more from Roach, the post-bubble era
Nov 15, 2002
Stephen Roach (New York)
The transition to a post-bubble era is daunting, to say the least. To the extent that return expectations of consumers, companies, governments, and investors were set during the days of froth, a rude awakening is now in order. That especially pertains to a wide array of contingent liabilities in the system – the funding of which was predicated on a pace of asset appreciation we may never see again. The resolution of this mismatch could well be the central challenge of the post-bubble era.
To oversimplify, assets are about today, whereas liabilities are about tomorrow. During the Roaring 1990s, financial assets – especially equities – were valued as if they would keep yielding bubble-like returns in perpetuity. The actors in the system became true believers in the legitimacy of these valuations. They established liabilities – such as pensions, retirement lifestyles, and debt-service obligations – that could only be funded if returns held to these new norms. The gap between assets and liabilities was presumed to be closed by a steady stream of reinvestment at high nominal yields. Few ever contemplated what would happen to this equation in a low yield environment. The asset-liability mismatch is all about the New Math of a low-return post-bubble era.
These mismatches are global in scope. They span borders, sectors, governments, and institutions. It is not easy to scale the full dimensions of this problem. A few key factoids hint at the enormity of the mismatch. Japan’s Financial Services Agency has just upped its estimate of the nation’s nonperforming bank loans from Y34 trillion to Y47 trillion. While still probably a serious understatement of the full extent of the problem, it nevertheless underscores the lingering inability of the Japanese banking system to intermediate the future stream of credit demands required to finance economic growth. At the same time, there are signs of distress building in the German life insurance industry; 20 of the country’s 118 insurance companies are already on a special watch list of Germany’s financial regulator and one researcher suggests that as much as one-third of the industry will fail over the next 3-5 years. Such a development would effectively devalue the stock of German personal saving. Moreover, much of Corporate America is still building in pension-plan return assumptions of 9% to 9.5% per annum into its earnings calculus – well in excess of the returns that can be expected in this post-bubble era. This points to a potential overstatement of earnings and shareholder wealth. According to Steve Galbraith, pension gains in the bull market had been contributing as much as $100 billion annually to "operating income" of the S&P 500. In this bear market, a reversal of comparable magnitude is not out of the question. Steve stresses that cash funding requirements of pension plans are considerably larger, possibly in the $200 billion range annually.
All of these problems have one over-arching characteristic in common – a markdown of current asset values in the face of an unchanged stream of future liabilities. An insolvent Japanese banking system, an impaired German life insurance industry, and an earnings-deficient US corporate sector all raise big question marks about future growth prospects in their respective economies. The same, of course, can be said for the unfunded pension liabilities of aging populations in the industrial world. Up until now, this has largely been a theoretical problem, something for the proverbial long run that has little immediate impact. But as bad luck would have it, the retirement of "baby boomers" has commenced at just the point when the post-bubble markdown of asset returns has occurred – making an already large pension gap all the more intractable.
Nowhere is that more evident than for American consumers, who have long been net lenders to the rest of the US economy. US Department of Commerce data show that in 2001 US households received some $1,091 billion in interest income, well in excess of the $592 billion they paid in interest expenses. In other words, household sector lenders have nearly twice the exposure as borrowers to the vicissitudes of the interest rate cycle. While low interest rates may help debtors, those dependent on interest income — especially aging workers and retirees — are hurt. For older baby-boomers (ages 55-64), my colleague John Scowcroft calculates that the median family currently has a negative net worth to the tune of $173,000; for the 9.6 million families in this cohort, that amounts to an aggregate shortfall of $1.7 trillion. Consequently, a post-bubble markdown of asset yields would only compound an already difficult asset-liability mismatch for this key segment of the US population.
