The story of the Fiscal Cliff on the Debt Mountain

There has been a lot of talk recently about the risks faced by the US economy if the Bush tax cuts were not extended into future years and were allowed to expire at the end of 2012. Their expiration would in effect be like a tax increase which, when combined with inevitable spending cuts, would create an economic vacuum, dubbed as the “fiscal cliff” by Ben Bernanke, chairman of the Federal Reserve.

Forbes magazine on their June 15^th issue went to quantify that the Fiscal Cliff could extract at least 3% from the GDP, triggering hence a recession.  It has unsurprisingly become a big political issue which is continually stretched in all directions in view of the upcoming election in November.

But, leaving politics aside, let’s look at the economics here: the Fiscal Cliff on that Debt Mountain is really an arduous escape route and not a suicide perch. Regardless of who is elected, economic realities dictate that government debt in the US starts dropping altitude instead of climbing to more treacherous heights. It is hard to imagine any American politician suggesting that we emulate what other imperiled countries in Europe did, and continue climbing the Debt Mountain.

Now, understanding how we got so high is a useful first step in charting a plan of descent from that mountain. It is generally agreed that the Bush tax cuts, Medicare Part D and, also, the unbudgeted expenditures associated with the two wars are largely the culprits.  But, what about the Great Recession of 2008:  has it played a role and, if so, to what extent?

It is difficult to cleanly dissociate all these correlated factors, especially in the presence of many others – such as the Fed’s decade-long lax monetary policies, or the record US trade deficits which have become endemic --  that have not even been mentioned as major contributors to the escalation of the US government debt. But recent IMF data points to an unmistakable message: since 2007, the burden of US government debt has alarmingly ballooned.  Only Greece and Ireland have done worse in a way of comparison when normalized relative to country GDP.

The Bush tax-cuts were supposed to lift the economy in a way such that the revenues from incremental growth would more than compensate for the reduction in government receipts.  That viewpoint was, and still is, tirelessly promoted by the renowned supply-side theorist Arthur Laffer for over 30 years.

Well, what empirical evidence do we still need to conclude that it doesn’t work ?  The US government pursued a lower-tax, stimulative fiscal policy well before and throughout the Great Recession  only to end-up with deficits which added an extra 51% of  its GDP in debt. To try a few more years to see if it finally might work is not the answer. Cutting spending levels and adjusting taxes is more likely to be it.

Granted, a lot of progress has been made with deleveraging in the financial sector. At the moment the US is 2 to 3 years ahead of Europe on that unavoidable path. But the total US debt load, private and public sectors combined, is still over 350% of the GDP, instead of being markedly lower by now. Shifting debt is not the same as shrinking it. Without shrinking it, expecting the economy to recover is wishful thinking.

Conversely, keeping government debt near 100% of the GDP and relying on more Quantitative Easing (QE) rescue-efforts is naïve, at best.  As the Fed Chairman Mr. Bernanke has repeatedly alluded and, more recently, his counterpart in the U.K. has explicitly said: “There is a limit to what monetary policy can hope to achieve”. 

But, hope makes for a rather poor remedy.  Let’s not forget that QE is just an unconventional monetary policy tool, and not the solution to the afflictions since 2007.  That view is also supported by Mr. Shirakawa , the central bank governor of Japan , the first country to espouse QE after their bubbles burst two decades ago: “QE just buys valuable time for mandatory structural changes, and nothing else.” he declared in a speech at the London School of Economics in January of this year. 

But, why has the US even embarked on QE?  Simple answer: to prevent bank insolvencies by supplying ample liquidity. By purchasing fixed-income securities from targeted commercial banks, QE bolsters the cash reserves of these entities while reducing their leverage which was unquestionably attributed to the Great Recession.  That injection of liquidity, combined with very-low interest rates for boosting bank profits, is supposed to avoid insolvency while also encouraging improved lending, so indispensable to the resumption of economic growth. To-date lending remains way below historic norms, especially to smaller companies.

Granted, five years later, other bank insolvencies like those of Lehman or Bear Sterns have been avoided, but structural changes are nowhere to be seen.

