Sometimes stepping back, taking a big breath, and looking at the basic picture reveals more important insight than anything else.
Such appears to be the case right now with the world convulsing over the partial collapse of it’s financial system(s). Articles and ideas are flying around the world. Major central bankers and an army of academics are calling for international reform under the overarching theme of “Macro Prudential Regulation.”
Large, multinational finance holding companies became hopelessly intertwined to the point where the failure of one or more staggered the entire system. Tremendous amounts of private and public capital was lost. Financial innovations, it turned out, contained severe flaws among which included an inability to be accurately priced as economic circumstances changed. This problem, among others, came close to shutting down the critical allocation of funds to enterprises of all kinds, in all places.
That initial crisis appears to have been averted in its worst form. But what remains is still a damaged and poorly functioning world financial system that is vulnerable to any further shocks. Common sense repairs are needed, and they must be implemented with all deliberate speed.
So let’s step back and make some basic observations.
Finance is an enabling business. It’s primary job is to efficiently allocate money (liquidity) to business, both public and private. Capital investment cycles are seldom steady. There’s an ebb and flow, with peaks and valleys. And in our modern world these cycles can be focused on one or more countries. One part of the world may have a tremendous need for capital investments, while another part of the world may languish.
Some history. The United States went through a tremendous capital investment cycle that began prior to WWI and continued after the war into the 1920s. It was a “golden age” where wage rates increased among labor as manufacturing innovations came one after the other.
But inevitably the cycle relented. Capital investments declined because little more was needed. In-place manufacturing just kept turning out product without much additional investment. Labor stopped gaining but the wealth for ownership continued to rise unabated. There appeared a widening “gap” between classes of wealth. A gap that, at the time, was little noted or understood.
The dearth of capital investment in the face of rising wealth creates problems, it’s now realized. Lacking enough productive investment opportunities, money searches for alternatives. In the 1920s it was the burgeoning stock market. Prices of these paper assets rose and rose creating a bubble that burst in the crash of 1929. Fortunes evaporated then, just as they have now.
It took a couple years, but the stock market crash eventually led to bank failures and a collapse of industry and global trade. The Great Depression ensued. Newly elected Franklin Delano Roosevelt declared a bank holiday and put the government on a path of radical change. With the unemployment rate in the mid-20s, the government became the employer of first resort. National programs of construction, from bridges and roads to parks and dams to art were government funded.
It was socialism on a massive scale. Just as is being done today, government back then stepped up and provided capital investments to a market where such investment had disappeared. Included in that investment were investments in labor and wages. One aspect of the programs was to push some of what was left of wealth down to the lower rungs of the income ladder, and therefore provide some life support for a wide range of industries, including those involved in consumer consumption.
While economic times remained hard compared to the 1920s, the efforts had dramatic effect. One was on unemployment, which dropped by more than 10% because of the government induced programs. The economy stabilized until 1937 when, under pressure from fiscal conservatives worried about government debt, FDR pulled in the spending causing the still fragile economy to plunge back into a severe recession.
The economy again began to recover as FDR took his foot off the economic brakes, but it wasn’t until the ultimate fiscal stimulus program (a totally socialist endeavor) of WWII that the economy truly recovered.
Fast forward to today. It has been documented that income inequality in the United States has been increasing for the greater part of two decades and accelerated after 2000. The top one percent of wealth went from roughtly 7% to more than 14%. And instead of a robust capital investment market the United States began shipping much of its manufacturing industries overseas in search of cheaper labor.
While capital investment in the United States languished in relative terms, the developing countries of the Far East, primarily China and India, were in the throes of a massive capital investment cycle.
But there are limitations in these countries on foreign capital investment. By tightly controlling this investment and manipulating currencies, China primarily but also India and other emerging Far East countries, dynamically pulled their economies forward with strong export industry growth. This wasn’t the advertised “free trade” but a solid example of the much older method of mercantilism. Importantly, the primary buyers of these products were Americans.
