Where’s The Victory Rally?
“The plot is easy to read. The Fed has read it all along. The plot is as follows – American consumers MUST AT ALL COSTS CONTINUE TO CONSUME.”
Richard Russell, April 16, 2003
Does the US economy hate both war and peace? A number of market commentators, including the Fed chairman, had been suggesting that capital investment, consumption, indeed the stock market itself, were all being depressed by uncertainties that would vanish with a successful conclusion to the war, bringing a huge victory rally and a corresponding surge in consumer and business confidence. Why has this not happened thus far?
The war’s swift conclusion has obscured the ongoing challenges facing the US economy. The mixture of global security risks, post-bubble adjustment and unbalanced growth in demand puts into perspective the euphoria experienced by many in the immediate aftermath of the toppling of Saddam Hussein. While policy makers continue to assert that the world economy could, in principle, enjoy a strong and durable recovery, it is unlikely to do so without vigorous policy action. But even if we were to get the co-ordinated global reflationary policies now required, the Fed would still face unique challenges even after 3 years of a wrenching bear market.
Economists generally agree that central banks do not become powerless when short term interest rates hit zero (although the Japanese appear to be doing their best to disprove that notion). At the very least, however, the experience of Japan does suggest that the ability of central bankers to control events does tend to become weaker when economies loom on the threshold of such uncharted territory, especially in the absence of any sustained balance sheet repair which would render the relevant economic agents better positioned to respond to fiscal and monetary ease. In this regard, the Federal Reserve has a uniquely unenviable task, given the existence of a parallel financial system in America, which seems to operate outside the parameters of a classic banking system that could (in theory) be made more responsive to monetary control in some way.
It seems foolhardy to speak of engineering a recovery as efficiently as the American armed forces appears able to effect regime change abroad, given the country’s huge existing imbalances, the looming threat of debt trap dynamics, balance of payments crises, as well as the ongoing tendency of Policy to work against proper balance sheet repair and the resumption of private sector savings. If Japan can be described as a country in which a third world political system has been uneasily grafted on to a first-world economy then, thanks to the Fed, America risks becoming the first instance of a first world military colossus operating within the constraints of an economy quickly degenerating to third world status.
The brilliance of America’s new parallel structured finance system has been the wonderful dispersion of credit risk. The price of this new found resilience, however, is nothing less than an enormous Achilles heel – there is no means of controlling it. There is not even the possibility of properly assessing credit risk. Indeed, policy not only tolerates the most egregious forms of financial excess, but encourages it.
Because banks can bundle loans into CDO's and other structured vehicles and securitize them off their books, there is little return to credit analysis at the level of the commercial banking system. Because the loans are bundled, the insurance company, pension fund, or hedge funds buying these credit sausages presume some safety from diversification, and are able to write credit default swaps to further lay off default risk on trances they may not feel are sufficiently diversified. There is little return to credit risk analysis then in the second tier of financial intermediaries.
Even the counterparties in credit default swaps may feel so compelled to reach for yield in a low nominal default free interest rate world in order to meet their explicit or implicit return obligations to clients that they see no point to engaging in serious credit analysis. They may perceive they have no choice but to walk further out on the credit risk limb in order to deliver results, correctly perceiving if the branch begins to break, either their competitors will fall with them, or a central bank will deem them too big to fail, and nail the branch back up again.
This fatal flaw has now come to the attention of one of the chief architects of the new credit system, Peter Fisher, formerly head of SOMA at the NY Fed, and engineer of the LTCM bail out. In light of his recent statements, it would appear that Mr Fisher has undergone something of a Damascene conversion. He now recognises the checks and balances in the US credit system have been dissolved with the new structured finance system. Fisher has gone on record in a recent article in the American Banker in favour of putting the genie back in the bottle. Mr. Fix-it (as he became known after the LTCM debacle), wants commercial banks to append their quant based risk models with “old fashioned credit analysis”. Indeed, he openly disavows the notion that the various episodes of financial instability which have visited the economy over the past decade and a half are the result of exogenous shocks to the system. Lenders and investors, Peter notices, can get it dramatically wrong, and when the evolution of the financial system perversely incentivises creditors to get it wrong, systemic risk of the sort now getting recognized is the inevitable result. So cogent is his critique that one would almost forget that this long time American mandarin himself bears some responsibility for the current parlous state of affairs.