Perhaps, the best way out of our conundrum is to consider what Albert Einstein said:  “We can't solve problems by using the same kind of thinking we used when we created them.” Expecting that a QE3 relief-package or extended tax cuts could solve the problem are both orthogonal if not opposite to Einstein’s philosophy.

Investors beware : when --  not if -- Wall Street or the global capital markets decide that the time has come to descend from Debt Mountain the escape routes from the Fiscal Cliff will be a lot more arduous and painful than the ones that could have been voluntarily selected earlier. Just ask Greece or Spain for pointers.

Perhaps that’s what the former Fed chief Alan Greenspan called a “hard landing”.

Financial Fitness: A key requirement for a durable recovery

The Question from Greece

The month of March, marked by Greece's massive debt restructuring which averted a vastly destabilizing credit default, appeared to some as if a major obstacle to economic recovery was finally removed. Yet, for others, it served to refresh a still puzzling question for the world's rich countries: can economic recovery ever take hold on shaky financial foundations?

By shaky financial foundations I refer to the insolvency risks still faced by a few big banks and sovereign governments, despite enormous injections of liquidity by central banks everywhere.

The top 8 central banks of the world are now sitting on bloated balance sheets holding mostly fixed income securities in excess of US$16 trillion collectively, more than twice their asset-volume before 2007. They got there mostly by swapping cash for bonds -- courtesy of Quantitative Easing, or QE -- as they tried to bolster the reserves of commercial banks which were hesitant to extend essential business credit, afraid that a new wave of illiquidity would expose them to potential bank-runs.

The fact is that over the last three years, thanks to globally coordinated central bank intervention, an unprecedented mixture of record-low interest rates combined with the abundant  liquidity of QE has indeed bought most banks enough time to appease their insolvency fears. That was the good news. The bad news is that it did not eliminate them; at least not yet. As they say in the medical world: the operation was a success, but the patient must still stay under close supervision.

For banks, insolvency is not to be confused with illiquidity. The latter is running temporarily short of cash. The former is the chronic inability to predictably service a debt load stemming from inadequate capital-levels unable to support deteriorating asset quality. In this last case QE can’t be of much help. Greece is a poster child of sovereign insolvency that increased liquidity couldn’t rescue. And, for reasons to be detailed below, it looks like they won’t be the last either.


Revisiting the Great Recession

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 advanced economies, while inevitably pointing to the next waves of uncertainty: exchange rates and globalization.

Rarely have economic crises -- undoubtedly among the few certainties in life -- managed to confound so many people, in so many places, so much and so long. Yet, to everyone’s dismay, the thrill goes on.

To illustrate the range of damage, what was once hastily estimated to cost some $500 billion to the US sub-prime lenders has gradually evolved into recent history’s largest and most brutal financial asset destruction story, erasing 30% of world’s GDP at its low point in March 2009. This has occurred in a world where sophisticated computer models, hedge funds and innovative financial products were all expected to mitigate risks and better cushion the impact of shocks.

Three years later, having retraced 2/3 of these losses worldwide, “deleveraging” still remains as the only imperative for the developed world. 

Alas, it still appears elusive for each and every advanced economy as they have all tacked-on more public-debt to avert the nefarious effects of deflation. No advanced economy has yet won the battle against the “phobia of deleveraging” because of the inherent risks in curtailing, eliminating or even negating economic growth.

Moreover, since 2007, growth in government debt has eclipsed the reduction in private sector debt in just about every rich country, further deferring national deleveraging to a later time. Hard to tell political procrastination from electoral capitulation, but does it matter which? To use another medical analogy: the patient, who could not lose weight (or debt) despite being told it was a matter of survival, has pinned all hopes instead on “giving time yet another chance”.


The Financial Fitness of Nations

The Bank of International Settlements (B.I.S) which acts as the central bankers’ bank worldwide, was so concerned about the level of public and private debt accumulating in the developed world that in 2011 it undertook some pointed research in that direction. More specifically, it wanted to establish some thresholds beyond which the burden of debt would damage growth.

