Collateral damage: why the usual fixes aren't stopping the financial freefall.
It all began last summer after a couple of Bear Sterns hedge funds went bust, causing concerns about securities based on the U.S. housing market contaminating the entire financial sector. Interbank lending evaporated, the system threatened to seize up.
The world's central bankers reacted as they have in every financial crisis of the past 25 years. They cut interest rates, opened the discount window, flooded the world with liquidity, and assumed that with all this new cash slopping around, financial markets would calm down and banks would again begin to lend. Instead, banks are locking their vaults, "deleveraging" is the word on investment bankers' lips, and the party on Wall Street is no more.
It hasn't taken long for the crisis to spill out of the financial sector into the real economy. Consumer spending was down 3.1 percent last quarter, the steepest decline since 1980, the first decline in 17 years. For the past generation, despite stagnating wages, even during recessions, American consumers have always managed to increase their spending, to the glee of producers around the world. If we don't max out our credit cards, a factory in China closes.
Debt has been the fuel that has propelled both the financial economy and the real economy. But with banks desperate to repair their balance sheets, they have choked off lending. Easy credit promoted both consumer spending and asset price inflation. With credit shrinking, no wonder house and stock prices are falling and consumers are finally closing their wallets.
Over the past few decades, we have stimulated demand and kept the economy growing by inflating a series of successive asset bubbles. Whenever one popped, low interest rates and increased liquidity created another one. The Latin American debt crisis, the 1987 stock market crash, the junk-bond defaults of the late '80s, the "tequila crisis" of 1994, the Long-Term Capital Management (LTCM) crash of 1998--all were cured with the same strategy of easy money. The biggest and best example is Greenspan's reaction to the popping of the dot-com bubble in 2000. He cut interest rates to the lowest level in 40 years and sparked the housing bubble, the bursting of which we are now suffering. Accustomed to Federal Reserve mollycoddling, financial markets became complaisant, confident that central bankers would bring out the punch bowl any time asset prices threatened to fall. But now, despite spiking the punch with massive amounts of cash, central banks are unable to calm markets. Why?
One explanation is that these years of debt-fuelled prosperity so over-leveraged investment banks that even relatively minor asset price declines became devastating. At 30 to 1 leverage, common during the halcyon days of the boom, a mere 4 percent decline can wipe out a firm's capital.
Another is that unlike 1987, and unlike LTCM, this is not a liquidity crisis in which fear of panic-selling by others causes investors to unload intrinsically sound assets at bargain-basement prices. This is a solvency crisis. The assets held by the banks are fundamentally worth less than their liabilities. The only way government can cure a solvency crisis is to overpay for the dubious assets on banks' balance sheets, a politically hazardous solution that rewards the fat cats whose profligacy got us into this mess.
A third is that the hypermathemitization of finance created such opaque securities that no one had any idea how fragile the system might be. Arcane models deluded bankers into thinking they could unload risk, not realizing that since the financial world is a closed system, risk can be moved but not avoided, and while you unload your toxic waste to another, he is simultaneously unloading his toxic waste onto you. Everybody knows there is a lot of bad debt out there. No one wants to do business when they fear their counter-party might go bust.
But there is a deeper explanation, perhaps more satisfying both aesthetically and morally. We have for a generation borrowed not to invest in productive resources but to consume. Our traditional understanding of finance, the one still found in the first chapter of introductory textbooks, is that financial markets take household savings and efficiently allocate them to the most productive ends. That is to say, finance is supposed to allow productive investment, which will create a cash flow that can repay lenders while still making a profit for entrepreneurs. Finance, then, by allowing real investment in productive capacity, mobilizes capital, makes workers more productive, and profits the entire society.
When J.P. Morgan used British capital in the 19th century to buy U.S. railroad bonds, that investment did more than make him lots of money: it built a transcontinental railroad, brought producers and markets closer together, reduced transportation costs dramatically, and thus enriched all of America. The debt incurred was wisely spent. That is the way finance is supposed to work. But it doesn't work that way any more.
