The WaveNET Perspective

The Attempt of Desperate Central Bankers

2011-11-30T13:35:00.000-08:00

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Something strange happened today, November 30th. Six central banks standing behind six endangered banking systems -- where 4 of them (namely USA, Eurozone, U.K. and Japan) have never been so strained -- decided to act in unison.

They have all agreed to provide cheaper dollar funding to the European Central Bank - so that it can now provide cheaper dollar loans to cash-strapped European banks. What a show of solidarity!

Or, was that rather an act of despair disguised as magnanimity? We will certainly know the answer in a few months, or less.

In times like these it always helps to look at the facts and separate them from fantasy. With the exception of Canada and Switzerland (assuming the highly-debatable “non-contagion” as a premise) all other central banks are encumbered with national megabanks that are overleveraged and, in many cases, insolvent. In simple terms, that means that these banks carry liabilities that cannot be met from their current capitalization levels. Recapitalizing them through private equity appears, at this point in time, not feasible all over the world. Just ask Europeans or Americans for some pointers.

So, what do the governments that have presided over this situation do instead ? They ask their respective central banks to buy them more time by resorting to obscure and largely-suspect techniques neighboring in the realm of Quantitative Easing. How is that going to help them deleverage? Go figure.

Never mind that it has been tried twice already in the US with little to show for it, or that it has been tried in many other countries since the Great Recession -- including the euro zone -- with similar results. The Western Banking world seems to think that time heals all wounds. The funny thing is that I would go along with that axiom if it weren't for my conviction that “this time is different”. (sorry Professors Reinhart & Rogoff, no pun was intended on my part ..)

What is different this time around is that we have huge and intricately interconnected global banks, with trillions of Dollars or Euros in their balance sheets that can no longer be rescued by their national systems which had franchised them to exist in the first place. The empowerment system behind these banks is broken.

The “too big to save” cliché has now come to haunt the governments that have tolerated such huge banks to balloon under the nose of their very own central bankers. Relying on bank nationalizations as “insurance” doesn't apply here anymore, because these banks have outgrown the fiscal capacities of the nations that have warranted their existence. Welcome to the era of “incapable nations” in a very confused financial world !

At stake here is a country's right to have a banking system, with an adopted currency, as a proxy for its economy. What does sovereign debt mean if countries can no longer stand behind their banks?

What does sovereign debt mean in the euro zone where a single currency denoting economic integration contrasts with the fiscal disunion of its member countries ?
What does sovereign debt mean for Greece that has a government whose fiscal incapacity is blatantly obvious ?
What does sovereign debt mean for the UK whose banking assets exceed by 300% the nation’s GDP, making as a result nationalizations an unlikely rescue outlet in case of more trouble?
What does sovereign debt mean for Japan whose government indebtedness, long thought unsustainable, is still resting on an export economy with deflating demographics ?

There is one exception in this group grope that stands out: the USA. If its economy could be invigorated to create jobs and growth, then its government deficits may come under control faster than others. Its demographics and productivity are favorable, if not even enviable.

But that requires fiscal policies that compensate for the profligate monetary policies of the last 30 years. Without acknowledging that reality and taking corrective steps, its sovereign debt will be facing much of the same questions of those in the desperate line-up of sovereign nations.

The arrogance of lecturing Europe with the wrong lesson

2011-10-02T11:51:00.000-07:00

The month of October, this time around dressed in the clothing of the European Sovereign Debt Crisis, brings once again to the forefront fundamental questions on the future of western world banking.

Since 2007, what originally started as a “housing bubble” in the United States and the United Kingdom quickly became a widespread credit crunch; was followed in September 2008 by an unprecedented crisis of confidence in world’s banks, central banks and the governments behind them; was later succeeded – and still is – by sovereign debt worries for developed countries, while inevitably pointing to the next waves of uncertainty: exchange rates and global trade.

What was most noteworthy last week was the dismissive European reaction to the advice dispensed by U.S. officials for decisively embracing a much larger rescue fund comparable to TARP. Who can blame them? It isn’t like TARP worked magic: it simply bought more time without properly addressing the underlying systemic deficiency issue with banks which I have addressed in one of my previous articles here and for a more detailed version of it here .

The one thing everybody agrees on is that the Great Recession of 2008 was unlike any other experienced in recent memory: it was global (it touched every single country on the planet) and it was disastrous (with $35 trillion of wealth evaporated at its peak in March 2009). But there was – and still is — considerable divergence on what caused it, let alone providing a lasting solution. Unless they don’t care about credibility and the associated accountability, how can government officials anywhere recommend a solution to a largely misunderstood problem?

Pinning the problem on US subprime mortgages, as had been the immediate and impulsive explanation back 4 years ago, fails to explain how this financial disaster reached all the way to Russia in the ensuing year. After all, the latter had apparently no banks exposed to subprime or to other toxic paper: subprime mortgages were just a bad symptom and not the root cause.

The “mispricing of risk” argument proposed by former Fed chief, Alan Greenspan, did not address the dangerous role that the “shadow banking” system — the non-bank financial institutions that defined deregulated American finance — played in this debacle. They, and not the conventional commercial banks with deposits-based lending, are behind the $7 trillion “debt bubble” which erupted in the U.S. financial sector in the decade starting in 1997.

“The failure of laissez-faire U.S. capitalism”, suggested by the former E.U. President Sarkozy, does not illuminate how Europe’s largest universal banks were also equally devastated in 2008, and look even sicklier now that the sovereign debt problems threaten their very solvency.

It is now increasingly clear that the Great Recession of 2008 was rooted in world’s biggest credit surge in the recent history of banking. That surge, which happened primarily in the preceding decade, was facilitated by central banks in the western world – predominantly the US and the EU-- of which the Fed still is the largest and the most influential. Whether central banks led their supposedly regulated commercial banks into this binge, or were led by them, is still unclear; but that is another topic altogether and will not be addressed in this paper.

Instead, since sovereign debt is the current preoccupation, let’s focus on a question that has been around for a while without a definitive answer: have the Fed’s monetary policies help or hinder the accumulation of U.S. public debt now near the precarious level of 100% of the GDP?

