawing its request for government assistance. Seeing that they could simply unload bonds to the Fed if the economic outlook soured, investors lined up to provide capital to Boeing and other companies that were facing default just weeks ago.
In a functioning market, Boeing would pay a hefty premium for loans. A global halt in travel, coupled with the costly 737 Max debacle, has severely weakened its operations. If enough Boeings obtain capital at below-market rates, we could see a zombie apocalypse in the U.S. corporate sector. In such a scenario, inefficient businesses surviving on life support would put a drag on GDP growth for years to come. As Hoshi and Kashyap outline, zombies raise the cost of capital for productive firms, decreasing innovation and reducing economic growth. They also depress prices by fueling overproduction, and drive up wages as central-bank largesse subsidizes labor costs.
Fears of a zombie apocalypse may not come to fruition. If the coronavirus shock ends in the next few months, the Fed might succeed in quickly unwinding its balance sheet, and the Fed’s corporate-lending facilities remain limited in scope and scale; the riskiest businesses will still have to tap private markets to stay alive. But a protracted economic shock could put more capital in the hands of weak businesses, especially if Powell expands the new lending facilities to include more high-yield–rated companies. Policymakers must strike a balance between staving off a deep recession and permanently hindering economic competition.
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