Their empirical analysis has established that public debt in excess of 85% of GDP puts a country at risk of default. In the same vein, it set the corporate debt threshold at 90% of GDP and the household debt threshold at 85%, for a total of 260% representing the total debt-to-GDP level at which growth is seriously hampered. (Curiously, they left financial sector debt out of their study. Whether it was because highlighting the reckless overleveraging in the financial sector as the primary culprit of the Great Recession would be politically too-hot to handle, or some other peculiar reason, remains a mystery.)

Then they go and document that some 30 years ago, in 1980, the weighted average of the total debt-to-GDP for all of the 18 OECD economies stood at 169%. Thirty years later, in 2010, that number had jumped to 306%, way above the 260% identified earlier as a “growth killer” threshold.

 For purposes of comparison, albeit empirical, let’s pick 10% below the growth-killer threshold ( it comes to 235%) as the number above which a county is no longer considered to be “financially fit”. Simply put, this becomes the maximum reasonable debt burden that a nation’s combined Private and Public sectors can carry. That, of course, needs to be supplemented with the exact components of that debt, national economic growth-prospects, competiveness, and demographic evolution, as they all provide for a more complete country-specific context in evaluating its sustainability.


First-pass Scoring

This preliminary look, will present the B.I.S. supplied information to do some comparisons, noting however a huge caveat: without including financial sector debt, this is like taking the patient’s temperature alone to evaluate his overall health condition – can be dangerously misleading.

At first brush on the snapshot below, two observations are appropriate: a) no single country is comfortably below the “growth killer” threshold, although Germany and the US are close; b) Greece and Italy look like they are better than most others, inviting immediate closer scrutiny as to why ?

Upon closer examination, with the 30 year history below, things look quite a bit different.


Firstly, Canada sticks out in the sample as a role-model for not letting debt outdistance GDP growth, closely followed by the Netherlands as another good example of restraint.
Secondly, Japan the outcast, redeems itself for having kept a relatively good lid on debt since 1980.

Thirdly, both Germany and the USA look like they are in a comparatively manageable position for reining-in their runaway debt loads.


On the other hand, Greece, Italy, Portugal and Belgium all clearly show signs of debt overdose, without even knowing if their financial sector exposures will further exacerbate their overall condition.


Finally, Spain, UK and France all share some “debt pains”, but it is not clear without a closer look if they should be admitted in our so-called “intensive care unit” anytime soon.




Second-level Assessment


Digging a little deeper to examine the leverage-levels in banking for these nations will prove to be a lot more revealing. This should not come as a surprise, because dissociating sovereign-debt problems from the credit capacity of a country’s own banks (as the first-pass scoring has done) is like disassociating the patient’s X-ray from his blood test results : largely inconclusive and potentially misleading.


However, our job is a little more difficult to do because Europeans and Americans present the data differently. In the US the Fed, as the central bank, periodically publishes the level of debt carried by the financial sector in its quarterly statistics. In Europe, by contrast, the ECB presents the total bank assets by country without explicitly reporting their debt-levels. They can be reasonably inferred, however.


In the US, the government has been unquestionably successful in deflating the financial debt-bubble that erupted in the last decade. From 2008 to 2011, financial debt relative to GDP has dropped from a treacherous 120% to a more realistic 90%. That was the good news. The bad news is that the gross public debt has climbed instead by almost the same amount, still leaving a total national debt-burden well in excess of

350% of the American GDP. Deleveraging at the national level is yet to take place in the USA: shifting the debt-load is not quite as shrinking it.

But the US is in a rather good spot: if its economy could be invigorated to create more jobs, then its government deficits may be curbed faster than other nations’. Its demographics and productivity are favorable, if not even enviable among all other OECD countries.

Yet, that will need fiscal policies that compensate for the lax monetary policies of the last 20 years. Without acknowledging that reality and taking corrective steps, its public debt will be facing questions similar to those raised against the European sovereign nations in crisis.

In Europe the situation was, and still is, rather precarious as financial debt clearly aggravates the prospects for a speedy recovery, even for Germany, assumed to be the growth engine. Let’s start with Germany.
With total bank assets north of 300% of GDP, financial sector concentration is about three times as much as in the US. Abstracting bank-leverage sustaining these assets from the German sovereign debt-capacity is simply naïve . As we have seen with the case of Dexia( Belgium) or ING (Netherlands), when so called “global banks” face insolvency, the rescue package doesn’t come from far away but from the national governments harboring them. So, the exposure of governments in the EU to outsized banks with vast global operations and assets cannot be simply dissociated form the public-debt capacity that has empowered them in the first place. That also applies to the leader of the pack: Germany.