We must conclude that Mr Fisher, along with some of his other colleagues who continue to float the notion of “unconventional policy measures”, has looked into the leveraging of the corporate and household sectors, has seen some of the same credit excesses we have been documenting, and has determined it is time to break ranks with Chairman Greenspan, who appears never to have met a credit bubble he hasn’t liked. Mr. Fisher’s message is 180 degrees at odds with his former boss, who all along has been urging bankers to not become overly prudent, otherwise they will induce a self-fulfilling prophecy of credit headwinds like the episode Chairman Greenspan fought from 1991- 3.
Just as the recent calls by the Wall Street Journal for the Fed to remove its implicit guarantee on the GSEs is now futile, so too, is it a bit late in the day for the Undersecretary of Domestic Finance to be encouraging a return to serious credit analysis and restraint by commercial bankers. In both instances, the excesses now decried are symptomatic of a broader monetary culture that has perpetuated and actively encouraged these practices over the past decade. One might as well instruct a person suffering from obesity to go on a strict diet after stuffing him full of chocolate, chips, and beer over that timeframe. In the words of our colleague, Doug Noland:
“We have reached the point where there is no turning off the Credit excess, no turning off the GSEs, no turning off the Mortgage Finance Bubble, no turning off the destabilizing world of derivative trading, and no turning off the rampant financial speculation and its increasingly destabilizing effects. It is truly one massive Bubble running out of control. And let’s not ignore the reality that these frightening financial convulsions are symptomatic of an extremely sick system. One of these days there will be a life-threatening seizure. What we have here is an historic circumstance of a dysfunctional monetary regime and a central bank that will defend it at all costs.”
Ironically, even as Mr Fisher calls for the return of a “hard nosed, grubby credit culture” the message from the Fed seems to be precisely the opposite, if we are to judge from Mr Greenspan’s recent Congressional testimony, in which he went so far as to deny the existence of a housing bubble, much as used to deny the existence of an equity bubble back in 1999. Perhaps there is a psychological need for Mr Greenspan to look the other way. Perhaps in his heart of hearts he realises that the very essence of this parallel financial system he has helped to create and nurture is that it is not amenable to any real kind of controls any longer. This might explain the Fed’s current reluctance to cut rates further, as opposed to any concerns about reigniting inflation per se. Any further rate cuts which failed to elicit the desired economic response would simply call attention to the Fed’s real impotence. Paradoxically, this so-called apostle of free markets, Alan Greenspan, has helped to make himself redundant, but cannot never bring himself to acknowledge as much because to do so would simply draw attention to previous policy errors.
On the other hand, notwithstanding the public pleadings of Mr Greenspan, personal expenditure cannot be financed for ever by a growing flow of net lending - that is by a continuing rise in the rise in debt. The drastic fall in interest rates and the extreme ease with which equity in houses can now be “cashed out” through repeated refinancings, has given a new lease of life to personal expenditure. But a rise of net lending cannot, by its very nature, be an abiding motor for growth of the economy; it can continue for a long time, but it cannot continue for ever. Equity can be cashed out only for so long as it exists; the process is a once-for-all affair even as the Fed tries to string it out indefinitely.
Presumably Mr Greenspan and Mr Fisher’s new boss at the Treasury, Jon Snow, are hoping that some form of external stimulus will help to extract them from this policy cul-de-sac. But things do not look much better abroad. The world economy is slowing rapidly and the US is still suffering the cumulative effects of years of eroding export competitiveness, given the perverse cultivation of a strong dollar policy in spite of mounting external imbalances. In Euroland, the continued cautiousness of the ECB is being exacerbated by the damaging, pro-cyclical implications of the ‘Growth and Stability Pact’. There is talk about “reassessing” the latter, but experience has shown the EU to be far more effective at talking about something than arriving at a genuine policy solution. Preliminary assessments of the U.K. reveal that a similar implosion is here underway with the housing market (long the backbone of the economy) registering its worst performance since 1995. And recovery in growth in Japan seems to fade further away with little yet to indicate a change in policy on the part of the newly appointed BOJ Governor Fukui.
