An Unusually Cheery Set of Links
Peggy Noonan pulls no punches: In one of her latest missives in the Wall Street Journal, Peggy Noonan poses a very simple question. Do today’s leaders of America really care about the future of this country? I often worry that the re-election cycle has gotten so short and the incentive to pass the burden onto future lawmakers is now so pervasive that we can do no better than short-sighted, even foolish near term fixes to current problems. Extend and pretend when it comes to financial companies and kick the can down the road when it comes to the bulging deficit seem to have become the official policies in Washington. Clearly, no one wants to force any more pain on already strained American households. But at what point do the consequences of the actions being taken actually become magnitudes worse than the painful rebalancing and restructuring we could choose to face today? It is within this context that Noonan posits an interesting theory. Her premise is that the current leaders have lived in a period of such US prosperity that they are essentially too arrogant to even contemplate the idea that country could be in the midst of a lasting decline:
When I see those in government, both locally and in Washington, spend and tax and come up each day with new ways to spend and tax—health care, cap and trade, etc.—I think: Why aren't they worried about the impact of what they're doing? Why do they think America is so strong it can take endless abuse?
I think I know part of the answer. It is that they've never seen things go dark. They came of age during the great abundance, circa 1980-2008 (or 1950-2008, take your pick), and they don't have the habit of worry. They talk about their "concerns"—they're big on that word. But they're not really concerned. They think America is the goose that lays the golden egg. Why not? She laid it in their laps. She laid it in grandpa's lap.
They don't feel anxious, because they never had anything to be anxious about. They grew up in an America surrounded by phrases—"strongest nation in the world," "indispensable nation," "unipolar power," "highest standard of living"—and are not bright enough, or serious enough, to imagine that they can damage that, hurt it, even fatally.
We are governed at all levels by America's luckiest children, sons and daughters of the abundance, and they call themselves optimists but they're not optimists—they're unimaginative. They don't have faith, they've just never been foreclosed on. They are stupid and they are callous, and they don't mind it when people become disheartened. They don't even notice.
Has Japan’s luck finally run out? When I hear people say that one of the worst case outcomes for the US in terms of the current recession is a Japan-like lost decade (or two), I usually am not so worried. Yes, the fact that the stock and the real estate markets are still massively below their late 1980’s peaks is not a particularly positive outcome. Additionally, years of dubious infrastructure building certainly has led to outsized fiscal deficits. However, so far, while growth has been understandably tepid for a long time, the Japanese economy has seemed to find a way to muddle through. Before you start to think I have lost my mind, you have to consider the alternatives. From what I know Japan has not experienced any meaningful deleterious social unrest. There have been no violent overthrows of the government. Interest rates have remained incredibly low without sparking inflation. My point is that while the circumstances in Japan during the past few decades have been far from ideal, the world has seen much worse. Unfortunately, this current financial crisis may have sent Japan over a tipping point. With a gigantic fiscal deficit, a scary imbalance between older and younger people, and an export-dependent economy that is being crippled by the strong Yen, suddenly the situation in Japan does not look sustainable. As a result, there are numerous financial commentators and economists sounding the alarm. Here is a recent piece in the Telegraph from Ambrose Evans-Pritchard:
Simon Johnson, former chief economist of the International Monetary Fund (IMF), told the US Congress last week that the debt path was out of control and raised "a real risk that Japan could end up in a major default"…
"The debt situation is irrecoverable," said Carl Weinberg from High Frequency Economics. "I don't see any orderly way out of this. They will not be able to fund their deficit. There will be a fiscal shutdown, a pension haircut, and bank failures that will rock the world. It is criminally negligent that rating agencies are not blowing the whistle on this."
Mr Hatoyama inherited a country that was already hurtling into sovereign "Chapter 11". The Great Recession has eaten up 27pc in tax revenues. Industrial output is down 19pc, even after the summer rebound; exports are down 31pc; the economy is 10pc smaller today in "nominal" terms than a year ago – and nominal is what matters for debt.
