Tools to Help Business Owners Understand and Survive the Financial Crisis
We’re Fighting the Wrong War
Posted by John Slater on February 28, 2009
“Generals are always fighting the last war.” Certainly this was true in Vietnam for many years. More recently we tried to refight Desert Storm in Iraq, without understanding that we were headed for another Vietnam.
But what about the economists? Are they subject to the same failings? Most certainly the answer is yes. We have now spent the last year fighting the Great Depression, when the current problem results from a very different cause. True the Great Depression followed the pricking of a stock market bubble, much like the worldwide equity bubble we experienced from 2002-2007. Yet there is one factor in the current market that is materially different from the conditions of the late 1920’s that precipitated the Great Depression of the 1930’s.
You have likely seen the chart below from Ned Davis Research sketching the history of leverage in the United States economy.
Leverage (Total Debt/GDP) peaked in the 1930s at ~2.6 x Gross Domestic Product. Leverage in the current economy peaked at 3.6 times GDP in 2007-2008. So what’s the difference? The difference is that there is no indication that, in the aggregate, the boom of the late 1920’s was caused by a massive leveraging of the economy. From 1923 through 1930, leverage ranged from 150% to 170% percent of GDP. On the other hand, in the current era from Q3 1998 to Q2 2008, a period similar in many ways to the boom times of the 1920s, leverage increase from ~2.6x to almost 3.6x. The massive spike in leverage to GDP from ~1.6x in 1930 to ~2.6x in 1934-36 resulted not from a credit bubble, but from the rapid decline of incomes and output while debt remained relatively constant.
The current down cycle is being driven by a phenomenon different from the forces that led to the Great Depression, i.e. a massive overleveraging of the American, and more broadly, the world economy. How did this happen? Starting in the 1980’s we learned new ways to create leverage. The then relatively recent invention of the credit card began to reach full blossom and consumers became empowered to “buy now pay later” at a previously unheard of rate. Similarly, the development of various securitization tools enabled the creation of new funding vehicles that drove a variety of markets, starting with home mortgages, but extending to all aspects of consumer, business and commercial real estate finance.
Mortgage securitization, which came into full flower from 2002-2006 with the invention of CDOs and credit default swaps, is now well chronicled. Less well understood are the mechanisms by which much of the rest of the economy became, in effect, a giant fractional banking system. The technology that drove mortgage securitization led to the ultimate securitization of “predictable” future cash flow streams from all aspects of the economy.
Not only were future consumer and business income streams securitized through pooling of credit cards, car loans, commercial real estate, equipment leases, etc., truly exotic products began to appear, such as securitizations of movie and music residuals. In 1972 the concept of royalty streams from Ziggy Stardust being securitized by Wall Street would have been thought even weirder than the music.
The net impact of all the securitization and borrowing was to bring to monetize future cash flows in order to make them spendable and investable in the present. This fueled a boom that has now clearly proven to be false. It appears that even the rapid growth major cities such as Phoenix and Las Vegas may have been fueled primarily by a housing boom built on the expectation of further growth in the future. Now the time has come to pay the piper. We are living in the future from which we borrowed in an earlier time. Now is the time to generate the excess cash flows that were leveraged so cavalierly during the boom.
It’s frequently assumed that, since the Great Depression ended as the world ramped up for World War II and government borrowed heavily to fund the war, that a massive increase in debt fueled spending dragged the U. S. out of the depression. The facts do not bear that out. The debt to GDP chart above indicates another mechanism at work during the period which may have been equally important. From 1936-1938 debt to GDP declined from 2.6x to 1.70x. Total debt to income ratios did not rise during the war years. In fact debt continued to decline a percentage of income through the mid-1950s, generally a very prosperous period for the economy. Clearly the exit from the worst of the economic malaise of the 1930s was accomplished without significant new credit creation.
There now seems to be almost unanimous agreement that future prosperity depends on the government’s ability to restart the economy’s credit creation engine. This has resulted in debt funded economic stimulus, TARP, TALF, and the nationalization of AIG, the GSEs and now Citigroup. Increasingly desperate calls from the likes of PIMCO for a restart of the securitization engine and other aspects of the Shadow Banking System indicate that the pressure comes not just from economists, but from the remnants of Wall Street as well. This pressure comes from a misreading of the lessons of the Great Depression. The apparent growth in leverage in the 1930s was a consequence of the economic decline, not its cause. In that scenario Keynesian stimulus made sense: fix the incomes and the leverage problem would fix itself.
In the current era on the other hand, leverage is the cause, not the result, of the economic crisis. We spent our future productive output and must now go through an extended period where we produce more than we consume. Until we wake up to this reality and develop economic theories, governmental policies and private actions to support the necessary era of capital formation and debt reduction, we are doomed to live in an era of privation where the focus remains on distributing a shrinking pie rather than growing our way out of the problem.
Tags: Tags: Banks, Economic Crash, Economics, Federal Reserve, Money Supply, Shadow Banking System, TARP
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