There was ample material last week for an entire book delving into critical financial issues of our day - US Treasury Secretary Henry Paulson's proposal on Monday for financial regulation overhaul; testimony on Wednesday by Federal Reserve chairman Ben Bernanke on housing and Bear Stearns before Congress' Joint Economic Committee; the appearance on Thursday by Bernanke, New York Fed president Timothy Geithner, Treasury Under Secretary Robert Steel and Securities and Exchange Commission chairman Christopher Cox before the Senate Banking Committee; and the later appearance before the same committee by JP Morgan chief executive Jamie Dimon and Bear Stearns CEO Alan Schwartz - quite enough for a book; I'll attempt a couple pages.
Invitation to disaster
To further inflate an unsustainable boom with additional cheap credit guaranteed only more problematic financial fragility, economic imbalances/maladjustment and resulting onerous adjustment periods. The astute were adamantly against the (Benjamin Strong) Federal Reserve’s efforts to actively manage the economy (and markets) in the latter years of the twenties, fearing that to prolong the reckless Wall Street debt and speculation orgy was to invite disaster (the "old timers" had witnessed many!). History proved them absolutely correct, yet historical revisionism to varying extents has been determined to disregard, misrepresent, and malign their views and analytical focus. Bernanke’s analytical framework of the causes of the Great Depression is seriously flawed.
Regrettably, all the best efforts by the Federal Reserve and Washington politicians to sustain the US bubble economy are doomed to failure. It’s not that they are necessarily the wrong policies. More to the point, the basic premise that our economy is sound and growth sustainable is misguided. We’ve experienced a protracted and historic credit inflation and it will simply be impossible to keep asset prices, incomes, corporate cash flows, and spending levitated at current levels. The type and scope of credit growth required today has become infeasible. The risk intermediation requirements are too daunting. Sustaining housing inflation and consumption levels has become unachievable. And the underpinnings of our currency have turned too fragile.
I'm all for long-overdue legislative reform. Who isn’t? But I’ll say I heard nothing this week that came close to addressing the key underlying issues. We have longstanding societal biases that place too much emphasis on housing and the stock market, while we operate with ingrained policymaking biases advocating unregulated finance underpinned by aggressive activist central banking and government market intervention. In a 20-year period of momentous financial innovation, our combination of "biases" proved an overly potent mix. And it is worth noting that Wall Street security/dealer balance sheets expanded three-fold in the eight years since the repeal of the (Depression-era) Glass-Steagall Act.
The focus at the Fed and in Washington is to sustain housing, the stock market, and inflated asset prices generally - to bankroll the consumption- and services-based bubble economy. Bernanke believes that if financial company failures can be averted - and with the recapitalization of the US financial sector as necessary - sufficient "money" creation will preclude deflationary forces from gaining a foothold.
He assures us the Fed will not allow double-digit price declines, despite the reality that such price moves have already engulfed real estate markets. To be sure, prolonging current financial instability increases the likelihood of significant price level instability going forward. And while the federal government "printing presses" will be working overtime going forward, it is also apparent that a key facet of Washington’s strategy is to "subcontract" the task of "printing" to Fannie Mae, Freddie Mac, the Federal Home Loans Bank, the banking system, and "money funds" - sectors that today still retain the capacity to issue money-like debt instruments with the explicit or implied stamp of federal government (taxpayer) backing.
Desperate undertaking
Basically, the strategy is to substitute government-backed debt for the now discredited Wall Street-backed finance. I’m the first one to admit that this desperate undertaking stopped financial implosion in its tracks. However, the problem with this whole approach - because of our "societal," financial, and policymaking biases - is that our credit system will just be throwing greater amounts of (government-supported) debt on top of already fragile credit structures underpinned largely by home mortgages. Wall Street-backed finance buckled specifically because this (Ponzi finance) debt structure was untenable the day increasing amounts of speculative credit were no longer forthcoming. The underlying inventory of houses doesn’t have the capacity to generate debt service - only the mortgagees taking on greater amounts of debt.
The underlying economic structure is now THE serious issue. The last thing our system needs right now is trillions more mortgage debt, although it would work somewhat to sustain consumption and our services-based bubble economy. The inherent problem with a finance, housing, consumption, and services-dictated economic structure is that it inherently generates excessive debt backed by little of real tangible value or economic wealth-creating capacity. System fragility is unavoidable.
It may appear an economic miracle, but for only as long as increasing amounts of new finance are forthcoming. At the end of the day, one is left with an extremely fragile structure both financially and economically.
Yet as long as Wall Street "alchemy" was capable of creating sufficient "money" to fuel the boom - and the world was content in accumulating (increasingly suspect) dollar claims - our bubble economy structure remained viable. It is, these days, increasingly not viable. The wholesale and open-ended government backing of US mortgage debt - and financial sector liabilities more generally - will prove a decisive blow to already shaken dollar confidence. And it is today’s reality that the massive scope of credit growth necessary to sustain the current bubble structure will correspond to current account deficits and dollar outflows that will prove (as we’re already witnessing) only more destabilizing in markets and real economies around the world.
No substitute
Government backing of our debt does not substitute for a sound economic structure. And it is the current structure that is incapable of the necessary economic output to satisfy domestic needs and to generate sufficient exports to exchange for our huge appetite for imported goods and energy resources. Today’s services-based economy will no longer suffice. Examining last week’s job data, one sees that 93,000 "goods producing" jobs were lost in March after dropping 92,000 in February and 69,000 in January. At the same time, Education, health, leisure and hospitality jobs increased 178,000 during the first quarter. Yet it is more obvious than ever that we need to consume less and produce much more.
Back to the "liquidationists". It is my view that our economy will require a massive reallocation of resources. We will be forced to create much less non-productive (especially mortgage and asset-based) credit in the financial sphere, while producing huge additional quantities of tradable goods in the economic sphere. In our expansive services sector, there will no choice but to "liquidate" labor and redirect its efforts. Throughout finance, there will be no alternative than to liquidate bad debt, labor and insolvent institutions - again in the name of a necessary redirecting of resources.
After an unnecessarily protracted boom, there will be scores of enterprises that will prove uneconomic in the new financial and economic backdrop. Liquidation will be unavoidable, policymaker hopes and dreams notwithstanding.
16.55
iphand