Tokyo's price index fell 2.4pc in October, the deepest deflation in modern Japanese history. Real interest rates have risen 300 basis points in a year. It reads like a page from Irving Fisher's 1933 paper, Debt Deflation Causes of Great Depressions.
Is the “New Normal” really playing out? Bill Gross and Mohamed El-Erian of PIMCO have been the major proponents of the idea of the “New Normal.” For those of you who aren’t familiar with this phrase, it refers to a US economy in which growth will be subdued for a pretty long time, the government will be more involved than ever before, and unemployment will remain stubbornly high. The New Normal unequivocally does not imply a V-shaped recovery. Now, we know PIMCO has been recommending bonds, especially US Treasuries, that would benefit relative to stocks if the New Normal scenario plays out. So there is definitively a possibility that the co-CEOs of PIMCO are talking up their book as they advance this concept. But Doug Noland of The Prudent Bear argues that New Normal is only a slight modification of the bubble-influenced period that led up to the crash and may not fully describe what the US economy is actually experiencing:
From my perspective, the “New Normal” appears more like the old than something new: I'm thinking more “The Newest Abnormal”. To be sure, there have been some popped Bubbles. But we remain trapped in the same old Bubble-inciting paradigm of activist central banking and government intervention. I have expounded the view that a “government finance Bubble” emerged with the bursting of the Wall Street/mortgage finance Bubble. I would argue that Bubble dynamics have taken firm hold in China, throughout Asia, and in the “developing” economies more generally. New Normal reminds me too much of “muddle through.”
“Deleveraging” is at this point overrated. Our federal government issued about $1.9 TN of additional debt over the past year. In my book, that’s “leveraging.” The Fed’s balance sheet has become much more leveraged. The mortgage businesses of Fannie, Freddie, Ginnie and the FHA have become much more “leveraged.” The Newest Abnormal is about massive synchronized global government Credit expansion and extreme monetary looseness. The Newest Abnormal sees massive “private” Credit expansions in China, India, Brazil, and the “developing” markets. The Newest Abnormal is fueling historic Credit and economic Bubbles in China.
The Newest Abnormal has seen a major resurgence in the global leveraged speculating community. The Newest Abnormal is acting with great speed to impair the dollar as the world’s reserve currency - taking unfettered financial “globalization” to a whole new level. The Newest Abnormal has animal spirits that could give the old ones a run for their “money”.
Mr. Gross’s New Normal – constrained by “deleveraging and reregulation” - seems to imply a more subdued and therefore stable Credit landscape. Such a backdrop would be consistent with lower average economic growth and lower investment returns. The Newest Abnormal – with varieties of newfangled Bubbles, excesses and uncertainties – would point to ongoing financial and economic volatility. The “averages” may indeed be lower going forward - but it may be the divergences that prove most noteworthy (hard asset returns vs. securities; non-dollar vs. dollar; China GDP vs. U.S., for example).
The New Normal implies more monetary order, while the Newest Abnormal suggests unrelenting Monetary Disorder. The proponents of the New Normal would tend to view extreme government intervention as a stabilizing force appropriate for a (deflationary) post-Bubble landscape. From the Newest Abnormal perspective, massive government deficits and market interventions inaugurate a dangerous new stage of global inflationism. Newest Abnormal analysis posits that a more stable New Normal backdrop would, at this point, likely arise only after a major government debt crisis.
