Three Processes to Restore Sustainable U.S. Economic Growth
by Thomas Auchincloss. March 31, 2009Print
Recent media and financial market attention has been highly concentrated on the latest initiatives of Ben Bernanke and Tim Geithner. While such attention is warranted, these activities are addressing just one aspect of the bundle of ills that befall the economy and there are actually three processes that need to complete to a sufficient, if not ideal, degree to restore an attractive basis for long term U.S. economic growth. They are: righting the financial system, systemic de-leveraging and re-balancing the global trade and currency systems.
1. Righting the Financial System – This has clearly been the focus of Bernanke and Geithner, and evidence suggests that progress if not perfection has been made. However, a key element of correcting the banking industry that requires more effort on their part is getting the shadow banking system out into the light and neutralizing the derivative bomb. Because the amount of derivative exposure is so huge ($ hundreds of trillions notional and $ tens of trillions net) and because it is unclear who, besides AIG, is holding the old maids, extension of credit will remain restricted until the practical creditworthiness of institutions can be comfortably assessed. Part of this is a disclosure issue, which will be ongoing. Another part is a one time clean-up of the current situation.
There are other measures, besides dealing with toxic assets and liabilities that should be implemented as well. First, any institution too big to fail should be broken up or if it presents some other risk to the system, that risk should be regulated out of the firm. Second, leverage must be regulated in business lines that on a pooled basis present a systemic risk. Even if no one institution poses a problem, a large group of institutions that collectively over levers can also pose a problem. Three, incentive structures need to be changed to discourage looting behavior. It is perfectly rational for individual executives to originate or underwrite overly risky and poor investments when bonuses big enough to retire on are paid near the time of origination and long before the risks and hazards play out. 30 years ago, when most Wall Street firms were partnerships, a comfortable retirement depended on executives not putting their firms into jeopardy. Four, the captive relationship between Wall Street and Washington should be broken. Politicians depend on well heeled bankers to fund increasingly expensive election campaigns and bureaucrats look to the street for well paying jobs when they have done their time working for peanuts at an agency. The inevitable quid pro quo from this dependency has resulted in de-regulatory favors, looking the other way (even at times for criminal behavior) and outright payments from taxpayers (call them bailouts or toxic asset purchases if you will). Government cannot serve the general interest of the populace when it is captive to the players of the securities industry. One tell-tale on this issue is a lack of indictments emerging from the present crisis. When the internet bubble broke a few years ago, several executives went to jail. The current mess, which has arguably been created by even more egregious behavior, has generated a rescue response rather than a draw-and-quarter response, complaints about bonuses notwithstanding.
2. Systemic De-Leveraging – Not only does the financial system need to be righted from over-leverage and other ills, but also the consumer sector, which is the major driver of the economy, needs to de-lever. Hedge fund manager Ray Dalio’s notion of a D-process seems right on the mark here. Years of easy credit for mortgages, auto loans, credit cards (under the guise of financial innovation) fueled purchases beyond what was possible with household cash flow (i.e. take-home pay). False perceptions that increases in wealth due to rising home and equity prices were permanent lured people to spend more than they had earned, reducing the national savings rate to 0%. To a lesser extent, the industrial sector needs to de-lever as well. A surge of cheap credit fueled a buyout boom, and there are several good businesses bought by private equity firms that are carrying too much debt. The extent of systemic leverage and how it has evolved is illustrated nicely in the chart below.
Asset values and the debts monetizing those assets have to return to a sustainable balance that is supportable with cash flow (ideally also recognizing requirements for future off balance sheet liabilities such as retirement). As Dalio has noted, this is a process not an event. Over the years, through the money multiplier effect, increasing leverage has been a significant driver of economic growth and thus systemic cash flow. With the tide going out, we are now in the difficult part of the cycle where the money multiplier works in reverse. That is falling asset values require reduced debt which reduces cash flow which further reduces credit which hurts asset values more and so on.
An interesting aspect of this process is the role of government. In order to reduce the pain of this process and perhaps to slow it down to a pace that can be managed (as an alternative to a collapse), the U.S. government has embarked on a process of transferring debt from the private sector (the banking system and consumers) to the public sector. Thus through bailouts, which allow financial institutions to settle debts, and outright purchases of mortgage backed securities by the Fed, government has been assuming a portion (a sizeable one actually) of declining leverage elsewhere in the economy. Furthermore, through transfer payments such as welfare to the unemployed, the government is braking the cashflow effect of the deleveraging process. It is clear though, that this is ballooning government debt (by some estimates currently on the order of $750,000 for a family of four) and that limits may be reached. If the federal government needs to go through a D-Process of its own, the implications will be significant. Rising treasury rates, a falling dollar either to other currencies and/or precious metals and surging tax rates may all be fallout from this in the future.
3. Rebalancing the global trade and currency systems – While the two processes above appear to be underway in varying degrees… and with varying competence… the process of reforming the trade and currency system appears yet to begin. While the globalization of trade over the last 20 years has clearly been beneficial to the parties involved (particularly those countries who have raised unprecedented numbers of citizens out of poverty), it has taken place in a less than perfect system. In the ideal of a free and fair trade system, markets and prices (including currency exchange rates) function so that economic forces (a la Adam Smith’s invisible hand) allocate resources to their most productive uses in a fashion that leads to long run balances of trade between participating countries. While there are degrees of freedom in the current system, there are also a host of structural restrictions that inhibit free market processes in ways that provide certain significant favors to various parties. There is a reason World Trade Organization rules and other “free trade” agreements are tens of thousands of pages long. They are actually not “free trade” agreements but “negotiated trade” agreements. Consequently, economic laws that naturally regulate supply, demand, pricing and other variables to achieve balance are constrained and influenced by the arbitrary rules built into the system.
Underpinning the trade system is the world currency system, which also has some imperfections. In a more ideal world, currencies float in value relative to each other and in doing so, they help signal important adjustments to economic activity so as to maintain balance. The existing system, which reflects the Bretton Woods Agreement of over 60 years ago, inhibits this ideal. While currencies do float in value, the U.S. dollar is established as the world’s reserve currency, which provides it some preferences that distort its value relative to other currencies. Furthermore, countries operating within the system, such as China, have been allowed to peg their currency values to the dollar, which has distorted those values not only against the already distorted value of the dollar but also against the various un-pegged currencies.
The consequence of structural flaws in trade agreements and the currency system have led to extraordinary imbalances in trade, which has divided the world into surplus economies and deficit economies. The current state of affairs is unsustainable. The question is whether the requisite changes that must be made can be achieved cooperatively or if the systems will be allowed to break down in catastrophic fashion before a new order can emerge. If the rhetoric between China and the U.S. is any indication, tensions are rising to a point where the stage may be set to implement change. Hopefully, talks and deals can be struck productively while avoiding trade wars or, worst of all, military war. What is at stake here is difficult to underestimate, and the political will and craft required to achieve favorable outcomes will be extremely challenging. It is no wonder that this process is being saved for last. While the market’s exuberance of the last two weeks should be enjoyed by all who have profited from it, eyes should be clear that other forces are also at work and more “interesting” times are in store.
Copyright © 2009 Thomas Auchincloss
Short Bio – I am the former chief financial officer of two public U.S. biotechnology companies (Metabolix, Inc. and Vertex Pharmaceuticals). Prior to becoming a CFO, I was an investment banker for many years with Bear Stearns and PaineWebber.