Policy Rx for the economy: Cash or credit?

Deborah J. Lucas, Sloan Distinguished Professor of Finance and Director, MIT Golub Center for Finance and Policy

(Consistent with the GCFP’s mission of non-partisanship and offering analysis but not policy advice, any recommendations contained in GCFP blog posts are those of the authors and do not represent the views of the GCFP.)

What is the best mix of cash and credit assistance to combat the economic fallout from the coronavirus pandemic, and what are the principles that should guide those choices? For policymakers to be able to design effective and affordable policies and avoid unintended consequences, it is essential that they understand the tradeoffs between these two broad policy alternatives. Yet this issue is rarely addressed head-on.

This is the first of a two-part series on the  policy choice between cash and credit assistance. It describes the tradeoffs, and sets out a set of principles to help evaluate credit policies and the features that are likely to make them more or less effective. The second installment will apply these ideas to an analysis of the likely efficacy and cost of key provisions in the $2.2 trillion stimulus package, and the implications for future rounds of support.  Even the headline number of $2.2 trillion that is arrived at by adding cash and credit support demonstrates the general lack of awareness of these two very different policy choices.

A policy  is best assessed relative to desired objectives. For the policies being adopted by legislatures and central banks to combat the economic effects of the coronavirus, I take the main objectives to be (1) tiding over individuals through this period of drastically reduced incomes so as to address immediate hardships and cover basic needs; (2) providing continuity and preventing permanent damage to individual livelihoods and organizational capital; (3) bolstering the resources available to the healthcare system; and (4) achieving policy objectives as cost-effectively as possible and in ways that are perceived as fair.

Cash assistance has several advantages over credit for addressing (1), (2), and (3). Cash almost always reaches the targeted recipients. It can be distributed quickly, through existing channels with little new bureaucracy. It is transparent who gets how much (with some notable exceptions when agencies are granted wide latitude on how money will be spent).

On the downside, cash assistance is expensive; it adds dollar-for-dollar to a federal debt that was on its way to being unsustainable long before the current crisis hit. Relatedly, the subsidy element of cash tends to be significantly higher than for credit. Subsidies, particularly large ones, raise concerns about fairness and unwarranted handouts to favored industries or constituencies.

Well-constructed credit programs can avoid or at least mitigate some of the drawbacks to cash assistance, but credit is not a silver bullet.

Like cash, credit can provide funds to tide households or businesses over spells of reduced income. When banks and other private financial institutions cut back on risky lending, or when borrowers no longer meet the normal credit standards, governments can step in with direct loans and credit guarantees.

The cost to the government is often quite low relative to the amount of funds that are made available, making it a cost-effective way to get money into the hands of people and businesses during times of crisis when liquidity is scarce. That’s because most of the money, including accumulated interest, is likely to be eventually repaid. Further, the obligation to repay debt makes it more credible that those who choose to borrow have a worthwhile use for the funds. (A detailed analysis exploring the power that government credit had as relatively inexpensive stimulus during the period following the 2008 financial crisis can be found in my Brookings Paper.)

Turning to some of the important principles for understanding and effectively implementing credit programs, here is my list (and see below for some additional discussion): 

(1) A forbearance policy for existing credit obligations will have fundamentally different effects from a policy that offers newly available federally-backed credit.

(2) Forbearance has most of the advantages of cash grants in terms of the speed of getting money out, target efficiency,  and lower cost.

(3) Removing impediments to refinancing federally-backed mortgages and other federal loans frees up cash by lowering the size of fixed monthly payments. Such policies also have a relatively low cost to taxpayers.

(4) In terms of cost, forgiving principal or interest is equivalent to directly providing cash. It is typically much less effective as a source of funds than either forbearance or cash assistance because reduced balances generally have little or no effect on current payment obligations.

(5) Creating new credit programs or expanding existing ones entails considerable uncertainty about utilization rates, and administrative and subsidy costs can be significant.

(6) Many potential borrowers will be reluctant to incur new debt obligations, even at a zero or negative interest rates, during a time of great uncertainty. Businesses cannot be expected to borrow unless it is clearly in their best interest to do so.

(7) A credit program with a very high default rate may be more costly to taxpayers than a cash program that provides similar amounts of funding when administrative costs, including for collecting on defaulted loans, are factored in. High-risk loans can also be harmful to the borrowers themselves, as defaults hurt future credit and foreclosures on homes can be traumatic.

(8) Finally, the budgetary treatment of credit in the U.S. systematically understates its cost to taxpayers relative to cash assistance, creating a budgetary incentive to over-rely on credit assistance. This does not negate the advantages of credit over cash in some instances, but it is a caution against believing that credit is often a free lunch, as budget estimates too often conclude.

Forbearance involves changing the terms of existing loans so that payments can be fully or partially postponed for a period of time, such as during a layoff or spell of unemployment. Missed payments are generally added to the loan balance, along with accrued interest. Those larger balances mean that eventually payments will be higher, but by spreading the increase over the remaining life of the loan, the future burden can be minimized. Forbearance can be combined with partial forgiveness, as is currently done with income-based repayment for student loans, to avoid unaffordable debt burdens.

Through its mortgage, student loan, small business, agricultural, emergency and other lending programs, the federal government is the largest provider of credit to U.S. households. Many of those programs already allow for forbearance in the event of a crisis.

Using its power to forbear provides the U.S. government with a powerful mechanism for quickly reducing the cash needs for the many tens of millions of citizens with mortgages, student loans, and other types of federal credit. Exercising forbearance also would contribute to the goal of minimizing longer term damage to individuals and the economy by avoiding defaults that would damage credit scores. That would not only preserve future access to credit, but it would also improve employment prospects.

The costs of such federal forbearance would likely be modest. Unless the economy has a much more protracted downturn than most experts are predicting, the ultimate default rate may be only slightly higher than it otherwise would have been. However, when forbearance is combined with forgiveness of principal or interest, the cost for that portion of the assistance rises to be equivalent to that of direct cash grants.

Extending new credit through expanded or newly implemented programs has much less predictable effects than forbearance or easing restrictions on refinancing. For example, there have been calls to lend to businesses so that they can continue to pay furloughed or underemployed workers. Borrowing for that purpose would put the business at risk to default, and it seems unlikely that the take-up rate for such a program would save a lot of jobs.