The question has two components: a direct one and indirect one. On the direct side, it is important to recognize that government spending was nowhere near “bubble” territory between 1997 and 2007, the decade preceding the Great Recession. The Fed’s own statistics document that the tech bubble of 2001 and the real-estate bubble of 2007 were not accompanied by inordinate ramps in public spending; if anything, on a comparative basis, government debt did not keep pace with GDP growth in all these years.

The problem with debt “explosion” lied elsewhere: the private sector.

click on the image to enlarge

It was indeed indirectly and in the private sector --mostly banks, but also consumers -- that debt was allowed to rocket and outdistance GDP growth, in the years preceding the Great Recession.

Had the Fed pursued more consistent and disciplined monetary policies in the decade preceding the Great Recession, the bubbles of 2001 and 2007 could have been contained, preventing as a result the Great Recession and the Keynesian government overspending that followed it. The accumulated government debt is not a cause per se, but a consequence.

To summarize, is there a cause and effect relationship between the Fed’s lax monetary policies and the huge US government deficits that followed them? The answer is indirectly affirmative. But, it is perhaps as important to realize that central banks – whether in the US or EU – do not make legislation, especially on what is permissible leverage for banks and what needs to be way better regulated to prevent lending risks from being nationalized while profits are privatized.

Let’s hope that as we explore solutions to lingering problems that we are learning from past mistakes: in economics -- much like in medicine --prevention is vastly superior to rehabilitation, even if takes regulation to enforce it. But to get there, key concepts resting on the notions of “efficient markets” and “self-governance in banking” must be reexamined for their potential to misguide and undermine economic stability.

Saving Western World Banking from itself

2011-09-17T13:04:00.000-07:00

Following the third anniversary last week of Lehman’s calamitous bankruptcy, it is disheartening to see that most banks, central banks and governments on both sides of the Atlantic have failed to draw the most important lesson: financial crises cannot be controlled by increasing bank capitalizations alone if they are rooted in systemic deficiencies. We hear a lot about systemic risk from pundits and regulators, but not enough on systemic deficiency which is the root cause for the systemic risk to exist in the first place.

I define systemic deficiency as the inability to successfully react and adapt to a disruptive change in one’s environment. Extreme variations in temperature for example are known to cause certain plants to die because they cannot adapt to the disruptions. In the medical domain, another analogy is the immune deficiency syndrome. It is not only a systemic failure to recover, but is also contagious -- ironically, as is the case with interconnected global finance -- when in close contact. Furthermore, it cannot be cured with better nutrition, no more than a tropical plant can survive in the Arctic winter with increased irrigation, or an unstable banking system can outlast capital shortfalls.

I propose that we consider systemic deficiencies in banking as well. Overleveraging is the first symptom that comes to mind. That in the thick of the panic of 2008, certain banks in Europe were carrying assets 80 times larger than their equity capital ( vs. 10 to 12 as the historical norm) illustrates the extent to which balance sheet deformities had morphed into insurmountable obstacles. But there are others. My favorite one, because it is still the most controversial, revolves around financial supermarkets.

In the spotlight here is the notion of Universal Banking (as the Europeans call it) or Bank Holding Companies (as the Americans call them) allowing financial conglomerates to combine all sorts of banking services with a vast array of risk profiles, thinking that it is just a supermarket of sorts. That notion is dangerously misleading.

A supermarket is not allowed to sell firearms or toxic specialty chemicals for a simple reason: the collateral risks outweigh the economic benefits of sharing their distribution costs, not to mention that it would pose innumerable regulatory oversight problems. It would be so much simpler to designate specialty stores which can be better monitored for compliance and enforcement when the products involved carry the risk of misuse or abuse. The systemic deficiency here comes from trying to combine businesses with vastly different characteristics.

Why should finance be different? Products like stock derivatives and currency futures also carry elevated risks for misuse or abuse ( both by the client and by the supplier, as both the 2008 Société Générale and last week’s UBS debacles illustrate) and, as such, don’t justify commonality in the funding of their procurement, sales, distribution and management oversight relative to conventional banking.

Simply put, I believe that combining the deposit-driven, highly-regulated retail banking business with the equity-driven, challenging-to-regulate investment banking business produces a systemic deficiency, especially when operating as a transnational company with unavoidable cross-subsidies. The two “business cultures” are simply too incompatible to manage by the same management team without, at some point, imperiling the whole. And when the whole is too big and too interconnected, the contagion risk to endanger most if not all of the others is too big a risk to assume for any society, no matter how daring.

To be sure, the trajectories to financial supermarkets have been historically quite different on both sides of the Atlantic. In the US, up until 1999, the Glass Steagall legislation barred in the preceding 66 years cross-ownership of banks, securities firms, and insurance companies. That explicit legal separation between commercial banking and investment banking served the US well -- and the world -- all these years, providing for a prolonged era of stability fueling the post-WW2 economic expansion.

In Europe, by contrast, retail, commercial and investment banking were usually carried out together by large and established banks that saw their roles as one-stop supermarkets capable of delivering a vast array of financial services. In countries like Germany, U.K., France and Switzerland, the Universal Bank notion had always been the guiding principle for combining all sorts of financial services leading to concentrated economic power in the hands of a handful of large banks. Things worked out well until two discontinuities emerge and insidiously shook the business model at its foundation to create systemic deficiencies.

1. First was the love affair with equities. As equities became more in vogue for a traditionally conservative European consumer, so did the volume of stock underwriting, derivatives trading and other market-making for the European banks. Moving rapidly from the time-tested, comparatively stable consumer and corporate lending business to the higher-risk, higher-volatility world of equities --and derivatives-- was bound to change the nature and predictability of the banking business. (And change it did, across both sides of the Atlantic.)

