Nothern Trust Bank warns of major risks to the financial system.
Is The Financial System More Prone To "Capsizing" Now?
May 24, 2002
Years ago, pleasure sailboats were designed and built for seaworthiness. This was before at-sea
Coast Guard helicopter rescues, more reliable radio communication, Epirbs, and in-water
survival suits. In other words, if a sailor was caught in a storm, he could not count on the
government coming to his rescue in time to save his life. Rather, he had better have a
seaworthy craft under him if he did not want to pay a premature visit to Davey Jones' Locker.
But seaworthiness comes at a price - a price in terms of dollars, speed, and versatility. A more
seaworthy craft is built with heavy-duty materials, with a deeper keel, with more ballast in the
keel, and with less beam. Obviously, the heavy-duty materials add to the production cost of the
boat. The heavier ballast cuts down the boat's speed. The deeper keel limits your sailing to
deeper water. And the narrower beam limits the below-decks living space.
Today, skippers care less about seaworthiness and more about cost, speed, and versatility. I am
not sure whether this came about (no pun intended) because of improved government
search-and-rescue services, or whether improved search-and-rescue services came about
because of flimsier craft. But whatever the case, there is a greater chance of capsizing in a boat
built today as compared to one built 50 years ago.
I wonder if the financial system has not gone through a similar transition. That is, I wonder if it
takes less of a "storm" to capsize the financial system today than it did a couple of decades ago.
Chart 1 (inspired by Jim Puplava, Financial Sense Online, "Rogue Waves & Standard Deviations -
Part 1" financialsense.com suggests as
much. Notice that in the 1970s and early 1980s, it took a relatively large increase in the fed
funds rate to elicit a financial crisis. As the 1980s wore on, it took less a funds rate increase to
trigger a financial crisis. And, in the 1990s, especially the second half of the 1990s, it took even
less a funds rate increase to roil the system. Heck, even now, with the funds rate stable at its
lowest level in four decades, the financial system has having trouble staying upright.
Why might the financial system be more prone to capsizing? Could it be that today's financial
"sailors" are more interested in speed than seaworthiness? Could it be that today's financial
system has too little ballast, or, what is the same thing, too much leverage? Chart 2 shows that
total US nominal debt (nonfinancial plus financial) in relation to the total US nominal capital stock
is the highest in the postwar period, and has been climbing steadily since the early 1980s.
Chart 3
shows financial debt as a percent of the nominal capital stock. This percentage has moved up
steadily throughout the postwar period. But notice that in the second half of the 1980s and the
second half of the 1990s, there was a sharp acceleration in this ratio, as evidenced by the
5-year growth rates. The 1980s were the era of the leveraged buyouts; the 1990s were the era
of the leveraged buybacks. And, of course, over the past two decades, that eighth wonder of the
world, the one Alan Greenspan holds in awe, the financial derivative, came into its own. So, it
takes more and more financial debt (financial engineering and/or intermediation) now to support
a dollar of our capital stock. That's progress!?
Leverage is wonderful for the return on capital when the financial and economic weather is fair.
But, when a storm hits, leverage can quickly capsize a country, a company, or a household. And
this is where Commodore Greenspan of the US Financial Coast Guard enters. When the financial
seas start to get choppy, Commodore Greenspan comes to the fleet's rescue either by
restraining increases in the fed funds rate or by cutting the rate. The commodore knows that
today's financial fleet is the least seaworthy in the postwar period.
The weather is now starting to take a turn for the worse, as evidenced by rising inflation
expectations and a depreciating dollar. Commodore Greenspan already is rescuing some of the
flimsiest of boats by keeping a lid on the funds rate. But what if the winds start to howl and the
waves build later this year to the extent that Commodore Greenspan can't launch an effective
rescue mission? Only those craft with a lot of financial ballast are likely to survive.
Paul Kasriel
Director of Economic Research |
