Should We Bring Back the Leisure Suit?

The economy in America and Europe is stagnant. Gas prices have risen sharply in recent years, and the Bureau of Labor Statistics reports rising inflation. The job market stinks. Business investment has ground to a halt. America is unwinding from unpopular wars. Young people just entering the labor force believe they face a lifetime of limited opportunity and lower living standards. They envy their parents, who seem to have had it so good. Prospects for the future seem like a blurred swirl in a porcelain bowl. Whether you believe history repeats itself or simply rhymes, the times are looking a lot like the 1970s. Maybe we should bring back the leisure suit.

The leisure suit had many attributes. It was casual, a rejection of the stuffy old formality of the 1950s. It usually came in pastel colors, brightening things up as the lights dimmed for electricity conservation mandated by rising energy prices. It was made of polyester, which thankfully led us to rethink the whole idea of better living through chemistry. It was flashy, ideal for mindlessly dissipating evenings in artificially fogged discos. Considering today's pervasive gloom, a bit of self-referential, sartorial frivolity might be just the thing we need.

But thinking of the 1970s reminds us of how glad we were to escape the malaise of those times. What is worth examining is how we made the escape. The fundamental economic problem then was price inflation. Already a nagging problem in the 3% range at the beginning of the decade, inflation was aggravated by OPEC oil price fixing, which escalated it to 13% by the end of the decade. Wages tended to keep fairly close pace with inflation, but the value of savings was eroded as interest rates lagged (does this sound familiar?). The stock market stunk, worth much less after inflation than it was worth at the beginning of the decade.

As students of economic history know, then Fed Chairman Paul Volcker raised interest rates sharply at the beginning of the 1980s to stabilize prices. In the process, the U.S. economy belly flopped into recession, with unemployment rising above 10% and stocks falling. Despite a tidal wave of criticism from the left, right, Democrats, Republicans, and just about everyone else standing on or about a bully pulpit, Volcker held firm, like a latter day Rock of Chickamauga. And prevailed. The recession of 1981-82 wrung inflation out of the economy, and it has never returned at any level approaching the confidence sapping double digits of the 70s. With inflation whipped, real economic growth resumed, employment levels rebounded, and the stock market took off on an 18-year bull run. The bond market, even more amazingly, took off on a bull run that hasn't ended even today.

An essential, virtually forgotten lesson from the disco era is that real pain had to be endured before the economy could be set on the right track. Investors, workers, businesses, savers, and homeowners all made sacrifices. There was no easy way out. Inflation had created economic distortions that had to eliminated. The relatively lax Fed of the 1970s was replaced by a stern, unyielding inflation slayer who wielded a mighty halberd.

Such is the path America must take today if it is to end today's dreary replay of the 1970s. The economy is distorted by asset bubbles, the leverage that made them possible, the fantasy mortgage loans that can't be collected but haven't been written off by the banks, Fed-prescribed low interest rates that encourage speculation while discouraging savings, and the dependence of the private sector on federal stimulus. Private businesses won't hire or invest unless there is a prospect of more federal intervention. Everyone wants a risk-free environment, or absent that, a federal bailout. Free enterprise, which means taking risk, barely exists any more and can usually be found only in the small business sector, where federal manna is scarce.

If the Fed wants to stimulate risk taking, what it must do is reverse the tide of moral hazard and stop the endless stream of largely futile accommodations. It should force business executives to take risk, not force savers to gamble their hard-earned retirement funds on dodgy financial instruments. When businesses realize that they will have to make their profits the old fashioned way--by taking risks and managing those risks to attain profitability--then we will see organic economic recovery. No amount of Fed coddling of corporate interests, and no amount of Fed punishment of savers and holders of capital, will achieve the spontaneous and self-sustaining growth that produces lasting prosperity.

Before there was a Federal Reserve, there were recessions, and bad ones at that. There were also recoveries from those recessions that led to sparkling prosperity. It's not like America endured an unrelenting stream of recessions followed by more recessions until the clouds parted and the Federal Reserve System was handed down to someone on Mount Sinai. The Fed has a legitimate role in stabilizing the financial system, and has done yeoman's duty in that respect. But it isn't and can't be the progenitor of all prosperity in America. In a free enterprise system, private enterprise must take on that job, and if corporate interests hold back in hope of yet another federal bailout, they must be made to understand it won't be forthcoming.

America is becoming like Japan, moribund and without a vision of the future. We don't want to take risks any more, and we don't want to accept pain. Blame and culpability are denied by the most powerful, even though their responsibility is greatest. The less powerful and the powerless are made to suffer the worst consequences of the Great Recession, even though their ability to cope is the least. Capitalism requires that blame and responsibility be assessed, and that losses be imposed appropriately. Without right and wrong, there can be no morality. And without losses as well as gains, there can be no free enterprise. We can have all gains only if we become one big government enterprise (and those gains would ultimately prove ethereal). We can't escape our current predicament by having the federal government (and, even worse, the EU) artificially support or inflate assets that are in reality worthless. There won't be a revival of sustained economic growth as long as the government holds out the promise of yet another bailout, yet more accommodation. While there remains a legitimate role for government in taking on tasks for which the private sector isn't well-suited, like building and maintaining infrastructure, and funding and conducting basic research (recall that the Internet started off as a Defense Department project), the government should stop trying to alleviate general business risk.

Otherwise, we might as well bring back the leisure suit. A dose of self-delusion as we circle the drain will numb the process of decay and decline. If we're going to stop thinking about tomorrow, we might as well have fun while we can.