2. Second, was the formation of the EU with a unified currency but with disparate legislations in the financial sector. As long as banking practices and regulations were managed by separate governments, that there would be over time bothersome differences emerge among members of the Eurozone could not have been a surprise. Even more important was the dissonance in fiscal policy: there was no shared “song sheet” on how governments intended to balance their public debt. A unified currency in a dissonant and unenforceable environment of fiscal discipline has now unequivocally proven to be a foolish experiment for testing the resiliency of banks, central banks and the sovereign countries that harbored them.

Three years after the Lehman implosion which saw over $30 trillions of wealth temporarily vanish inexplicably worldwide by March 2009, the eruption of the sovereign debt crises in Europe raises an unavoidable question: is Western World banking threatened to the core? As the globe waits impatiently for an answer, three remedial approaches are noteworthy.

· First is America’s financial reform under Dodd-Frank which grappled with the too-big-to-fail problem but succumbed to lobbyist pressures without really providing the needed clarity for actionable specificity. A notable exception is the “Volcker Rule” (named after the famous former Fed governor) which severely curtails a conglomerate’s ability to own entities that engage in unrestricted and lightly regulated activities -- such as hedge funds or private equity funds –- and also prohibits proprietary trading which exposes all ordinary shareholders to an inordinate level of undesirable risk.

As of this writing, it was disconcerting to see that there was still considerable political resistance for the adoption of the Volcker Rule in a timely fashion, if at all, confirming my fear that the most important lesson from the 2008 financial meltdown fell on deaf ears.

· Second is the Basel 3 deliberations to drastically tighten capitalization levels on all banks by 2019 but without addressing neither the source of funds (estimated to exceed $1 Trillion while being highly dilutive to existing shareholders) nor how would that address the above two discontinuities posing systemic instabilities. Basel 3 is a classic example of addressing the “are we doing it right?” question without first asking “is this the right thing to do?”

· Third -- and this is a big surprise -- is the approach in Britain to universal banking. In September 2011, the independent commission advising the U.K. government ended up recommending the structural separation between commercial and investment banking. Although it stopped short of a complete legal separation as in Glass Steagall, the “ring-fencing” of retail banking with the purpose of insulating it from external shocks clearly underscores their recognition of the inevitable need for structural reforms.

It is ironic that the systemic deficiency warning came from the country where banking is relatively the most concentrated in the world, and where too-big-to-fail is almost a euphemism for too-big-to-save. But, hey, why shoot the messenger? Finally one country has discovered that what I call the OMO Principle (for opacity, mendacity and obstinacy) in banking is self-destructive.

The British, in a totally understandable move of self-preservation, are pointing the way to the rest of Western banks that perhaps Glass Steagall wasn’t bad after all. The French have even a saying to denote the nostalgic impulse for humans to gravitate towards the well-understood: “plus cela change, plus c’est la meme chose.”

Could this be a new beginning?

U.S. FISCAL POLICY: a 30 YEARS PERSPECTIVE

2011-08-17T13:04:00.000-07:00

Data source : the US Congressional Budget Office.

The U.S. Federal deficit which was once successfully eliminated in the late ‘90s went through a shock with the Great Financial Crisis of 2008. By 2011, the gap between revenue and spending reached a record 10% of GDP.

U.S. FEDERAL GOVERNMENT REVENUES AND OUTLAYS as a % of GDP

In that timeframe, the level of interest-bearing U.S. Public Debt (in green below) almost doubled relative to its 30 years average.

U.S. FEDERAL DEBT as a % of GDP (Gross Public Debt includes intra-government debt)

Note that the ECB takes exception with the American way of accounting for the national debt and points out that the Gross Debt is the proper way of reporting public indebtedness -- a line of thought shared by a few prominent US economists including, among others, Carmen Reinhart and Ken Rogoff. By that metric, the % is already close to 100%.

Individual and Corporate Income Taxes, already on a declining trend with the Bush tax-cuts, continued their descent after the Great Recession producing as a result a total revenue base of 15% of GDP: a record low. Contrary to misleading lobbyist pronouncements, it is noteworthy that Corporate Income Taxes in the US -- already dwarfed by Personal Income Taxes by a 6/1 factor -- are now at record historic lows despite significantly improved business profitability and the backdrop of record unemployment around 10%.

U.S. FEDERAL GOVERNMENT TAX REVENUES ( by major source as a % of GDP)

The largest aftershock of the Great Recession was a spike in Mandatory Spending which helped cope with the unemployment crisis. Yet, record-low interest rates helped reduce the cost of debt-servicing.

U.S. FEDERAL GOVERNMENT SPENDING (by major category as a % of GDP)

But, with the size of Government Debt at record levels relative to GDP, these low and unsustainable interest rates do mask a large and destabilizing future threat:for every 1.5 % increase in interest rates, the government deficit as a % of GDP is poised to widen by about 1%. Unless proactively addressed by curbing the growth in budget deficits, the cost of servicing the public debt could seriously handicap future economic growth.

Total discretionary spending has now grown by 50% over its low-level of 6.2% of GDP, reached in 1999. Defense spending already galloping ahead with the wars since 2002 has been accompanied by a surge in Domestic spending, indisputably due to the still lingering nefarious effects of the Great Financial Crisis. Over the next 10 years bringing both Defense and Domestic Spending to about 3.5% of GDP each is doable if economic growth and job creation returns to normalcy , yielding $1 to $2 Trillion in cumulative spending cuts.

U.S. FEDERAL GOVERNMENT DISCRETIONARY SPENDING
(by major category as a % of GDP)

Total Mandatory Spending reached a record of 14.8% of GDP in 2009 mostly because of the unemployment benefits and other support programs to American people most affected by the Great Recession. On the other hand Medicare and Medicaid have now started to pose a structural problem with their alarming upward trend. While raising Medicare age limits from 65 to 67 for future beneficiaries, and slowing the increase in cost-of-living adjustments in Social Security are the most likely measures to be adopted, generating $1to $2 Trillion in total spending cuts over the next 10 years will necessitate tackling the intrinsically excessive cost of US HealthCare

U.S. FEDERAL GOVERNMENT MANDATORY SPENDING (my major category as a % of GDP)

WHERE DO WE GO FROM HERE ?