Furthermore, it appears that surplus countries (e.g. Japan, emerging Asia, and China) are accumulating mountainous dollar reserves which they have been using to prevent any natural rebalancing process from taking place. Indeed, Mr Snow himself continues to parrot the strong dollar policy of his predecessor, even as the US economy shows a desperate need for a massive dollar devaluation to help initiate this rebalancing process. Given the extent of the country’s external debt position, perhaps this is one Pandora’s Box that American policy makers do not dare to open, as a whole of other problems might ensue. In addition, Asia’s neo-mercantilist impulse has undoubtedly been exacerbated by the traumas experienced by those countries during the late 1990s and the conspicuously unhelpful US policy response at that time. Blowback can take many forms.
In sum, so far it was rather the rest of the world which relied heavily on the U.S. as importer of last resort. Were the U.S. to slow-down even more, the knock on effect on the rest of the world would be devastating, as Stephen Roach of Morgan Stanley has warned in numerous recent publications. As Professor Wynne Godley has pointed out in a recent strategy paper for the Levy Institute, “it would be madness for the U.S to base its economic strategy on the assumption that it will be hauled out of stagnation by a discontinuous and autonomous expansion in foreign parts. At present, not merely is the rest of the world itself locked into a stagnation, it is looking to the U.S economy to be the motor which will fuel its own growth.”
If not stimulus from the export sector, what about fiscal policy? Even without a war, the budget deficit would have exceeded $300 billion this year -- just three years after the budget experienced a surplus of nearly $240 billion. (This was in the midst of a four-year run of substantial surpluses.) With war costs escalating and revenues falling as a result of the flat economy, however, this year's deficit could rise to $400 billion. In fiscal year 2004, it is likely to be higher. If, as we expect, the US economy continues to disappoint, further increases than those already contemplated by the Bush administration will be required. But as Godley noted in the foregoing paper, the scale of the required deficit is too large to be credible and would almost invariably promote fright and potential capital flight from overseas holders of US debt:
“The primary balance of payments in the fourth quarter of 2002 was equal to about 5 per cent of GDP - easily a post-war record. If, as all official documents assume, the economy grows fast enough during the next six years to generate some reduction in unemployment, there is a presumption that the primary balance will deteriorate further, to at least 6.4 per cent, causing the US's foreign debt to rise to nearly $8 trillion or 60 per cent of GDP. And if, as the ERP assumes, the stance of monetary policy reverts to neutral so that short term interest rates rise to 4.3 per cent, the net flow of interest payments out of the country could well rise to $2-300 billion per annum, thereby raising the deficit in the overall balance of payments to about 8.5 per cent of GDP. As the private sector's financial deficit is likely to revert towards its usual state of surplus, it follows as a matter of accounting logic that the government would have to run a deficit at least as large as the balance of payments deficit - that is, the budget deficit would have to rise from some 3 per cent of GDP as now projected for 2003 to perhaps 9-10 per cent of GDP in 2007-2008. For a number of reasons this is not a credible scenario - if only because such a position would not itself be a stable one; the rate at which foreign debt would be accumulating would be such as to generate a further, accelerating, flow of interest payments out of the country, requiring even larger budget deficits in subsequent years.”
Given this impending balance of payments crisis, we find it very difficult to take Mr Fisher’s warnings as a true indication of a change of policy at the top. We may well conclude that there is some wing which now can recognise the system’s fatal flaw, and (for the sake of historical salvaging of reputation) is positioning itself favourably for the day when CDO's, credit default swaps, and their ilk start to come undone. The witch hunt which will accompany the fall of structured finance will inevitably lead back to Chairman Greenspan, and it is for this reason we must presume why Peter Fisher is beginning to distance himself from his prior master. But as one of the architects of this policy, we doubt he can avoid being swept up in the impending maelstrom that can be adduced from the harsh logic of Godley’s analysis.
If only America’s economic problems could be resolved as efficiently as the country appears to conduct its military campaigns. The anomaly could hardly be more striking: a military power unrivaled globally, yet still mired in the midst of an Argentina-like economic predicament. The dollar’s renewed descent this past week might be hinting at this paradox. But if the best one can hope for is a “growth recession”, as Godley suggests, or a race to the bottom via a series of competitive devaluations, it does imply that the quickly dissipating war euphoria on Wall Street cannot obscure the fact that very difficult times still lie ahead. |
