The Federal Reserve has become the first responder for the U.S. economy. Normally, the Fed is concerned with the safety of the financial system. But its fate as an independent central bank may turn on whether it can preserve the real economy.
To succeed, the Fed needs to put aside normal concerns about credit risk and picking winners and losers. Clearly no moral-hazard issues arise from this virus outbreak. The Fed must move quickly to get cash in the hands of business owners. Small businesses constitute almost 50% of the country’s workforce. Many have only a three- or four-week cash cushion. They need money now.
The Fed is the perfect vehicle to save the economy. It’s trusted politically, staffed by skilled professionals, and has the experience of 2008 from which to draw. Most important, it can create money and operate with negative capital. The Fed can always pay its bills.
The Fed responded initially to the crisis on the week of March 15 by massively expanding liquidity. Its balance sheet has since increased by more than 30% to $6.1 trillion. The Fed also lent using the discount window, while minimizing the potential stigma for bank borrowers.
In the weeks following, the Fed re-created several facilities that were successful in 2008: purchases of highly rated commercial paper, loans to banks to purchase money-market fund assets, loans to primary dealers, and purchases of a range of asset-backed securities (with a welcome expansion to commercial mortgages on April 9).
The Fed also created facilities, not used in 2008, to buy investment-grade bonds (extended to high-yield on April 9) in either the primary or secondary market, along with exchange-traded funds. Precedent for Fed intervention of this kind would have to go back to the Industrial Advances Act of 1934, which empowered the Fed to extend credit to any industrial or commercial business.
While the announcement of some of these facilities may have stabilized markets, to date the Fed has disbursed only $86 billion, under the primary-dealer and money-market funds facilities, neither of which serves the real economy.
Congress took up the small business mantle in the Cares Act—an acronym for Coronavirus Aid, Relief and Economic Security—creating the $349 billion Paycheck Protection Program, with loan forgiveness, to cover core expenses like payroll and rent for businesses of fewer than 500 employees. The Cares Act also authorized similar coverage for businesses with up to 10,000 employees, without forgiveness.
On April 9, the Fed unveiled its plan for small business (with a one-week comment period that allows for revision). It has allotted $600 billion across two “Main Street” loan facilities, or MSLF, backed by $75 billion from the Treasury, to support bank loans. MSLF will cover core expenses for medium-size businesses, as authorized by the Cares Act, and cover critical noncore expenses, like accounts payable and maintenance, for both small- and medium-size business.
Unfortunately, the facilities are too limited in scope. The requirement that loans be at least $1 million will leave out the smallest borrowers. The facilities also provide that the Fed will purchase only 95% of each bank loan, leaving 5% with the bank, presumably to protect the Fed’s own credit risk. Yet as a result, the loan terms must encourage banks to lend. The Fed may manage to spur lending with its proposed adjustable interest rates of 2.5% to 4% plus fees and a four-year maturity. But the terms may be too onerous for struggling borrowers. (Compare the Fed’s terms with usual ones from Small Business Administration: a fixed rate of 1% and no fees.) The Fed should instead purchase 100% of the loans, with terms attractive to borrowers, and compensate the banks for processing them.
The Fed’s new proposal is praiseworthy for keeping paperwork to a minimum and relying on self-certification to avoid delay. But there is too much additional documentation the banks must require to protect themselves. This could be eliminated by 100% Fed purchases. As with the SBA program, the banks should be protected from liability for processing errors and fraud should be deterred by the promise of strong Justice Department enforcement.
Fortunately, the Fed has the firepower to save the economy. Backed by $195 billion of Treasury guarantees, its April 9 actions promise $2.3 trillion in liquidity, consistent with the leverage envisioned by Treasury Secretary Steven Mnuchin and Fed Chairman Jerome Powell. And existing Fed funding can be more than doubled with the remaining portion of the $454 billion provided by the Cares Act.
A central bank can make unlimited loans and incur unlimited losses without government backing. The only legal limit on the Fed is Section 13(3) of the Federal Reserve Act, as amended by the Dodd-Frank and imported into the Cares Act, which requires that Fed loans to nonbanks be collateralized, an impossibility for many borrowers. Fortunately, the Treasury guarantees can serve as a collateral substitute. If more backing is needed, because of loan demand or credit risk, Congress can provide it. And the 13(3) borrower solvency requirement should be handled through self-certification.
The Fed has a staggering task ahead. By acting boldly and quickly it can make all the difference. Failure to do so may spark a political backlash that jeopardizes its independence and imperils the country.
Mr. Scott is an emeritus professor at Harvard Law School and director of the Committee on Capital Markets Regulation.