Spending cuts, although mandatory, cannot solely be the answer to the US Public debt problem.

· Immediate and deep cuts, whether Discretionary or Mandatory in nature, amount to austerity measures which will put an untimely damper on the already anemic economic demand.

· Since 2007, the assumption that the Private Sector could provide for the much needed long-term investments in creating new jobs -- and more taxpayers -- has proven to be largely illusory.

Furthermore, the Bush tax-cuts have also proven to harbor false expectations as they have neither bolstered consumer spending nor increased capital expenditures in the economy.Instead, with poor domestic demand, both contributed to enlarge the government deficit.

· These increase the risk that with renewed recessionary pressures in 2012 tax revenues could shrink once more, cancelling out the benefits of spending cuts while widening the deficit.

The US Public Debt problem needs as much focus on increasing revenue as on reducing spending:

· Tax revenues from Estate and Customs in the US are at historical lows: increasing them should be given no less serious consideration than curtailing Social Security or Medicare benefits.

· Revenue from corporate taxes is also at a historical low: instead of increasing them, there could be plenty of room to stimulate employment with a “use it or lose it” tax credit arrangement.

· As to individual income taxes, we have lots of empirical evidence over the last 30 years that the most robust economic growth -- whether under Reagan or Clinton -- took place despite significantly higher marginal tax rates. Consequently, starting with a reform of the Tax Code for eliminating all unneeded and unfair tax credits, focusing on revenue improvement is a must.

· Finally, creative schemes such as a VAT or something similar should not be ruled out either.

The US Public Debt resulting from these accumulated deficits unfortunately overshadows the fact that continued hesitation with fiscal rectitude cannot always be compensated with lax monetary policy. Simply put, the Fed is not the answer: it can no longer come to the rescue of political procrastination.

The danger ahead is clear: it would simply be devastating if the long anticipated growth in new jobs was aborted by a sudden jump in long-term interest rates affecting the cost of US Sovereign Debt.

The European experience of the last 2 years should serve as a “what not to do” in handling the incipient US Sovereign Debt Crisis: nothing is as risky in finance as gambling with lenders’ confidence.

Invigorating the “deficit nation” - Part 1

2011-01-20T18:16:00.000-08:00

The triple-deficit nation at the crossroads in 2011

The steady and substantial decline of the US dollar against most major currencies over the last 8 years is no accident. It is the result of a nation suffering from the triple deficit syndrome.

First, there is the public deficit resulting from budgetary shortfalls with our governments, whether federal, state or local. Estimated to exceed a disturbing 10% of the GDP in 2010 alone, the cumulative US Public Debt is now poised to surpass 90% of the GDP, including the still escalating liabilities in US Social Security and Medicare. Going above 100% is typically considered “high-risk” by the IMF for its potential to destabilize the sovereignty of nations.

Then, there is the trade deficit which stems from our imports dwarfing our exports. Now, that one is truly puzzling because, in theory, a depreciating currency should have made our exports a lot more attractive and help eliminate our trade imbalance. Not in our case: the Commerce Department reports that the US trade deficit is still projected to exceed 4 % of the GDP in 2010. These trade deficits, benign in the early 90’s, cumulated to exceed 60% of the GDP since then.

Finally, there is the current account deficit which measures the international flow of money resulting from trade and investments. Year over year, it feeds the NIIP (Net International Investment Position) to provide an indication of a country’s international standing. No good news there either : based on official 2009 data, America switched from being world’s largest net creditor in 1980 with 11% of its GDP invested internationally to becoming world’s largest debtor nation, with 25% of its GDP borrowed from other nations, notably China and Japan.

Countries with large negative NIIPs face the prospect of more wealth transfer to other nations just to service their debt, let alone finance their growth. Not a comfortable position to be in.

A few percentage points of the GDP leaking over here, a few more over there, it all adds up: the American economy must now grow well above the average of the last 30 years to compensate. A daunting task considering that globalization has now introduced unprecedented challenges.

As an example of how globalization has altered the predictability of conventional thinking consider this: despite a 40% decline in the value of the dollar against the euro over the last six years, its impact on trade has been inconsequential. The total US trade deficit was still stuck at a stubborn 4 to 6% of the GDP during that entire interval, demonstrating the complex interplays in a global economy where imports and exports depend on many things, not just pricing.

So, how did we become a “triple deficit nation” with a currency in chronic decline? Was the dollar sacrificed or, was its decline simply caused by grossly dissonant economic policies?

After all, realizing that in the history of civilization no country ever sustained greatness on the back of a persistently weak currency, what was the Administration thinking all these years?

Moris Simson, former high-tech executive who now heads a strategy consultancy, is a fellow of the IC² Institute at the University of Texas

Invigorating the “deficit nation” - Part 2

2011-01-20T18:04:00.000-08:00

The US Public Debt level: alarming, but controllable

Although it is clear that the US dollar has declined in value because of the continual triple deficits – in fiscal, trade and international investments – something still remains unclear: was the dollar sacrificed willingly or was that an inadvertent outcome? Besides, didn’t the US have appropriate economic, monetary and fiscal policies to counter the dollar’s persistent decline?

It appears not. The irony of the situation is that during the greenback’s long lasting slide we had appalling double-talk in the political arena: successive US Administrations declared that they were committed to a strong currency, yet delivered slowly but unmistakably the opposite.

Of the reasons cited for the erosion in the international value of the dollar, a prominent one is the level of US public debt: the result of continued government deficits which ended piling up.

Fortunately for the USA, it wasn’t always like that. According to the US Treasury’s data,12 years ago the level of public debt as a % of the GDP was around 60%; and in the early ‘70s it was at a memorably low of 40%. So there are good reasons to be hopeful.

It is clear that America needs to reclaim back its fiscal rectitude by combining inevitable spending cuts with some unpleasant tax increases. Neither is popular with voters, but both have long been waiting for transformative changes and not just incremental ones. Observations like “the country already has a high tax burden” and “the timing is wrong: we are in a recession” will only defer the unavoidable without addressing the problem. Yet, one thing is even more evident: without meaningful spending cuts fiscal rectitude is out of reach.

