Central banks are playing a critical, yet little discussed, role in limiting the economic damage of COVID-19. In this episode, Chicago Booth professor and former Governor of the Reserve Bank of India Raghuram Rajan discusses how the pandemic is forcing the Federal Reserve and its international counterparts into uncharted territory.

Unedited Transcript

TESS VIGELAND: The COVID-19 outbreak continues its devastating march across lives and livelihoods. Lockdowns and quarantines have slowed the spread of the virus. But countries around the globe are now confronting unprecedented economic challenges.

EDUARDO PORTER: Central banks will play a critical role in helping to limit the damage. It is a role that is not widely understood.

TESS VIGELAND: This is Pandemic Economics, a podcast about the global impact of COVID-19 from Stitcher and the Becker Friedman Institute for Economics. I’m Tess Vigeland.

EDUARDO PORTER: And I’m Eduardo Porter.

TESS VIGELAND: We’ve been invited to have this series of conversations with University of Chicago economists.

EDUARDO PORTER: In this episode, I talked with Raghuram Rajan of the Booth School of Business about how the economic crisis is forcing the Fed and its peers around the world to deploy every tool in their toolkit, including lending directly to businesses.

As a former president of the Central Bank of India, could you help us understand what the role of central banks is in a moment like this? What can they do in this economic emergency?

RAGHURAM RAJAN: First, I think it’s useful to think about what the emergency is. We have a pandemic hitting us, which effectively shuts down significant parts of the economy for the short run and some parts of the economy for a much longer run. We’re not going to see crowding into cinema halls for quite some time and. Overlaying all this is extreme uncertainty. And so in this environment, obviously, business is going to be very cautious. But lenders are also going to be very cautious. Even households who have money to invest are going to be cautious– do I really want to put my money to work for a long time when I don’t know what the risks are? That’s what central banks are confronting right now.

But the Fed essentially intervenes in probably three ways. One is through interest rate policy– cuts or raises interest rates. And if it raises interest rates, it’s favoring lenders a little bit less as borrowers, but it’s sort of hidden in the overall objective that the Fed has of ensuring low and moderate inflation. And given that objective, I think people are willing to allow the Fed to make these interest rate decisions. It’s not making decisions on long term interest rates– only on short term interest rates.

The other thing it does is it supplies liquidity to markets. And this is, again, a reasonable rule for the Central Bank. It’s a well accepted rule. And what that means is when certain markets become illiquid and you’re not able to sell financial securities into that market, the Fed will intervene and buy those securities.

EDUARDO PORTER: What kind of securities?

RAGHURAM RAJAN: So for example, when the government issues the enormous amount of treasury bills and treasury bonds it has to in order to finance the spending, where do they sell those bonds into? If they had to sell it into the market, the market may not be so deep as to accept all this in the short run. So effectively, they place it with the central bank, they place it with the Fed. And over time, the Fed can, if it desires, sell them back into the market. But it’s sort of a purchaser of last resort at times like this also for government debt.

EDUARDO PORTER: Is this sort of garden variety central banking or is this something new?

RAGHURAM RAJAN: Well, what is unprecedented is when the Fed actually takes credit risk. And the Fed has verged on taking credit risk. There are a whole lot of lending programs during the global financial crisis, but typically, these were to firms that had adequate amounts of capital. So there was very little risk of the Fed losing money through default on these.

This time around, it’s different. The Fed has effectively lent to what are called fallen angels– that is, firms that were thought of as investment grade before the crisis, but have seen their bonds downgraded below investment grade. And this does mean that there is a serious amount of credit risk involved in lending to these firms and buying their bonds. And of course, the Fed says well the treasury has backed us by putting money behind us.

But as soon as the Fed starts making decisions that involves the possibility of loss, it’s in a different ballgame, because it’s picking between different entities, some of which people will ask, why did you pick this one and not the other? It’s making decisions on who lives and who dies. And when it is an unelected body making those decisions, the taxpayer certainly has the right to ask, why do you choose A and not B?

The Fed is trying its best to be transparent on this. It’s trying its best to be objective. It’s trying its best to lend across the spectrum. But at some point, it does make these choices, and that opens it up to greater scrutiny as well as political questioning.

EDUARDO PORTER: Why is this justified in this crisis when it was not, say, in the financial crisis a little over 10 years ago?