But in the United States, wealth was still being created and income was flowing up, not down the income ladder. Outside of one industry, that of finance, there was a lack of productive capital investment opportunities. And just as in the 1920s, this wealth searched wide and far for someplace to go, for alternatives.
Enter financial innovation created by the one industry growing strongly in the United States: Finance (at its height, this industry comprised more than 30% of GDP as opposed to a normal 7-8%). Using property as the underlying “asset,” both commercial and housing, but primarily housing, Wall Street designed securities, called derivatives, comprised of these assets. They were designed to mimic more traditional bond investments that normally provide a significant source of money for productive capital investment.
As in the 1920s, for a long while these underlying assets went up in price. There was a boom in liquidity as wealth from around the world rushed into these bond-like securities that promised the manna of all wealth preservation: Steady income and a safe return of principal. During the boom, as with all paper asset booms, leverage became common and the prudent boundaries on leverage use were discarded.
The inevitable happened. The underlying property stopped increasing in price and rolled over. A heavily indebted populace whose incomes had not kept pace with inflation found themselves unable to support debt that had become greater than their property asset. The derivatives market boom collapsed. Buyers disappeared. Within months trillions of dollars in what had been thought were safe investments evaporated.
International finance holding companies, the princes of the derivatives boom, teetered on the brink of collapse. Governments around the world, but primarily in the United States and in Europe, quickly moved to shore up the balance sheets of their biggest banks. It’s still going on and the process is being severely hampered because many of the derivatives are almost impossible to price. It turns out much of them become illiquid in extremis and, as a result, stubbornly weigh down bank balance sheets.
Mark Twain is famously credited with the observation that “History never repeats itself, but it ryhmes a lot.”
With FDR’s stimulus spending as a guide, the current administration of President Obama quickly received from Congress a $780 billion stimulus package, which is now just beginning to flow into the general economy. At the same time, Federal Reserve Chairman Ben Bernanke, often in concert with Treasury Secretary Tim Geithner, pumped liquidity into the markets, particularly into markets that service the business communities (such as commercial paper markets) and the property markets. Wherever the staggering banks withdrew their support, the government stepped in.
What is needed are more productive capital investment opportunities. Private industry is staggered. And much of what it has invested in capital, has been and continues to be, in foreign countries. Which leaves the government, just as in the days of FDR.
Fortunately, there are many areas where the government can invest. Unfortunately they exist because for the past 30 years the government has not been investing in the United States. The lack of productive capital investment opportunities arose, in no small part, because the US government ceased investing in badly needed projects such as energy reformation, public transportation, universal health care or pure research and development.
At days end, it is this investing which will lay the groundwork for real recovery. Private capital, once it recovers its balance, will join in this next cycle of capital investment. And like all such past cycles, part of that investment capital will benefit labor, which will help the recovery from the bottom up.
So what’s the take away? One, governments need to have steady, forward looking, capital investment programs. A strong government must continuously direct investment, public and private, into the nation.
Two, investment securities must have strong contractual relationships to underlying assets. As long as these direct relationships are uniformly maintained then pricing can be determined even in extremis, making a financial liquidity crisis less likely.
Three, large financial institutions probably need to be broken up into smaller, independent businesses. And a solid, impenetrable regulatory wall must be re-imposed between commercial bank deposits which are insured by government and all other financial services which should not gain any type of government guarantee, implied or otherwise. Without this change finance will continue to hold government hostage (regulatory capture).
Four, trade imbalances must be better controlled. In hindsight, the idea that the US economy could continue at the level of 75% of GDP coming from consumption is ridiculous. Warren Buffett has recommended an import certificate regime be imposed where trade balances between nations are kept in check. One thing is clear, the US can no longer afford to ship “mission critical” jobs and skill sets overseas. Fair trade between nation’s must replace what we have today.
Five, leverage must be strictly limited, particularly regarding commercial bank functions. And these limits should be imposed globally.
The devil’s in the details, of course. But an understanding of fundamentals, basics which in truth haven’t changed for centuries, is necessary. Otherwise, we’ll just be back here again.