On the way there, shaking some of the dogmas away from our lawmakers would certainly help: no country can indefinitely tax its way into prosperity, no more than it can avoid insolvency by refusing to shrink its growing deficits. What is needed is a balance, but a balance nonetheless.

To be sure, ideological fixation with tax-cuts as the sole elixir for fiscal restoration – a controversial topic from the Reagan era with noticeably questionable impact in the recent Bush years – didn’t help much either. As Sheila Bair, the chair of FDIC, candidly observed in a recent speech that “ it is only over the last 7 years that the government debt doubled in size”, it is fair to point out that the recent deterioration in public debt did not happen from reckless overspending or political malice : a couple of unexpected events were mostly to blame.

First among them is the surge in defense and homeland security spending after 9/11 leading to the wars in Iraq and Afghanistan. Secondly, and more importantly, was the necessary and exceptional ramp-up in government spending following the Great Recession of 2008.

Adding the stimulus funding of 2008, the TARP (Troubled Assets Relief Program), QE1 and QE2 (the Quantitative Easing programs), the government has borrowed almost $3 trillion from the future performance of the American economy: an unprecedented spike in US Public Debt.

Despite the cacophonous partisan rhetoric and still lingering rancor, there simply was no other way to prevent an economic depression. The length and the severity of the present economic contraction, despite the emergency measures, prove that it could have been a lot worse.

That being so, there is still no reason to condone the public debt without examining the roles of monetary and fiscal policies in the preceding years: did the Fed truly help or hinder here?

Moris Simson, former high-tech executive who now heads a strategy consultancy, is a fellow of the IC² Institute at the University of Texas

Invigorating the “deficit nation” - Part 3

2011-01-20T17:53:00.000-08:00

Fed’s monetary policies: did they help or hinder ?

A question that has been around for a while without a definitive answer is: have the US Fed’s monetary policies help or hinder the accumulation of public debt now over 90% of GDP?

The issue has a direct and indirect component. On the direct side, it is important to recognize that there was no “bubble” with government spending between 1997 and 2007, the decade preceding the Great Recession. The Fed’s own statistics ascertain that the tech bubble of 2001 and the real-estate bubble of 2007 were not accompanied by inordinate ramps in public spending; if anything, on a comparative basis, government debt did not keep pace with GDP growth in all these years. The problem with debt “explosion” lied elsewhere: the private sector.

It was indeed indirectly and in the private sector --mostly banks, but also consumers -- that debt was allowed to rocket and outdistance GDP growth, in the years preceding the Great Recession.

This Great Recession was unlike any other experienced in recent memory: it was global (it touched every single country on the planet) and it was disastrous (with $30 trillion of lost wealth at its peak in March 2009). Moreover, most explanations were often dubious.

Pinning the problem on US subprime mortgages, as had been the immediate and impulsive explanation, fails to explain how this financial shrinkage spread all the way to Russia. After all, the latter had apparently no banks exposed to subprime or to other toxic paper.

The “mispricing of risk” argument proposed by former Fed chief, Alan Greenspan, did not address the dangerous role that the “shadow banking” system — the non-bank financial institutions that defined deregulated American finance — played in this debacle. They, and not commercial banks with deposit-based and regulated lending practices, are behind the $7 trillion “debt bubble” which erupted in the U.S. financial sector in the decade starting in 1997.

“The failure of laissez-faire U.S. capitalism”, suggested by the former E.U. President Sarkozy, does not illuminate how Europe’s largest universal banks have also been equally devastated.

It is now increasingly clear that the Great Recession of 2008 was rooted in world’s biggest credit surge in the history of banking. That surge, which happened primarily in the preceding decade, was facilitated by central banks in the western world – predominantly the US and the EU-- of which the Fed still is the largest and the most influential. Whether central banks led their supposedly regulated commercial banks into this binge, or were led by them, is still unclear; but that is another topic altogether and will not be addressed in this paper.

To summarize, is there a cause and effect relationship between the Fed’s lax monetary policies and the huge US government deficits that followed them? The answer is indirectly affirmative.

Had the Fed pursued more consistent and disciplined monetary policies in the decade preceding the Great Recession, the bubbles of 2001 and 2007 could have been contained, preventing as a result the Great Recession and the Keynesian government overspending that followed it. The accumulated government debt is not a cause per se, but a consequence.

Let’s hope that our Fed has learned its lessons well: in economics -- much like in medicine --prevention is vastly superior to rehabilitation, even if takes regulation to enforce it. But to get there, key concepts resting on the notions of “efficient markets” and “self-governance in banking” must be reexamined for their potential to misguide and undermine economic stability.

Moris Simson, former high-tech executive who now heads a strategy consultancy, is a fellow of the IC² Institute at the University of Texas

Invigorating the “deficit nation” - Part 4

2011-01-20T17:41:00.000-08:00

For the US Trade Deficit the US $ is not the problem

What about the US trade policy: did it help or hinder with the trade deficit? At the moment, our Administration believes that the artificially low Yuan is a problem.

Hence, it has been pressuring China to allow its currency rise in value against the dollar. Such a development, by making U.S. exports cheaper and Chinese imports costlier, is presumed to reduce the trade imbalance between the two countries, contributing as a result to close the US national trade deficit which has annually ranged from 4 to 6% of GDP over the last decade.

But, what if the whole ideology behind our trade thinking was flawed? What if, as most recent trade data suggests, the assumption of a cheap dollar coming to the rescue was an illusion?

Consider this: Between 1980 and 1985, following the Volcker interest rate hike, the dollar's value rose some 40 percent in relation to the currencies of major U.S. trading partners, but the trade deficit did not spin out of control as feared , as it peaked at only about 3% of GDP in 1985.

Conversely, between 2004 and 2009 the dollar depreciated by more than 30% relative to other major currencies -- notably Euro, Yen and the Canadian dollar—and yet the trade deficit still shot up (not down!) to reach a peak of 6% of the GDP in 2006. What happened to the theory?

