How the Fed’s Rescue Program Is Worsening Inequality

Americans have been justifiably disturbed by stories of deep-pocketed corporations accepting loans from the Paycheck Protection Program designed to save small businesses and non-profits. But outrage over generous loans to well-heeled businesses is obscuring another troubling problem: The Federal Reserve’s efforts to preserve liquidity in the corporate debt market are, however inadvertently, sending wealth up the income scale, exacerbating inequality.

To appreciate the scale of the problem, consider the corporate debt market. Bonds issued to investors by healthy businesses tend to command lower interest rates, or yields. Companies already saddled with substantial debt pay higher yields simply because investors worry that those loans won’t be repaid. The riskiest debt, “high-yield” or “junk” bonds, are so precarious that they are predominantly purchased by sophisticated institutions, such as hedge funds.

Needless to say, the investors willing to tolerate high levels of risk are not people of lower and moderate incomes; they are disproportionately wealthy and white. In fact, some junk bonds have been managed or “leveraged” explicitly to ensure that special classes of wealthy and sophisticated investors reap even larger rewards.

With many highly indebted businesses facing severe revenue challenges, the junk bond market should be reeling. But not only are high-yield bonds not in free-fall—relatively speaking, they’re being actively marketed by respectable intermediaries to ordinary conservative investors. Businesses that might normally be on the brink of insolvency have, in many cases, had little trouble finding money from the markets.

Why? It’s not because investors necessarily have greater faith that these companies are poised to thrive. Rather, the junk bond market is on a tear because the Federal Reserve, with the blessing of the U.S. Treasury, is ready to purchase certain downgraded corporate bonds, giving investors a secure avenue to offload junk bond risks and avoid losses if they have to.

No “junk” risk

In other words, by buying up junk bonds, the Federal Reserve is effectively offering the globe’s wealthiest investors the opportunity to purchase high-yield bonds without fear they’ll lose their shirt. They’re being presented with all the upside that comes with a junk bond, but none of the risk that, before now, made it, well, junk.

Even as mom-and-pop businesses struggle to secure the financing required to retain their small businesses, as millions of Americans are out of work and struggling to feed their families, Washington is backstopping loans that are predominately purchased by wealthy investors.

The Federal Reserve, having acted forcefully and admirably in this crisis, arguably did not err when deciding to intervene in the junk bond market, even if some investors have shamefully over-leveraged some companies in pursuit of outsized returns. Absent the Fed’s support, at least some struggling businesses might have been frozen out of the bond market and many would be forced to declare bankruptcy, prompting additional layoffs and unemployment claims, and a deluge of consumer, student, mortgage, and other defaults, deepening the recession for everyone.

But if the Fed’s move is indeed prudent, their unconditioned interventions should prompt a recalibration of the government’s broader approach. In other words, if the wealthiest investors are getting a three-course meal, small businesses and struggling families shouldn’t be left fighting for scraps.

This all points to a lesson too often ignored in recent history: Some of the best-intentioned federal economic interventions can serve to worsen inequality. After the Second World War, for example, Washington’s desire to expand homeownership spurred Congress to establish new government-supported mortgage programs. But beyond incentivizing suburban sprawl, federal agencies seemed not to notice that many lenders iced out applications from low- and moderate-income, typically minority communities, purportedly to minimize the government’s risk. This “redlining” then became standard practice within private industry, necessitating passage of the Community Reinvestment Act (CRA) in 1977.

Redlining’s legacy effects have scarred the ability of many families to build wealth. We can’t afford to make the same sorts of mistakes again. Today’s economic policymakers should take steps now to mitigate the inequalities that will cause more problems – and potentially new CRA-style legislation – in the future.

This would mean, for example, that the Treasury Department and Small Business Administration would fix the Paycheck Protection Program so that funds are reserved for small businesses truly on the brink in neighborhoods that have been left behind. The spirit behind CRA standards – an obligation to serve the entire community – should be applied to government actions now. If investors in the high-risk debt markets are going to in essence to be made whole when the Federal Reserve purchases and supports those loans, low- and moderate-income businesses and charities, such as churches that often provide social safety net programs, should be able to expect the same level of support.

Wealth distortions

The need to address the wealth distortions produced by policy also suggests that in addition to the government’s support for business, more aid should directly target individuals who have been laid off. In this regard, Sen. Mark Warner (D-Va.) has proposed legislation which would provide federal support to help workers remain attached to their jobs by guaranteeing salaries of up to $90,000 for anyone who has been displaced or laid off in the wake of the crisis. The Fed is purchasing corporate debt because they want to keep viable companies up-and-running. Well, we need to keep those companies’ unemployed workers and their families up-and-running as well.

Finally, the responsibility to embrace a new approach expands beyond Congress and White House. For example, the Fed should be using its new Main Street Lending Program even more aggressively than it is proposing to help fill this gap for middle- and lower-income Americans. There is much to like in the MSLP. However, currently its terms are too tough and rigid to serve the needs of many small businesses. By requiring all loans to be more than $500,000, the central bank is icing out smaller banks and smaller borrowers. At the very least, the Fed should use its relationships with smaller banks to facilitate making subsidized lending to mom-and-pop businesses.

We’re living through an economic crisis equivalent to a war, and as Nobel laureate Robert Shiller has pointed out, the spirit of togetherness born from wars can spur nations to tackle divisive challenges that appear impregnable during peacetime. In this national emergency, government has the opportunity to level the playing field for families living in trying circumstances, particularly communities of color.

The legitimacy of our economic system is at stake. If the wealth gap grows while the mainstream suffers, capitalism itself will almost certainly come under more withering criticism. If, in an amplified echo of post-war redlining, Washington decides to serve the wealthy but not the poor, the price will not just be financial, but political.