It’s not easy to get a handle on the overall magnitude of these mismatches. Again, the anecdotes provide some hints. The numbers are huge, especially when it comes to pensions. Trevor Harris notes that in 2001 the total pension obligation for the S&P 500 amounted to $1.1 trillion. Moreover, a recent OECD study suggests that publicly funded old-age pension spending (i.e., state pension plans) for the nine largest industrial countries will have to rise by at least $350 billion between now and 2050 in order to keep benefits constant at current levels (see "Ageing and Income: Financial Resources and Retirement in 9 OECD Countries," 2001). These estimates are fuzzy at best – and probably far too low, according to Trevor Harris. Any such calculations are highly dependent on unchanged demographics and productivity of the work force. Longer life expectancy and lower productivity growth, for example, would significantly boost pension obligations. Conversely, pushing out retirement ages – a key focus of Germany’s reform debate – would lower pension obligations.
Nor can the cross-border ramifications of the asset-liability mismatch be ignored. This shows up most clearly in the extraordinary current-account disparities that have opened up in the world over the past decade. In particular, the funding of America’s massive current account deficit has led to ever-rising purchases of dollar-denominated assets by foreign investors. The International Monetary Fund estimates that 18.3% of all US long-term securities were foreign owned at the end of 2001; that works out to roughly $4.9 trillion in dollar-based assets held overseas, or 23% of the non-US portion of world GDP. By way of comparison, foreign holdings of US assets totaled just $1.5 trillion at the end of 1994, or only about 8% of non-US world GDP. During the bubble, foreign investors developed a voracious appetite for dollar-denominated assets and the sharply elevated longer-term returns they were presumed to offer. This "buy America" campaign was presumed to be a surefire recipe to help close the foreign asset-liability mismatch. That presumption is now drawn into serious question in this post-bubble era of lower returns. Needless to say, a decline in the value of the dollar from its present lofty levels would only compound the shortfall arising from the diminished ability of existing US assets to fund a future stream of foreign liabilities. Consequently, not only do foreign countries suffer from asset-liability mismatches of their own, but they have imported the American strain as well.
All this underscores the intertemporal aspects of the asset-liability mismatch. Liabilities are basically a given – largely determined by the unrelenting ticking of the demographic clock and the social contract between governments, companies, and individuals. While it is possible to buy some extra time – mainly through higher productivity growth and/or deferred retirement – there can be no escaping the endgame. To the extent that pension liabilities – both public and private – to say nothing of retirement lifestyles, have been based on unrealistic growth expectations, the asset-liability mismatch underscores a new set of macro tensions. The choices are rather stark: Either policy makers reflate in order to boost nominal returns, or aging populations accept a wholesale markdown of future living standards. My bet is with the former. Squeezing an ever-burgeoning class of retired workers is the stuff of political upheaval – an unacceptable outcome for the powers that be. By default, reflation may then be the only way to finesse the growing asset-liability mismatch. But even that’s a delicate balance. Reflationary efforts that go too far result in high inflation – an outcome that has an equally corrosive effect on individual lifestyles. In the end, it’s probably not that black and white. I suspect that we’ll probably see a combination of both policy reflation and reduced standards of living.
There is, however, one critical complication to the potential resolution of this mismatch – the limits of conventional policy to fix it. With risks increasingly skewed toward deflation, the odds of a reflationary tilt to stabilization policies are high and rising, in my view. It’s already happened in Japan. And now a similar drill seems to be unfolding in the United States – 525 bp of monetary easing and a four percentage point swing in the federal budget balance as a share of GDP over the past two years. There is good reason to believe that Europe will probably be next to join the anti-deflation brigade. One small problem is that these policies may not work. A lack of policy traction is the rule, not the exception, once deflation has taken hold. Japanese authorities have long been "pushing on a string." And there is reason to fear that a similar phenomenon might unfold in the United States; the three sectors where policy traction is most likely – consumer durables, residential construction, and business capital spending – have all gone into a zone of excess that may not be responsive to counter-cyclical measures. To the extent that reflationary initiatives simply don’t bite, the asset-liability mismatch would then have to get resolved the politically incorrect way – by tampering with the lifestyles of voters. That’s when the story could really get ugly |