The theory does not take into account three realities. Firstly, America’s trade deficit is the result of overdependence on two kinds of imports: petroleum and Chinese goods. Secondly, import demand is unlikely to lessen materially for either of these unless there is a large price increase in dollars. Thirdly, partly because China insists on maintaining exchange-rate stability with the dollar, the volume of US exports – the critical piece – changed little despite a weak greenback.

Instead of sharply focused Energy and Trade policies to stop and possibly reverse the overdependence on oil and China, the US emphasis has wrongly been placed on a cheaper dollar. It is surprising to see the indifference toward a cheaper dollar which could end-up importing inflation to the US while exporting deflation abroad resulting from goods and services now priced at an artificial discount, such as a Boeing airliner, an Intel chip or Google software.No, America’s response to the trade deficit should not have been to engage in commodity-like, price-based competition, but in innovation-driven, product-based competition.

Today most of the things that China, Japan or the EU import from the USA are higher-value, higher-margin products anyway: why reduce their price artificially with a cheap dollar unless it translates to a commensurate increase in volume? If Intel or Microsoft try to boost their exports to the rest of the world with a price-discount, that decision should be theirs, and not that of the government.

Also, even if China succumbed to the pressures and let its currency appreciate say by a sizeable 20%, this would only reduce the total US trade deficit by only about a tiny 6%, unless China also imports $200B of extra US goods. Simply stated, contrary to the current mindset, fixing the Yuan’s exchange rate will do precious little to solve the problem. The answer lies elsewhere: “fixing” free-trade -- in an asymmetrical world with no reciprocity -- is a better place to look.

It is increasingly clear the US did not get to be a triple “deficit nation” simply because of the way it taxes and spends its citizens’ money, but because of dissonant fiscal, monetary and trade policies over the last 25 years. Especially in the last decade, the profusion of easy credit led to financial overleverage everywhere, seriously destabilizing our banks and the economy until the Great Recession of 2008, urgently necessitating extraordinary government spending and unprecedented monetary stimulus by the Fed, further undermining the value of a dollar whose weakness did not help the trade deficits, sustaining as a consequence the rise in foreign debt.

This vicious circle must be broken. But if one thing is clear, the dollar is the victim not the cause.

Moris Simson, former high-tech executive who now heads a strategy consultancy, is a fellow of the IC² Institute at the University of Texas

Invigorating the “deficit nation” - Part 5

2011-01-20T15:50:00.000-08:00

For a change, try a stronger US $

Obviously we need better coordination in the US between our fiscal and monetary policies, but we must first recognize that we are stuck in the wrong paradigm: wealth reshuffling is not wealth generation. No amount of reshuffling resulting from adjusted taxes, reduced spending and Fed’s quantitative easing will produce sustainable economic growth, unless also accompanied by business or industrial initiatives stimulating wealth generation. The latter is about creativity and productivity, not about administrative or financial skill.

Also, it is not about whether we should empower more the public or the private sectors, but about discovering again that America prospered most when both sectors were in harmony 50 years ago. It is not an “either/or” proposition, but a “collaborative/together” approach that worked well in the past, and must be embraced again, to revitalize this country’s economy.

For the skeptics who don’t think it can be done, look no farther than the G20 economies after the Great Recession. What do the ones that bounced back first, like Brazil and South Korea, have most in common? It is a collaborative public/private economic model that works. The trick for the USA is to ensure that growth in the public sector will not outpace growth in the private sector. This is a politically contentious issue that should be addressed right from the beginning.

But, who should be in charge of making it happen in America?

Clearly it is the role of the President, the chief executive of the nation, and that of his team. Delegating the economic revival responsibility to the Fed alone, is overly naïve or delusional. Economic growth entails a lot more than monetary policy, although the latter can clearly help.

What can the President do then to eliminate the dissonant public policy practices of the past?

The trick is in finding a unifying, easily understood and willingly shared goal to guide our lawmakers while avoiding the paralysis of “gridlock politics” and “ideological dissonance”.

I propose focusing on a stronger dollar. If all policies, monetary and industrial, were attuned to help increase the value of the dollar, there would be no political bickering on the purpose and the interpretation of the goal. It is readily measurable and highly visible for all to see. Besides, the foreign exchange market would serve as an unbiased and responsive referee.

First in line is the Fed whose mandate needs to also encompass the stability and strength for the currency. Intentions alone don’t suffice anymore; results are needed rather urgently. Besides, how can domestic inflation stay contained with the dollar falling uncontrollably?

Then, the US public debt which has outpaced the rest of the world (see chart sourced from ECB) must be brought again under “adult supervision”. It is high time we realize that deferring the inevitable is not a cure: both strategic spending cuts and selective tax hikes will be needed to curb and reduce the US public debt. Hoping that only one of them will suffice is delusional.

Lastly, and most importantly, is the public/private collaboration for economic growth and revival. Without that, America will be misguided that it can again be a viable global competitor.

There should be no illusions here: a “strong dollar policy” will create winners and losers among companies that depend on trade. But all policies involve trade-offs, by definition. Yet, the rationale behind the shift should be to encourage America to focus its competitive zeal not on the low-price but on the high-value of its exports, like in high-tech, aerospace and software. A cheap dollar extracts less value from USA’s leading R&D and treasured innovations, not more.

Orchestrating toward a stronger and a more stable dollar promises not only better harmony across evolving economic and industrial programs, but also the possibility to accelerate the tempo, as required, in the effective promotion of innovation, entrepreneurship and competitiveness: the most vital elements behind job creation and national invigoration.

Moris Simson, former high-tech executive who now heads a strategy consultancy, is a fellow of the IC² Institute at the University of Texas

2009-09-21T15:58:00.000-07:00

Why forgetting the Great Panic is not acceptable

Only 6 months ago, at the peak of the financial crisis, the world witnessed well over $30 trillion of its wealth disappear inexplicably. That came as a surprise to just about every banker or regulator, as none of them believed a general contraction of such severity was possible for our planet’s free-market economies.

