For the second time in 15 years governments around the world are shelling out billions of dollars in grants and loans to the stabilize their largest corporations. Is this the right thing to do?
What is a bailout?
Bailouts usually are either grants or loans to businesses intended to help them overcome disruption or to engage in uneconomic investment.
Grants are permanent transfers of wealth to the recipients which are never repaid, and we see grants given to private concerns routinely. Under normal economic conditions grants are used by governments as an incentive to encourage people to do something that would otherwise not be worth doing from a financial perspective. That includes things like funding the Arts, Alternative Energy and a host of other things that lose money consistently.
In recent years it has also become normal for governments to give grants to subsidize profitable ventures. Local governments routinely give tax holidays and other incentives to companies that will locate in their jurisdiction. And it is only the largest and most profitable companies that benefit from these gifts.
Giving taxpayer money to charities that provide “social goods” is a legitimate alternative to having governments provide them. Charity was once the domain of the religious institutions… they ran hospitals, fed the poor, counseled the troubled and provided most of what we think of now as social services. That’s one of the primary reasons religious institutions do not pay income taxes.
During the Great Depression governments got into the charity business in a big way and they’ve been expanding their role in that space ever since. They now run hospitals, provide subsidies for the poor and so forth. They are in the charity business big-time.
Along the way people’s expectations of the role of government have shifted. People nowadays seem to believe that government is actually responsible for everything in society. Politicians croon about employment and the economy as if they were responsible for success. They are not – it is the private sector that creates all wealth in society. Governments govern – i.e. set boundaries and rules – for the private sector , they does not run it.
Grants to companies? – NEVER.
Giving grants to the private sector businesses in the form of grants is, was and always will be an indefensible concept, because it is a transfer of wealth from citizens at large to a select group – investors. Whether the rationale is to bribe a company to set up shop in their backyard or to build products that cost more than they are worth it is always a gift to investors. And those investors are not stupid – they know the purse has no bottom, so they get greedy.
Loans to companies? – Sometimes.
Loans to the private sector are a little better than grants in that the money gets repaid with interest (in theory) back to the people. The only purpose in lending money to anyone is to enable them to fix a timing difference in cash flows i.e. need money now, will have money later. This is the root of banking, which grew up around the oldest timing difference in the world – planting seed and waiting for the harvest. And under normal circumstances it is the banking system that should be extending all credit, not governments.
The rationale for bailout loans is that the banking system cannot or will not provide credit sufficient to bridge a cash flow timing difference. The need for a bailout loan can arise from problems in the banking sector that inhibit their ability to fund loans (typically a market liquidity problem) or problems in the finances of the company seeking the bailout. Today we are looking at the latter.
Companies seeking bailout loans in today’s market are doing so because they have an unexpected change in their cash flow caused by the current virus pandemic. Fair enough, they have an unexpected need for cash.
Debt or Equity?
But is this a timing difference or a permanent difference in their overall cash needs? In other words is this shortfall going to result in a surplus in the future or is it money that is simply gone.
Today’s situation is temporary, but the loss of cash flow companies are experiencing to day is permanent. I do not see any way that airlines, hotels, restaurants and countless other industries are ever going to get the cash back that they have lost – it’s a real loss and it’s lost forever.
Lending is for temporary funding situations. Equity is for permanent funding situations.
Equity, unlike debt, is not repayable. It is a permanent injection of cash made with the hope of future gains, with no guarantee of ever getting your money back. Equity is what a company relies on to survive periods of loss. When companies run out of equity they go bankrupt.
Equity is what these companies need today. Some will argue that many companies have been negligent by operating their businesses with insufficient equity capitalization – especially when looking at companies that have done “buy-backs” of shares during the recent cycle of prosperity. While it is true that these share buy backs reduced the available equity to survive today’s losses, is it reasonable to assume that this viral pandemic was a foreseeable event that should have been provided for? If you think the answer is yes, then everyone – individuals, governments and the private sector are all guilty of myopic planning. I believe that position is unreasonable given the fundamental optimism of people… no one was planning for a shut-down of the entire global economy for months at a time.
To minimize disruption of the supply of goods and services and preserve our way of life individuals and companies both need an injection of equity to cushion the unexpected financial shortages this viral pandemic is causing.
The US government is working on a bill as I write this to inject equity into individuals’ balance sheets with a direct cash payment. This is the right thing to do although I expect that magnitude of the injection will be far too small. What people really need is 3-6 months of cash flow permanently funded by the government on a one-time basis. Since citizens “own” the government this makes perfect sense – they are repatriating capital from the government for their own use, because they need it.
Capitalizing large companies
The same is true for companies. They also need a one-time injection of money permanently funded by the government. The difference here is these companies are not “owners” of the government. Since they need equity from the government to continue operating, the government can and should make equity investments in companies to restore their capitalization to a state of adequacy for continuing operations.
Capitalizing small businesses
For large public companies the solution is obvious and easy to do – inject 3 months worth of cash flow in equity and, if required, do it again as often the situation goes on. For the vast majority of companies – those held privately, including partnerships and small companies – it is exceedingly difficult. The government has no knowledge of the adequacy of their capitalization or how much capital they would require to survive. Yet these small businesses account for about half of all the economic activity in the country.
So what do we do for small businesses? Doing nothing will result in widespread bankruptcy of both businesses and their owners through no fault of their own. The answer is not loans, or deferring payment since the gap is permanent, not temporary. Determining their capital shortfalls caused by the disruption is practically impossible – many small businesses have little cash equity investment because they were “funded” by the toil of the owners – this is called “sweat equity” – which does not show up on their balance sheets.
The choice here is very difficult. To let small businesses die due to a lack of equity caused by the pandemic while rescuing individuals and big companies is grossly unfair. It would also permanently alter the risk/reward equation that entrepreneurs evaluate when starting a business, to an extent I believe would make future start-ups irrational for all but a handful of business opportunities. This could be extremely destructive to the future of the economy in America.
On the other hand, it is nearly impossible to find all these small businesses or to figure out how much capital they need to survive. Especially in a matter of weeks, after which time most of them will fail.
One option might be to grant money to business owners based on prior year revenue filed with the tax authorities last year. That might be the best proxy we can find for how much revenue loss they may experience. Doing that at least identifies a sound list and some rational basis for determining an allocation of funds to small businesses. A one-time grant equal to 3 months of the prior year’s revenue might do the trick (again, repeat if required, depends on length of the disruption). The downside is anyone who started a business during the last year would not be on the list, which is tragic, but maybe unavoidable.
Finally, did you notice I said grants to small business? Yes that was not a mistake. In reality it makes no sense for the government to become a shareholder in hundreds of thousands of small business – the administration burden would not be worth the potential upside. Besides, for decades governments have been giving grants, special loans and tax incentives to big businesses, maybe it’s about time small business got a leg up. Give ’em grants and call it a day…. this could save your economy.