In Part I of my 2009 Outlook series, I wrote about how the US's current economic policy framework is driven by a reaction to the Great Depression, when the old policy framework that favored producers, lenders and exporters collapsed into deflation and shrinking world trade. The policy mix since that time has been designed to favor consumers, borrowers and importers and has been embraced by both parties in different ways. The result has been a promotion of consumption at the expense of savings, a build-up in US indebtedness, and chronic trade deficits. In Part II, I discussed the link between a rising dollar and trade deficits, between trade deficits and a rise in overall indebtedness, and between dollar decline and foreign currency manipulation.
Ideally, an economic policy mix would balance the needs of consumers and producers, importers and exporters, lenders and borrowers. Unfortunately, that is not how politics work. People build up their biases over their lifetimes and they don't let them go easily. Also, we have a peculiar political situation in the US currently, in that the GOP has a traditional policy platform that favors producers and lenders, but those economic policies tend to favor the "blue states" in the north and west coast. The Democratic Party traditionally promotes the interests of borrowers and consumers, but those policies actually favor the economic interests of the "red states" in the South, Rockies and Great Plains. The only economic policy that has retained its traditional regionalism is trade, with the south favoring free trade more than the north. This policy confusion stems from the parties' gradually switching regions from the late 1960s to 2000, when the Red State-Blue State realignment was completed under George W Bush.
In my first two sections I focused on what should be done to fix the economy, which would be to stimulate foreign demand at the expense of US consumption, stabilize currency values, and take action to prevent US trade deficits, even running temporary trade surpluses to reduce our net debt. Of course it's actually more important to know what actually will happen. The people in charge of our economic policy…politicians, fed officials, treasury officials…have all been taught to fight deflation and support demand at all costs. That means large increases in the supply of money and talk of massive fiscal stimulus. These things ARE going to happen, so the important question at this point is whether the programs will work.
After much deliberation, I have come to the conclusion that the government "bailout" of the financial industry is vital and too small, and that the proposed financial stimulus program is unnecessary and potentially counterproductive.
Economic crises are always banking crises
Since the dawn of capitalism, every broad-based economic downturn has been caused by the same thing: contraction of banks' balance sheets. Banks are inherently unstable institutions because they are highly leveraged. They make loans, which are bank assets. They can post these assets as collateral to borrow from each other essentially ad infinitum, so that their assets can far exceed their equity capital. When times are good, banks get overextended by borrowing too much relative to their equity capital and by making overly risky loans. The economist Hyman Minsky described the process of the banking boom-bust cycle as moving from hedge finance (cash flows cover interest and principal payments) to speculative finance (cash flows cover interest but not principal) to ponzi finance (cash flows cover neither interest nor principal, and loans can be repaid only by selling the asset at a higher price). The migration to ponzi finance was evident in the recent real estate and LBO bubble. When the bubble of ponzi finance pops, the cycle runs in reverse from ponzi to speculative to hedge finance. The reverse cycle means valuations (price relative to cash flow) need to fall until the yield is able to service both principal and interest payments.
The boom-bust cycle would be limited to the primary area of speculation and would not affect the broader economy if it were not for the highly-leveraged nature of banks. If a bank has equity capital equal to 10% of its assets, it could withstand losses equal to 10% of its assets before its liabilities exceed its assets and it becomes insolvent. Of course it's actually worse than that. If a bank started with a capital ratio of 10% and the value of its assets fell 8%, it would have a capital ratio of 2% and for all means and purposes be insolvent anyway, because depositors would remove their money from a bank with such a small capital base. Undercapitalized banks feel the need to sell assets to raise cash and meet depositors' demands, which of course depresses asset values even further and causes more forced selling. Back before the Depression, this would cause banks to collapse, which would wipe out customers' deposits. The vanishing deposit accounts amount to a contraction of the overall money supply, which leads to price deflation. The New Deal financial reforms were designed to prevent deflation by breaking banks up into smaller, more specialized entities that would trade high levels of regulation for the benefit of being able to maintain relatively high leverage.
The above chart from the Economist is forecasting that new regulations will force commercial banks to return to pre-Depression era levels of capitalization. For this to happen, however, either banks' assets would have to decline by 33% relative to the same equity base, or bank's equity would need to increase by 50% relative to the same asset base, or some combination of the two. That would be difficult enough if it was not for another large wrinkle.
The decline of the "shadow banking system"
As commercial banks tottered through crises in the 1980s (Latin American lending, the S&L crisis, the LBO bust), a new, parallel financial system arose that has been dubbed the "shadow banking system". Financial innovations like the money market mutual fund, commercial paper, asset backed securities, structured investment vehicles, derivatives, credit default swaps, collateralized debt obligations, credit hedge funds, and prime brokerage services allowed for the creation of a huge lending function performed by the securities markets and off the balance sheets of traditional commercial banks.
The changing mix can also been seen in this chart I once found (apologies to the authors…I can't remember where) that shows the balance sheets of various sectors of the financial system prior to the financial meltdown.
Here it's clear that the financial intermediaries in the shadow banking system (brokers, hedge funds, GSEs like Fannie Mae and Freddie Mac) are the ones that behaved particularly irresponsibly. At 30:1 leverage, if your assets fall only 3% in value, you are wiped out…which is exactly what happened. Since that time, the federal government has seized the GSEs and the commercial banks have absorbed the balance sheets of the brokers. In addition, the commercial banks have added around $500 billion in loans as commercial paper back up lines were called in and the entire structured investment vehicle universe was shut down. That means commercial banks, before the effect of write-downs in the financial crisis, would have had assets of $16,690 billion, liabilities of $15,419 billion and equity capital of $1,271 billion, or leverage of about 13.1 times equity or a capital ratio of 7.6%. If we include savings institutions and credit unions on the banking sector balance sheet, we arrive at assets of $19,352 billion, liabilities of $17,765 billion and equity capital of $1,587 billion, or a capital ratio of 8.2%.