Ironically, the real surprise is not that it happened, but that we still don’t know how it happened. Governments and economists everywhere are still perplexed as to how the global financial system sunk so deep and so fast. As the G20 nations prepare to discuss new banking regulations in Pittsburgh next week, the most critical element is still missing: consensus on the reasons behind the crisis. Without that, how can global regulations exist, let alone be effective?

But politics is a funny business: comprehension is always secondary to pleasing. It seems that debating compensation caps on bankers’ pay is more newsworthy than exposing the more complex reasons behind the panic, still shrouded with disbelief. Besides, with many of world’s stock markets now near euphoria, as manifested by their 30 to 60% rebounds in 6 months , why spoil the party? “Selective amnesia”, or the ability to choose not to remember that we still have many unanswered questions, is more comforting for most, even if temporary.

Yet, euphoria and amnesia form a strangely perverse blend: the more they mix, the more they feed on one another, until their combination is no longer possible. The excitement of euphoria, which is usually focused on the future, cannot co-exist with the embarrassment of amnesia, which is concerned with the past: until and unless reconciled, their combination is an unsustainable proposition.

Elusive causes and misconstrued effects

Anticipating that sooner or later some of these unanswered questions will surface again, revisiting some of the problems perceived to be behind this economic crisis, presents a fertile platform for reflection and learning. Let’s review some of them.

Pinning the problem exclusively on the U.S. subprime mortgages is naively biased, as it fails to explain the severity of this global economic contraction, reaching all the way to Russia. After all, the latter had apparently no banks exposed to subprime or to other toxic paper.

The “mispricing of risk” argument proposed by former Fed chief, Alan Greenspan, does not address the dangerous role that the “shadow banking” system — the non-bank financial institutions that defined deregulated American finance — played in this debacle. They, and not commercial banks with deposit-based and regulated lending practices, are behind the $7 trillion “debt bubble” which erupted in the U.S. financial sector.

“The failure of laissez-faire U.S. capitalism”, suggested by the former E.U. President Sarkozy, does not illuminate how Europe’s largest universal banks have also been so devastated. It is now widely acknowledged that, beyond the venerable U.S. investment banks – most of which could not survive - the practice of overleveraging was alive and well on both sides of the Atlantic : banking conglomerates like UBS, Deutsche Bank, RBS and Barclays, to name some, were keeping rivals like Bank of America, Citigroup and JP Morgan in good company.

It is increasingly clear that this economic crisis, although triggered by the US subprime mortgage problem, has its roots in world’s biggest credit surge in history. Simply put, many financial institutions everywhere have been allowed to create and lend a lot more money than reasonable, finally disrupting the delicate global balance.

Are there any lessons to be drawn ?

Well, who is it precisely that allowed this to happen: Governments? Central bankers? Regulators? Management? If lawmakers worldwide are expected to devise and implement lasting solutions, the answers cannot be ambiguous. It is in this spirit that I would like to point out three areas from which lessons must be drawn before attempting to craft new rules or regulations.

The first one is on the role and impact of an accommodative monetary policy. For world’s central bankers, that financial assets were ballooning away could not have been a secret. According to the Federal Bank’s own records, from 1997 to 2007, the US financial sector’s debt grew much faster than GDP to exceed $16 trillions. And, that is only part of the problem. Recognizing that the U.S. accounts only for about 20% of world’s GDP, the corresponding global excess scales up from there to more scary heights. Enough to make even those central bankers defying acrophobia take notice.

So, what have learned from this: should world’s central bankers avoid using cheap credit to prevent debt bubbles from forming? Most likely, but not without understanding the merits and pitfalls of the opposite force: expensive credit. As remarkably demonstrated by Paul Volcker in the past, independent tight monetary policy is salutary in curbing speculation and control inflation, but how will that play out now in a global scene where interdependence is the new norm? Can any large country now modify its monetary policy independent of the ramifications that it might have on its major trading partners and the valuation of its currency?

The second area for examination is the creation of debt overdose. Although much has been said about the U.S. investment banks and their pushing the capital-ratio limits beyond 30 with exotic and risky derivatives, this was not an exclusive practice. Over-leveraging was also eagerly embraced by Europe’s largest banks, known as universal banks. Whether it was because of their regulators who could not rein them in, or because of their management’s insistence that they should be exempt from capital limits, no one has so far claimed responsibility, let alone accountability, for what has now proven to be serious errors of judgment.

So, how can we introduce more regulations without understanding what should be a “permissible” leverage for financial conglomerates? If governments must stand behind entities “too big to fail”, then they have a duty to determine how much risk is reasonable to assume on behalf of their taxpayers money. The irony is that, contrary to recent arguments by some banking executives, this is not interfering with capitalism, but safeguarding its survival and prosperity.

The third area is on the governance model of publicly-held megabanks.Come to think of it, in these troubled megabanks, who or what was in charge of supervising the disproportionate allocations to real-estate, high-risk lending for oversized takeovers, off-balance sheet opaque bookkeeping and, finally, allowing a compensation system that begets uncontrollable risk taking? The answer is clear : their corporate governance system. Whether it is called a Board of Directors in the US, or a Supervisory Board in Europe, this is the place where the validity of the strategy, the accuracy of accounting, the quality of the performance and the adequacy of executive pay are supposed to be objectively and regularly assessed.

Yet, it seems that in the financial sector oversight has been divorced from accountability. Allowing high leverage to associate so closely with executive compensation — leading to dangerously destabilizing excesses on both fronts— points to at least malfunctioning, perhaps even regrettable corporate supervision.

Finally, one of the least understood lessons from the Lehman bankruptcy is the role of corporate governance vis-à-vis : a) shareholders - the purveyors of equity capital on whom banks depend to exist, more so than in any other business – and, b) the taxpayers -- providers of invaluable guarantees through government backing- , when things go wrong. Overlooking the pain inflicted on both shareholders and taxpayers while debating compensation limits on the so called “talent” that wrecked the system is neither reasonable nor constructive.