France is clearly in the second best position in the EU with an overall profile not too far away from Germany’s, except for oversized corporate debt. This is fine. Of all the places debt could bulge in a country, the business sector is certainly where talented management combined with productivity could make a difference the fastest. South Korea is a vivid example of that.


Italy comes in as a surprise with a relatively smaller concentration in banking and hence a sovereign debt-load comparatively more shielded from another global banking crisis. This reinforces the prevailing view that Italy’s problems depend on lowering labor-costs and more structural reforms for reducing government deficits and, over-time, its sovereign debt-load. Italy is unlikely to be “Greece” anytime soon, especially with Mario Monti as its prime minister.


Spain on the other hand, suffers from two large disadvantages in comparison to France : a massive concentration in the banking sector making them susceptible to increased solvency risk and, a massive corporate debt-load at twice the GDP facing uncertain domestic demand resulting from a record 20% unemployment. Radical changes with a new government focused on labor laws and labor costs will help, but will it be enough to prevent getting worse is far from clear, as already manifested by their pre-announcement of missing their 2012 fiscal targets.


Portugal, already singled out in the first-pass as a problem case, only confirms the gravity of its situation with a relatively large banking sector that leaves little room to manoeuver.


Netherlands and Switzerland, understandably the two most active countries with financial reforms and bank re-capitalizations in Europe, are in comparatively good fiscal health: it helps!


Of all the countries in Europe, the United Kingdom stands alone on an island (literally) as the one with the most dangerous exposure to the vagaries of finance. Not only its consumer and business debt is comparatively large, but it also carries an inordinate level of foreign debt, four times the size of its GDP. The IMF recommends that external debt be kept under 100% of GDP, unless the country has a large trade surplus. If Greece has succumbed to runaway government debt, Britain’s largest challenge is its overwhelming exposure to the risks its banks carry.

The problem is that British banks are too-big-to-save, even after the reforms that have been proposed for segregating commercial banks from investment banks while ring-fencing them. The only saving grace for the U.K. is its independent currency which is free from the Euro “straightjacket”. Continuing to debase the Sterling, as has been the case for the last 40 years, does come close to gradual deleveraging but it affects all citizens, not just the overleveraged banks. This obviously reduces the chances of improving national prosperity for the once prominent world superpower.


Concluding remarks

No, it is not the disastrous bankruptcy of Lehman Brothers alone that wrecked world’s financial order. The damage, albeit serious and brutal, could have been better contained if the richest nations of the Western World had not seeded systemic instability through three mistakes: overreliance on lax monetary policies for economic growth, grossly imprudent fiscal policies and, last but not least, unclear accountability in the self-governance of the largest banks.


On second thought, it is not just a global financial crisis we have been going through, but the tremors of the remodeling of a new World Economic Order, with China leading the charge.


On the way to that new order it is important to realize that finance is not about the creation of wealth, but about its management. Wealth is created by matching capital with human ingenuity in the employment of productive labor. Over the last three decades those lines got blurred; wealth reshuffling got confused with wealth generation. These large "credit bubbles" facilitated excessive wealth-concentration and income disparities, encumbering the road to economic revival and dragging along unsuspecting governments into the untold traps of public-debt.

How will developed nations, currently saddled with excessive debt, rising unemployment and lackluster growth, will compete with developing nations in their quest for restoring prosperity will undoubtedly shape the first part of this century. Clearly, improved financial fitness through deleveraging is going to be a critical and necessary first step in that direction for all rich nations.


What is still unclear though is whether deleveraging can be realized without crossing paths with some deflation. If the answer is negative, then QE, although successful at preventing bank insolvencies, would have deferred the inevitable, delaying a durable recovery by a few years.


It is still too early to declare that the Great Recession is behind us.

The Attempt of Desperate Central Bankers

****************************************************

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

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

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

                                  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.