What could global central bank tightening mean for equities? Well, we now know that there are a number of countries out there that are not going to wait to raise interest rates until the US is ready. Australia, for example, has not been shy about increasing its rates despite the fact that the US is still engaging in zero interest rate policy. While the Fed communiqué released today did not give any indication of plans to boost rates any time soon, the actual minutes apparently included meaningful discussion regarding the appropriate exit strategy from all of the current liquidity backstops. As a refresher, I am a member of the deflation and inflation camp. I think the lack of credit and slack in the labor force will continue to make deflation the most near term risk. However, it is hard for me to believe the Fed will be able to unwind its facilities, unload its balance sheet, and deal with bank reserves without creating inflation at some point down the road. Considering this point of view, the idea that the Fed is considering pulling the punch bowl away now is somewhat startling. I don’t know if we need more stimulus or increased quantitative easing, but what I do know is that any economic improvements are incredibly tenuous and allowing certain markets to function on their own might be disastrous in the short run. Additionally, given the fact that Fed liquidity has been a major driver of the stock market rally, my guess is (and according to this piece in the Telegraph) that central bank tightening and abandoned stimulus are not going to be good for stocks:
Teun Draaisma, Morgan Stanley's equity strategist, said investors should move with care as central banks awaken. A study of 19 "bear market" rallies over recent decades shows that bourses tend to tip over as the US Federal Reserve starts tightening. Equities fall back 25pc over the next 13 months on average. It is unlikely to be better this time.
"Given the amount of leverage in the economy, little changes in rates can have a disproportionate impact. The poor state of government finances, the high supply of bonds, and the fear of inflation could further exaggerate a bond market sell-off once tightening starts," he said.
Timing is tricky. Stock markets began to fall four months before the first rate US rise in 2004, but they did not tip over until the tightening started in 1994.
Japan's Nikkei index in the 1990s slumped each time Tokyo drained fiscal stimulus, most notoriously by raising VAT from 5pc to 9pc in 1997 - a warning for Britain as the VAT cut expires in January.
Yet another instance of why the government should not be backstopping large banks: In an article from this weekend, James Surowiecki of The New Yorker identifies some additional structural advantages that the largest US banks have over smaller ones, especially those with an explicit (sorry Tim Geithner, implicit) government bailout guarantee. First off, switching banks is costly and time consuming, particularly if you have multiple accounts or products with the same bank. Plus, inaction is especially attractive when you know the government won’t let your big bank fail. Similarly, Surowiecki argues that as a result of the government backstop, the brands of even the most troubled and controversial large banks are still intact because relative to the small enough to fail banks, the behemoths are viewed as safer. This is truly perverse but it makes complete sense from a customer’s point of view. Even more disturbing is his argument that the banks reputation among corporate business has not been meaningfully impaired. Despite the fact that these institutions could not even manage their own business well enough to make it through the recession without taxpayer support, for some reason businesses continue to want their advice on M&A and may even trust them to handle their IPOs. While none of this is surprising based on what has transpired over the last two years, it is hard not to be struck by the resiliency of these institutions even in the face of nationalization:
So why aren’t customers and clients moving on? In the case of ordinary consumers, “switching costs” have a major effect. It’s a serious hassle to shut down a bank account and transfer money to a new one, especially with direct deposit, automatic bill payments, and the like. The same is true of refinancing at a different bank from the one that currently holds your mortgage, or trying to persuade a new bank to give you a business loan. These costs aren’t trivial: a 2001 study showed that the cost of switching a loan came to about a third of the loan’s annual interest rate. Even if people are dissatisfied with their bank, it’s usually cheaper not to fight than to switch. If you’re a restaurant or a retailer, you have to work hard to insure that your customers keep coming back. But once banks get a customer he’s pretty much theirs for good.
The big banks have the further advantage of their brands, however tattered the brands may be. It’s nearly impossible for consumers to evaluate how healthy a bank is. So, at a time when banks are failing with some regularity, the size and ubiquity of these big banks is reassuring. It seems improbable that they will simply vanish (the way a bank like IndyMac did), because the government won’t allow it. It’s possible, in fact, that the crisis, instead of eroding the reputational advantages of the big banks, ended up bolstering them. In times of uncertainty, people are inclined to shun experiment for the safe choice.
Reputation arguably plays an even bigger role in the competition for corporate business. A major part of what Wall Street firms do for their clients is, in effect, to vouch for their financial prospects: when a bank underwrites a company’s bond offering or an I.P.O., it is essentially certifying that company in the eyes of investors. Companies hire high-profile firms to advise on mergers not just for the advice but for the public signature of approval. The more powerful the bank that’s giving the advice, the better the cover it offers. Success, then, feeds on itself: having a big market share today makes it easier to win business tomorrow.