Learning from all three of the above areas will be critical in designing a more dependable and robust financial system. Failure to do so, as we have regrettably experienced last year, erodes confidence in banks, even among depositors, threatening capitalism at the core.

Moris Simson

2009-09-05T18:07:00.001-07:00

The pathology of debt bubble(s)

The global financial crisis, although triggered by the US subprime mortgage debacle, has its root cause elsewhere: global debt overdose. Most explanations focused on irresponsible debtors and careless lenders, whether pointing to excessive borrowings by consumers or even by entire countries, tell only part of the story.

There is another facet to this crisis which has remained shrouded in mystery: the steady and imbalanced growth in the indebtedness of financial institutions among G8 nations. That is where the most worrisome overdose occurred: one with lasting implications for global financial stability.
Simply put, some of these banks or financial institutions have been allowed to borrow and lend a lot more money than reasonable, disrupting, in the end, the delicate balance in world’s credit markets. The level of global wealth destruction in the 18 months following September 2007, the beginning of the crisis, is historically unprecedented: $40 trillion.

In September 2009, one year after the cataclysmic demise of Lehman Brothers -- which triggered the largest convulsions in this crisis -- the majority of that staggering destruction still remains unexplained. Who is it precisely that allowed this overdose to happen: Management? Central banks? Governments? Something else?

If regulators worldwide are expected to devise and implement lasting solutions, the answers cannot stay ambiguous. After all, there is a limit to invigorating wobbling economies with national or regional stimulus financings, no matter how long and for how much: sooner or later, taxpayers of countries most affected by this disruption deserve solid answers.

A nation’s total debt

That consumers in America and Europe were both living beyond their means, and that perhaps the average household debt should have been capped not to exceed 120% of the average disposable income, is reasonably well understood and documented.

But it weren’t just consumers and households enjoying the foolish comforts of living on borrowed money; most governments among G8 nations were on it too.

That brings us to the notion of total indebtedness of countries, which comprises not just the loans held by its consumers and households but also, the ones held by its businesses, farms, governments and all its financial institutions. Economists measure the reasonableness of a nation’s total debt outstanding by comparing it to the size and growth of its GDP. Much like a consumer’s capacity to finance his loans with his future earnings, the comparison to GDP provides some insight into a nation’s ability to pay down its debt over time, helped by total economic expansion and productivity gains.

The national debt outstanding of the USA is an interesting place to start. The most prominent creditor nation some 50 years ago, now the largest borrower in the world,has a total debt outstanding nearing 350% of its GDP.

Although this ratio is not as bad as for certain European countries, the irony still remains that over the last decade the world has witnessed a record acceleration rate in the debt burden of its wealthiest economy.

Left unrestrained, such acceleration has a number of disquieting consequences ranging from abrupt credit contractions to alarming currency fluctuations. As already witnessed over the last 2 years, these are all destabilizing and can have dire consequences.

So what is it about the USA that got its total national debt into a “hockey stick”?

Dissecting the US debt “bubbles”

While from 1997 to 2007 the US GDP grew from $8 to over $14 trillions a few things happened to the make-up of American total debt. Some of these are well known and understood, some others are less so. Yes, there were debt-bubbles in the US over that decade, but not everywhere. The chart below, derived from data form the US Federal Reserve, graphically and unambiguously tells the story of these bubbles.

Household and consumer debt clearly formed a bubble, as it outpaced growth in GDP by more than $4 trillion for a number of reasons. Chief among them was the availability of low interest rates which allowed increased borrowings for purchasing homes but, also, for consuming more as well. Reckless lending led to subprime mortgages that allowed home buyers, who would otherwise never qualify, feed the speculative housing boom which also inflated other forms of consumption. But all that is well known and understood.

Surprisingly, in the same decade, corporate indebtedness has kept pace reasonably well with GDP growth. Although it outpaced it a little bit, it was not by an alarming amount. Perhaps this is because of the 2001 stock market crash. Following the crash, businesses of all sorts and sizes had started to exercise more prudence. With the exception of construction and real-estate companies, credit was reasonable, especially among technology companies who learned the importance of having manageable debt loads.

What is less known, and even less publicized, is that in spite of negative press coverage, government debt (including Federal, State and local) has lagged behind GDP growth. Despite the war on terror and unexpected tax cuts, the fact remains that talk about government deficits at all levels has been more successful in the political blame-game than in stimulating economic vitality during that decade. But, that is another and rather complicated topic which we are not going to address here.

Without a doubt, the financial sector debt has delivered the largest and the most disturbing of bubbles to the US economy. Had it kept pace with GDP growth -- instead of galloping ahead uncontrolled -- it would have risen closer to $9 trillion than the $16 trillion it ended up surpassing in 2007. The result? A $7 trillion bubble in 10 years, from a sector which includes all the banks and savings companies, but, also, other financial institutions ranging from insurance companies to retirement funds. On closer look to Federal Reserve’s statistical data however, it is the country’s “shadow banking” system — investment banks, securities dealers, hedge funds, mutual funds, and all other non-bank financial institutions that defined deregulated American finance — that contributed to inflate this bubble to unprecedented heights, and not regulated banking. Whether we call it excessive financial leverage or easy and reckless credit, the results are the same: economic instability and dislocations.

To-date, we have heard rumblings about grossly inadequate or blatantly inconsistent regulations, along with mistaken policies of abundant money supply. We have also heard about the lack of parsimony in the American consumer culture and the need to moderate the temptations of a credit society.

But what we haven’t heard in sufficient clarity yet is: who was ultimately responsible for overleveraging in the financial sector? Allowing overexposure to real-estate, jumbo loans for gigantic corporate takeovers, non-transparent bookkeeping, and, perhaps most importantly, a compensation system that begets uncontrollable risk taking, all have more to do with poor corporate governance than with the shortcomings of regulations.

It is increasingly obvious that both are intricately linked and perhaps even inseparable, but how are we going to address the issues if we don't start by recognizing that the notion of self-governance in banking has failed shareholders, employees and, ultimately, taxpayers ?