RAGHURAM RAJAN: I think one of the justifications, at least at the beginning, was this was about keeping the economy together for a couple of months. Paul Krugman had the imagery of putting the economy into a coma and essentially waking up the patient at the end of two months. The patient was kept alive through all these Fed programs. And the patient that is the economy walked off the sick bed at the end of the coma perfectly fine, perfectly intact, and one can think about was this pandemic was a bad memory, there would be no permanent effect on the economy.

At least that was the fable that allowed us to make all these interventions saying, you know, OK, we’re doing bad stuff, but it’s for two months, and everything will be fine after that. Now I think there’s a sense that this is going to be more long-lasting. There will be dramatic changes in the economy. Certain kinds of firms, certain kinds of enterprises will never open again. You simply cannot walk off your sickbed. You may have a lot of debt that you’ve piled up, you may have to restructure.

And so the idea of intervening for a couple of months, keeping everything alive, and then the economy is fine after that– that now seems a little naive. And I think we have to, in a sense, change the game plan– not for a short duration crisis, but a longer duration one. And that then means that you have to also rethink how much intervention is necessary.

TESS VIGELAND: So Eduardo, this certainly seems like we could be calling what’s happening now, a very activist Fed, but I think the scale at this point is really unusual.

EDUARDO PORTER: Well, yes, I mean, the scale is huge. And Raghu is suggesting that this really has no precedent, not only in this scale, but also in the kind of tools that the Fed is using. And he’s worried that this might bring some unintended consequences.

TESS VIGELAND: And we will hear more about that from Eduardo and Raghu. Stay with us for more Pandemic Economics.

EDUARDO PORTER: What are the potentially problematic side effects to all this kind of new type of central bank activity?

RAGHURAM RAJAN: Well, the central bank is supposed to be reviving markets when they collapse. But not really substituting for markets. And one of the worries is that with all the central bank activity, markets simply are not pricing risk appropriately. If you look across the world, what has happened is that there was an initial sort of spike in worries when a pandemic really became serious somewhere in March, and markets plunged but then many markets have recovered and many entities that couldn’t get financing have gone back to the markets and raised a lot of financing. And in fact, now Wall Street is supposedly telling firms, take it while you can, because it’s not going to remain there forever.

Now on the one hand, this is maybe for the ones who are clever and take advantage of it, they’re getting a lifeline. But some people aren’t actually taking all the risk into consideration at this point. And the worry is these kinds of distortions will make things worse. I mean, for example, supposing you have a crippled firm, which is better off closing down SIMPLY because it’s business no longer exists– for the sake of argument, let me say a cruise ship operator. It’s going to take a few years for it to come back.

By that time, the nature of ships may have changed, they may be restructured for hygiene, they may all have HEPA filters– whatever. And that could mean that its current assets are not worth that much, and keeping it alive is actually going to consume resources. But if you finance such an entity today simply because we are getting support to take on credit risk by the central banks, and these guys can raise money, well, that means there’s more good money going down bad holes.

And that’s the worry– that what was necessary and reasonable for a two month period may prevent the economy from adjusting while increasing the costs of adjustment if this goes on for much longer. The word that economists always fear is distortions. Distortions could be building up in the economy if you don’t let markets do their normal work. In other words, you don’t want the markets to panic, but you don’t want to completely kill their beneficial rule also, which is of essentially figuring out what will be viable and what will not.

EDUARDO PORTER: There is another risk that I’ve been hearing about a lot these days, and this is the idea that inflation might be returning. Now the US hasn’t really experienced high inflation since the oil shock of the 1970s, right? Inflation has been actually very tame pretty much all over the world over the last decade or so.

RAGHURAM RAJAN: A little bit of inflation is not necessarily a bad thing, and in fact, the Fed has been saying we’re willing to tolerate a little more inflation. The concern about inflation is not really about the short term. The short term demand has fallen significantly and as a result, apart from a few items, in general, the effect will be lower inflation for a while. The worry is once the economy recovers, you have an economy with an enormous amount of debt.

And in a situation where you have a tremendous amount of debt, the incentive is, of course, to inflate a little. The central bank has that incentive, because it wants to see growth, and if growth is relatively slow, it would rather see a little more inflation. And of course, the worry is that once these incentives are in place or credibility of the central bank to stand against inflation breaks down and you get back to the pre inflation targeting environment, when central banks didn’t have credibility to fight inflation.

