A Sense of Unease as the Cycle Begins a Laborious Turn (posted 10/24/09)


Most economists now seems fairly confident that an economic recovery of global dimensions is taking place.  Indeed, much of the domestic data we follow has stopped declining and there are many series which have turned up at least slightly. The most notable exceptions are employment, which continues to decline, commercial real estate, and state and local government expenditures. As we are told by the optimists, employment is a lagging indicator, but as it continues to deteriorate it can be a heavy burden for any recovery to carry.

 The effects of cost cutting on operating leverage are showing up in better-then-expected earnings for dozens of major companies, lending credence to expectations of a quick return to past peak earnings when volume growth resumes. The question is when and how does volume growth begin.

 Mind you, there is still plenty of room for recovery just to get back to where we were in real GDP, industrial production, and profits.  At its worst, industrial production registered a 14.7% year-to-year decline, the steepest of the Post-War period.  It has now recovered a very slight 2.5% from its low point.  Capacity utilization, having dropped to the lowest point since the data started to be recorded, has risen only slightly off the bottom.

 States and municipalities (which employ more people than manufacturing) are in agony over declining revenues and increased demands for services. It’s only because of federal stimulus money going to the rescue that major disruptions in services have been avoided.  Higher taxes seem out of the question politically, but look as if they ultimately cannot be postponed.

 As we look for a slow recovery for the U.S. economy we must keep reminding ourselves that it’s a global economy we live in, and generally speaking it’s the developing part of the globe that is the best growth engine at the moment.

 Financial markets have become increasingly sure about a global recovery and its effects on corporate profits. But as I watch the optimism grow, and even as I accept the turn of the cycle, I have an unease, a sense that all is not right.

 I certainly share that view that with consumers deleveraging at a considerable speed, with unemployment still rising, bank credit still contracting, and capacity utilization very low, the recovery will lack vigor. But that’s not the reason for my unease.

The financial world has not been reformed.  Far from it.  The “too big to fail” firms have only become bigger as a result of governments’ moves to save them. Bernanke and the president himself have asked for an end to “too big to fail”. Just how we do that is quite unclear.  I am becoming convinced that any reform legislation should require that these financial giants be broken up into smaller pieces to restore the kind of healthy competition that any industry should have. If that’s not going to happen, then we need very strong oversight and regulation of the survivors. We can’t let them return to playing the same games that finally sent them to the taxpayer trough.

 When I read a Wall Street Journal headline that investment banks expect to pay record bonuses, I get mad.  Has nothing changed?  These firms are remarkably politically insensitive to flaunt their record profits in the faces of taxpayers and the body politic, seemingly thumbing their noses at the rest of us, including the millions who are unemployed because of the excesses created by these very same firms? Goldman Sachs may have paid back all the taxpayer money, but they might not even exist had not the federal government injected sufficient cash into AIG to allow that company to make good on its portfolio of credit default swaps.

 So far I see nothing in the way of seriously proposed reforms that is likely to produce real change in behavior. Naked short selling continues, and bear raids on a company’s stock, which brought many firms to their knees last year, are still possible. The uptick rule, which we lived with for more than 70 years should be reinstated. (This rule required any short sale to be executed only on a price uptick from the previous sale.)

 Global financial markets need a watchdog to oversee systemic risk, to identify it early and then prevent it from developing.  The IMF would seem to be a likely candidate, but we’re a long way from any program with real teeth. The capital structures of financial firms must be firmly regulated. Leverage and asset quality need strong oversight.

As a starter, we need a domestic overseer of systemic risk, but we seem to be mired in a turf battle that is slowing progress on this to a crawl.  The longer we tarry past last winter’s point of maximum stress the less likely we will see an effective agency put in place.

 In an earlier Musing I asked this question: If prolonged periods of stability sow seeds of their own destruction, what kind of seeds do periods of instability create?

 Over the past 60 years the U.S. has experienced 10 recessions.  As we navigated these periods successfully, that is, without ultra severe consequences or systemic collapse, business and financial markets became increasingly confident that depressions were both structurally unlikely and preventable by appropriate fiscal and monetary policy.  We also saw in the early 1980’s that monetary policy could successfully be used to kill inflation.  Each time an economic problem was overcome, confidence rose another notch, culminating in willingness on the part of financial institutions, businesses, investors and consumers to assume greater and greater risks.  Financial leverage at all levels finally exploded upward.

 So the answer to my question is that past periods of instability, as they were overcome, sewed the seeds of higher confidence in stability!

 Now, in this crisis we have seen government actions in dimensions far greater than anything in the past.  I wrote here last December that I thought the Federal Reserve had taken the possibility of a depression off the table. I think that has been proved correct. But what price are we paying? 

 The immense increase in federal debt gets the most attention. To be sure, the fiscal realities facing the OECD economies are daunting.  The future almost assuredly must include some combination of substantially higher taxes, higher interest rates, higher levels of private saving, and curbs on government spending on entitlements. A potent list of growth dampeners, to be sure.

 But additionally, have we created a dangerous faith in our ability to prevent depressions?  Does the fact that we have avoided a depression cause confidence to rise again?  Are we going right back to the same games that got us in this mess?                                                                                                     

 Looking at the remarkable comeback of the stock market one might think so. And given the spineless moves toward re-regulation and prevention of systemic excesses one has a legitimate right to worry.


4 Responses to A Sense of Unease as the Cycle Begins a Laborious Turn (posted 10/24/09)

  1. a.p.gibb says:

    if there are firms that are too big to fail[tbtf], they ought to be identified annually by the secretary of the treasury and the chairman of the frb, stating the reasons each was designated tbtf. any merger would require a review of the tbtf status of the surviving entity, before it is effected.
    tbtf firms should be required to hold higher capital reserves, and to pay higher rates of fdic/fslic/sipc fees, as applicable, than firms not so identified.
    a firm could relieve itself of its tbtf designation by appropriate divestiture or restructuring.

  2. J says:

    “Goldman Sachs may have paid back all the taxpayer money…”

    GS has not paid back all the taxpayer money. They have 22bn of TLGP debt outstanding, which was issued at a lower interest rate than they would have otherwise paid precisely because of the taxpayer guarantee! GS, JP (44bn outstanding) etc. continue to benefit from these ongoing taxpayer subsidies.

  3. Paul F. Miller, Jr. says:

    Thanks for the comment. I still maintain that all the taxpayer money has been repaid. The debt you refer to is NOT taxpayer money. It is a guarantee by the FDIC. You are correct in saying the rate being paid on the debt is lower than it would have been without the FDIC, but no taxpayer money was invested in these bonds. You might say that to the degree that the bonds are owned by taxable entities, the federal tax take on the interest is lower, but I think that’s pushing the point.

  4. J says:

    The FDIC is a government agency. One might respond that it’s financed by the banks, but it is ultimately backstopped by the Treasury, i.e. by the taxpayer. Bair has already proposed ‘borrowing’ from the Treasury. There is c. $300bn of TLGP debt outstanding. If a bank defaults, do you really think the rest of the industry will be sufficiently healthy to pay higher premiums to cover the cost of that default? And if not, who will cover the costs? Again, it seems the taxpayer

    The government’s approach to this crisis has in large part involved simply writing insurance contracts and hoping they never come due — exactly what AIG FP did. This, of course, is very attractive, because the ‘contingent liability’ is off-balance sheet.

    Thank you for your point on the federal tax take, I hadn’t considered that!

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