The Economic Crisis: Is There a Policy Beyond Loss Transfer?

Today's 185 point drop in the Dow Jones Industrial Average is attributed by many in the financial press to the market being "overbought" or "ahead of itself." More specifically, price-earnings ratios for the S&P 500 are above 18, whereas the historical average is around 16. At the recent market low in March 2009, the p/e ratio was around 11. Maybe a sell-off makes sense. However, there is nothing inevitable about a drop from a p/e ratio of 18. In the late 1990s, the S&P 500 had a p/e ratio in the high 20s, yet the index proceeded to go higher. Why, then, would the market drop from a p/e ratio of 18? Because the future is uncertain. (Actually, it was uncertain in the 1990s but people deluded themselves into thinking it wasn't.)

The federal government has relied heavily on the financial equivalent of methadone to get the economy through the past year. The Fed printed money nonstop, while the Bush and Obama administrations greatly increased deficit spending. These measures treated the symptoms of the problems, and soothed some of the pain. But they didn't get at underlying causes. Doctors don't treat cancer by administering painkillers. They employ surgery, chemotherapy, radiation therapy and other measures aimed at removing or suppressing the disease. But federal policy has been ineffectual at dealing with underlying problems.

This recession began as a crisis of the financial system, not the real economy. The financial system made a vast quantity of really dumb mortgage loans, and extremely well compensated Wall Street executives managing the big banks somehow couldn't figure out that this gargantuan mass of future losses was looming. Perhaps they were too busy counting their enhanced compensation. We're now familiar with the mess that followed. Real estate, previously thought by Wall Street not to be subject to ordinary market forces such as downward price movements, fell in value. The vast ocean of bad mortgage loans then did what bad loans do--they defaulted and created losses. A lot of losses, since there were really a lot of bad loans. The flow of losses persists, since rising unemployment leads to more defaults and foreclosures. At this point, many of defaults are of seemingly good, prime mortgages owed by people who lost their jobs. With unemployment expected to rise, mortgage losses will be hitting the banking system for years.

There probably are trillions of dollars of unrecognized losses in the banking system, especially when one considers the foreclosures to come. Banks continue to cut back on lending in order to preserve their capital to cover more mortgage and other recession-related losses. There won't be a lively flow of bank credit to revive the economy any time soon.

The Federal Reserve printed trillions of dollars to keep the banking system propped up, and has managed to prevent Armageddon. But that approach does little to ameliorate the trillions of dollars of unrecognized losses that haunt the banks. The Fed's approach simply transferred most of the losses to the future. Federal bailout measures, like TARP, transferred a lot of losses to taxpayers. The largely ineffectual mortgage modification programs tend to transfer losses to taxpayers as well. (Banks and investors in mortgage-backed securities are taking some losses, but the total number of mortgage modifications is so low that the result is like a tiny drop in a 55-gallon barrel.)

It seems to be the federal government's strategy--a strategy that is little more than hope--to keep the financial system on life support long enough that the real estate market revives and rising real estate values erase the unbooked losses. But with mortgage credit scarce and consumers now embracing newly found prudence, real estate prices will probably not return to 2006 levels for a decade. Meanwhile, the banking system will remain crippled by its vast pool of unbooked losses. Credit will continue to be tight. Economic growth will be slow.

Hope won't win the day. The PPIF program, a public-private sector concept that would supposedly buy up toxic assets from banks, isn't very active, because banks are allowed by a recent politically coerced relaxation of accounting rules to sweep dodgy assets under the carpet instead of recognizing their losses. If they sell those assets to PPIF, they would have to book losses. That would detrimentally impact executive bonuses, something to be avoided at all costs.

The federal government's focus should shift from loss transference to spurring economic growth. Targeted stimulus spending, focused tax breaks, public works spending (especially for needed infrastructure repairs and improvements), and other growth-oriented measures are in order. Measures to maintain retiree buying power could enhance consumer confidence. Social Security retirees are not likely to get a cost of living increase this coming January because of the absence of inflation. But their medical insurance expenses will rise, so their real incomes will shrink. If you want to see people pull back on spending, reduce their incomes. A consumer-driven economy such as America's cannot recover in an environment where incomes are shrinking. When Wall Street bankers are collecting multi-million dollar bonuses because the federal government saved their employers, it's really weird to get wound up about "windfalls" like a 1% increase for Social Security recipients, whose average benefit is slightly over $11,000 a year.

A growing economy can more easily absorb the impact of the unbooked losses remaining in the financial system. A stagnant economy will only be made more stagnant when the losses have to be recognized. The government should concentrate on stimulating the real economy.

The future direction of the stock market is likely to depend on earnings growth--real earnings growth, not the contrived stuff that we've recently seen. With ultra-cheap federal credit and the politically coerced relaxation of accounting standards, the banking system has pushed a lot of losses into the future and returned to "profitability." But a strategy of loss transference has a limited half-life; the losses have to booked sooner or later and the impact on the economy is likely to be ugly. The stock market can't continue to thrive on "earnings" resulting from federal loss transference policies. The market--and the economy--need real earnings if the future is to be bright.