Economist Nouriel Roubini of RGE Monitor (www.rgemonitor.com) has estimated that US banking losses and write-downs in the crisis are likely equal to $1,800 billion. (For the record, Mr. Roubini has been one of the most prescient observers of the financial bubble and subsequent meltdown.) That means assets contract to $17,552 billion, liabilities remain at $17,765 billion, and equity capital becomes negative $213 billion. Just to return the banking system to adequate capitalization of 10%, the banking system needs nearly $2 trillion of total equity injections. So far, there has been $350 billion from the TARP, another $100 billion or so in private and sovereign wealth fund capital and another $350 billion in TARP II funds just approved by Congress (as long as it isn't wasted on trying to prop up housing prices). Maybe there has been another $100 billion in offsetting retained operating profits (I'm being real rough here, I don't know the data). Basically, the banking system of the United States needs another $1-1.2 trillion of capital injections, probably from the federal government, just to be adequately capitalized.
Shrink the stimulus, triple the TARP
Until banking system is adequately capitalized, no matter how much you spend on fiscal stimulus the gears of the economy won't catch (in a forward direction at least). Japan is a conspicuous example of this problem. Japan spent trillions on "infrastructure" spending in the 1990s, running their national debt to over 100% of GDP, with no natural economic expansion to show for it. While Japan's borrowing and spending on infrastructure was better than doing nothing, the country has been mired in a soft deflationary depression for the past two decades. Japan's "zombie" banks and corporations were propped up just enough to slowly work their way out of insolvency, but not enough to expand lending and borrowing. Now asset values in Japan are back to levels not seen since the early 1980s. In the United States, that would be the equivalent of retreating to the values of the early 1990s…think Dow 2,500 and S&P 300.
Besides, the problem in the US has not been a lack of demand, it has been an excess of demand driven by relentless expansion of the financial sector, prolific consumer spending and, at times, prolific government spending. Rather than try to prop up domestic demand at unsustainable levels, the government should instead focus on easing the effect of a decline in consumer spending by figuring out ways to shift the mix of demand to more domestic sources of production. Many of the items in the proposed stimulus package are worthwhile in this regard, and should be part of the long term government spending program. They just won't really stimulate the economy in 2009. If the money is borrowed from abroad, the offsetting capital account surplus will directly cause a current account deficit and be subtracted from 2009 GDP growth. If it is paid for by the Fed's printing money, then it is pure inflation. (I'll leave the rest of my discussion of fiscal policy to Part IV.)
The good thing about the TARP is that it is buying assets that can be monetized at a later date. The US government gets to borrow at 0-3% and purchase preferred stock that pays 5-10%. The banks, after they return to health, can buy back the preferred stock or it can otherwise be sold into the open market. In my view, the government should issue straight preferred with a dividend rate at the high end of that range. This would encourage the banks to repay the preferred stock as quickly as possible, without giving the current common stockholders a super-sweetheart deal when they actually deserve to be wiped out. Because the preferred stock will be repaid, with dividends, it gives the federal government a way to stimulate the economy without adding to the future debt of the United States or further debasing the currency. It would not, however, be great for existing bank common stock holders.
In addition to this capital overhang, I expect the Obama administration and the current Congress to clamp down on the financial system with a new regulatory regime. My assumption is that the regulatory regime will focus on systemic risk and managing bank capital ratios in a counter-cyclical fashion. It will also reign in hedge funds and risk-taking by banks. The golden era of finance in the US will be over, not to return for at least two generations.
The secular decline of finance
One consistent trend in the US economy since World War II has been the rise of finance. While the financial sector got beaten up pretty hard by the Roosevelt Administration in the 1930s and 1940s, it has climbed relentlessly since then. Financial debt to GDP has risen from 3% of GDP in 1952 to nearly 120% of GDP in 2008. The finance sector expanded its balance sheet faster than trend in the late 1970s, early-to-mid 1980s and late 1990s, all of which were major periods of innovation and expansion. While there have been many benefits to the rise of finance, it has also distorted the economy. The US government has practiced an asymmetric "socialism for the rich" with its policies of letting booms run and then fighting downturns by printing money to protect investors. In history, when nations over-luxuriate in the riches of high finance, they experience inflation, deteriorating terms of trade, a decline in the productive economy and high income inequality. It is not dissimilar to the effect of oil wealth.
I work in finance, but nevertheless feel that the US would benefit from a shrinking of the finance sector relative to GDP. I expect the new financial regulatory regime to effectively turn the banking system into a conservative oligopoly, which will dampen both asset and price inflation. This in turn will direct capital away from speculative uses like trading derivatives and gambling on real estate inflation. Capital will instead flow toward investment projects with more of a demonstrable cash-on-cash return on investment.
What does this mean for 2009?
I don't think that there is any way out of the general debt deflation until the banking sector is recapitalized with an additional $1-1.2 trillion. There may be some initial euphoria surrounding the stimulus plan, but it will likely be short-lived. There is no way to avoid a continued 15-30% decline in house prices in 2009, outside of hyperinflation. The auto sector needs to shed 20% of its capacity to be remotely viable. There will continue to be liquidations of retailers and large amounts of commercial real estate bankruptcies. The media and consumer internet sectors are saddled with overcapacity as well. The inventory-to-sales ratio has spiked, which will lead to continued discounting throughout the economy. Consumers will continue to increase their savings rates and pay down debts (as they should, economists be damned).
Until I see the TARP increased by $1 trillion, I will maintain a cautious stance, heavily overweighting short term treasuries, investment grade bonds and gold.
Next: Part IV – The recession's end is not near