Finance has become self-referential--dare I say postmodern?--ever more divorced from the business of building productive resources. Arbitrage, the buying and selling of almost identical securities with enormous leverage to exploit minute price anomalies, does nothing to promote productive investment. Neither do leveraged buyouts or private equity deals that use a company's cash flow to pay for its own takeover. They might make a few investors and investment bankers rich, but by saddling a company with huge unproductive debt, they make it impossible for the firm to expand, to invest in productive capacity, to increase research and development, to hire more workers.
Indeed, because of corporate stock buybacks, for the past 20 years the flow of funds in U.S. equity markets has actually gone in the opposite direction. Instead of sending funds from households to allow corporate investment, retained corporate profits are being sent in the opposite direction, to stockholders to fund even more consumption. The rise of finance has seen a decrease in real investment as a percentage of GDP.
With wage and goods inflation under control, the spectacular increase in the money supply since 1982 went into inflating paper assets. Increased asset prices raised the value of collateral, making banks ever more willing to lend. But just increasing the value of an asset does not create a cash flow with which to repay that debt. Your house may have been worth $1 million in 2005, $700,000 today, $35,000 in 1979, but it is still the same house. Building a railroad creates a cash flow that can pay off a debt. Buying a house does not, except, of course, by allowing access to home equity loans.
And so the ultimate reason that the traditional medicine of increased liquidity isn't working is that we cannot borrow and spend our way to prosperity forever. It worked as long as the value of paper assets kept going up, as long as debts could be dissolved away as asset price increases allowed further borrowing. But all our borrowing has not created real productive investment that would have created a cash flow with which to pay off our debts no matter what happens in financial markets. Credit is a form of faith. We have been dependent on that faith never faltering, even as the real economy grows less able to back up the financial economy's promises.
Recapitalizing the banks with taxpayer money will not do the trick as long as banks fear clients' ability to service their debts. The problem is that the financial economy has cashed checks that the real economy cannot honor. The rise of finance has coincided with the slowdown of growth in the postwar Western economies. Indeed, the median male American worker makes less money in real terms today than he did in 1973. This is not a coincidence. When finance no longer does its traditional job of creating real investment, of building productive resources, of creating factories or infrastructure, it becomes a paper game, a parasite on the real economy. When labor's share of the economic pie increases, that stimulates demand, which allows the economy to grow. When the entrepreneurs' share increases, that stimulates investment, which makes the society more productive. But increasing finance's share--interest payments were 1 percent of GDP during the postwar Golden Age of economic growth, compared to over 16 percent today--neither creates real investment nor stimulates mass-market demand. It promotes high-end consumption, helping yacht brokers, Lamborghini dealers, and Greenwich real estate, but doing little for the rest of us.
We will, one way or the other, in the long term or short, ultimately revitalize the balance sheets of the financial sector. The big question is what can replace debt-fuelled consumption to stimulate demand. The Achilles heel of capitalism is overproduction. (This is a good thing, it reflects the staggering efficiency of capitalism. The Achilles heel of every other economic system is underproduction.) In the past quarter century we have solved the problem of stagnating wages and thus under-consumption with increased availability of credit. The willingness of households and governments to incur ever increasing levels of debt has maintained effective demand and thus allowed global economic growth. Unfortunately, our hunger to consume has proved both essential and unsustainable.
If there is one reason to be optimistic, it is that we are learning that focusing on Wall Street will not make us all rich, that our concentration has to return to the real economy of goods and services, of wages and work, of real investment for the future. For too long, our economic masters have thought that a booming stock market is the goal of economic policy. It is not. We have borrowed our way to prosperity, borrowed not to create productive investment but to buy beyond our means. Shifting from consumption to investment just might save us.
Tom Streithorst is an American living in London.
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|Publication:||The American Conservative|
|Date:||Dec 1, 2008|
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