EDUARDO PORTER: Yeah, just to clarify, this incentive that you’re talking about is because higher inflation will erode the value of debt and make it easier for governments and indebted households and businesses to manage their debt, right?

RAGHURAM RAJAN: Exactly. And it even makes the central bank’s task a little easier apart from seeing a little more inflation, but lower debt means the economy is a little more sustainable, financial fragility is lower, people don’t have as much outstanding claims to service, growth is a little higher. Inflation is quite welcome at that point.

EDUARDO PORTER: There’s an important thought that you brought in at the very beginning of this conversation and it is about this power that the central bank has, that the Federal Reserve has, and its political independence, a lack of political oversight with which it exercises its power. And I wonder, is there a case to be made for more oversight of an authority that has this immense power?

RAGHURAM RAJAN: Well, it’s a great question, right? The original rationale for giving central banks independence came during the fight against inflation. And the idea was, look, from the politicians’ perspective, pumping up a little more demand is a good thing, it creates jobs, it creates well-being, but it also creates inflation, which in the long run is problematic for demand itself. The problem is that job description has changed. It’s no longer about keeping inflation low. In some cases, as you said, it’s about pumping up inflation because it’s too low at this point.

But even more than that now, it is about financial sector rescues and even real sector rescues. People are saying, we can’t let these large companies go into bankruptcy that will kill jobs, erode value. We need the Fed to lend to all these people and keep the economy alive. And that is a different job, because it is actually making political decisions. It’s making decisions about who lives and who dies. Does the cruise company deserve to be funded or should I instead put the funds towards an aircraft company?

Resources are scarce. Even the Fed has limited resources. So who does it help and who does it not help? The short run, you don’t have to make the decision– help everyone. But if this is a longer term game, you have to make those decisions. And the politician basically sees you intruding on their turf and is going to ask, well, the Treasury told you to do all this, but why did you let this guy, and why did you not lend to people in my constituency?

And essentially, it opens up the central bank to a lot more scrutiny, a lot more questions, because now you can’t hide behind technical details and say, we cut interest rates because such and such model told us we had to. Instead, you have to say, why we lent to this guy and not that guy. These are questions the politicians understand very well and can second guess.

EDUARDO PORTER: And this might be the moment for those arguments to rethink the institution get some traction, right? Because as you say, if this problem turns out to be long and entrenched, these kinds of decisions that the Fed is going to be making are going to come under scrutiny.

RAGHURAM RAJAN: I would say, given the enormous financial resources the Fed has and given that they can be used or misused, there is still a case for trying to make those decisions as professional as possible, and to insulate them from political activism. And I think the central bank also, therefore, has a role to play in deciding even if it ventures into taking credit risk, how transparent can it make the process so that it’s not picking red states versus blue states or friends of the president versus enemies of the president.

That it actually can defend each of the decisions it’s making. And those decisions are not firm by firm or state by state, but based on as objective a set of principles as you can, and you have to communicate it widely. So we’re in murkier terrain, but it’s extremely important to keep it as clean and clear and transparent and to distance it from political influence as far as possible.

TESS VIGELAND: So the role of the Federal Reserve probably isn’t going to change anytime soon, but it’s clear that it is essential right now in keeping this COVID economy moving. And when we talk about keeping the economy moving, we also have to talk about consumer spending. 2/3 of the US economy is based on us taking out our wallets, going into our bank accounts and spending money. But of course, that came to a screeching halt back in March. And next week, we’ll talk with two economists about the long term effects of that clamp down.

SPEAKER 1: If I don’t have enough money to pay for food and the mortgage, I might actually decide not paying the mortgage to make sure I can put food on the table. But actually, even among those that continue paying some debt, it also looks like people actually make only partial payments.

TESS VIGELAND: Pandemic Economics is produced by the University of Chicago as Becker Friedman institute for Economics. Our producers are Devin Robbins and Dana Bialik. Our executive producer is Ellen Horn. Production and original music by Story Mechanics. Pandemic Economics is part of the University of Chicago Podcast Network. I’m Tess Vigeland.

EDUARDO PORTER: And I’m Eduardo Porter. Thanks for listening.