Good Thing Goldman's Earnings are Down

It's a good thing Goldman Sachs just reported that its 4th quarter 2010 earnings are down 52%. Not for its officers, employees, or shareholders, but for the economy and the nation. Too much capital has flowed into financial services. Too much of America's talent and energy has gone into financial engineering. If creating and trading cleverly concocted financial side bets becomes less lucrative, maybe some of the nation's best and brightest will devote their careers to something that has lasting value.

It's really not surprising that Goldman's earnings are down. The financial crisis of the past three years caused the derivatives market to contract sharply. Too of these contracts that were too clever by half proved to be pigs in pokes, and investors grew twice shy. Derivatives, enveloped in opacity, commanded high margins. Without this lucrative business, and in an uncertain economy where clients didn't want to take big risks, Goldman's financial performance was bound to lag.

One wonders if Goldman's personnel are taking the news a bit too hard. Almost surely they had an inkling of what was coming before it was announced. GS's stumble in the rather public Facebook private placement may smack of an investment bank trying too hard to buttress its reputation for prowess on the eve of a decidedly downcast earnings announcement. Sometimes, it's better to go with the flow. Capitalism is cyclical. Exceptions aren't made for even the best investment banks. And that's good, because America can't retain its standing as a world power through financial intermediation. China has become the second most powerful nation in the world with a financial system that is rudimentary compared to ours. America needs to return to its economic roots and concentrate on producing things of value.

The 21st Century Global Economics Experiment

Not since the days of the Cold War has there been such a clash of national economics policies. The UK has made an abrupt U-turn away from deficit spending, embracing the hair shirt of austerity. Elsewhere in Europe, big spending EU governments have followed suit, although not with the fervor of true believers. Keynesian economics may be disproved, or not.

America is caught in political crosscurrents, with fiscal policy stifled by a prairie fire of populism. The Federal Reserve is the only show in town, and the financial markets believe the Fed will put on a dazzling performance. Stock, commodities and bond valuations all presume that the Fed is going to walk into the joint and be a real big spender. Monetary policy is at the plate, and no one is on deck. The Austrian school of economics may be disproved, or not.

In China, an ad hoc amalgam of state controlled enterprise and fiercely capitalistic forces has propelled the Chinese economy into a meteoric rise. The Communist Party in China has craftily exploited market forces to raise living standards, thereby legitimizing its continued control while it gradually jettisons a failed ideology. The Chinese are wittingly or unwittingly recreating an updated version of dynastic China, where government played a large role in the economy but allowed private trade and commerce to spark growth. Imperial China was for over 1,000 years the wealthiest nation in the world, so this model has a history of success. If China continues its upward trajectory, free market ideologues may be discombobulated. Or not, if the heavy hand of state control of the economy and political freedoms smothers the individual initiative needed for lasting prosperity.

Since economists can't conduct controlled experiments, the world today is about as good as it gets for students of comparative economics. Ten or twenty years from now, tentative conclusions might be possible. Or not, since nothing in economics is ever truly resolved. Schools of thought mostly go in and out of fashion.

But what if they're all wrong? What if austerity in the Old World produces stagnation or even recession? What if the Fed's forthcoming liquidity dump fails? The financial system already has a trillion dollars of unused liquidity on deposit at Federal Reserve banks. More liquidity is likely to be just the proverbial push on a string, while stagnation continues. And what if China's real estate and credit bubbles burst, pushing China into the stagnation experienced by Japan and now America? With China's severe demographic problem of too many old and not enough young, any slowdown in China's growth could upset the entire apple cart the government is trying to push along.

If all models and all schools of thought are wrong, we have a problem. There wouldn't be any credible paradigm in which to find solutions. We might find ourselves mired in slumps and malaise, with struggling to muddle through the only strategy. But Americans are good at muddling. Every major crisis in American history, from the Revolution to the Civil War to World War II to the Cold War, was a painful muddle. Even if all the economists are confounded, Americans can still have faith in themselves, and that's always proven to be enough.

Japan: 20 Years of Lessons for America

On Dec. 29, 1989, the Nikkei 225, Japan's stock market benchmark, closed at an all time high of 38,915.87. On Friday, Dec. 25, 2009 (a trading day in Tokyo), the Nikkei 225 closed at 10,494.71. It's been lower, with a post-1989 low of 7,603.76 in April 2003. That's about an 80% drop, not quite as bad as the Dow Jones Industrial Average's 89% drop during the Great Depression but still pretty awful. An investor who bought the Nikkei 225 at its peak would have a 73% loss today.

Japan's economy was the world's most impressive from 1960 to 1989. In the 1960s, it grew at a rate of about 10% a year, comparable to China today. In the 1970s, it grew at an annual rate of 5%, and in the 1980s, 4% a year. The slowing growth rate reflected the maturation of the Japanese economy, but not decline. In the late 1980s, Japanese investors bought American icons like Rockefeller Center and Columbia Pictures. Many viewed Japan as an unstoppable economic juggernaut.

The 1980s Japanese stock market bubble, and a concurrent real estate bubble, were attributable to the ready availability of cheap capital stemming from Japanese government policies that encouraged saving and low interest rates. The combination of the two led many Japanese to speculate in stocks and real estate. If this sounds familiar, then look at the late 1990s and the 2000s in the United States. There is an eerie resemblance, with the Federal Reserve using monetary policy to ensure a steady supply of cheap capital.

Like all assets bubbles, the Japanese stock and real estate markets popped eventually. The Japanese response also resembled America's response to the 2007-08 financial crisis: all government all the time. Banks were propped up as their accounting standards were relaxed. Losses were swept under the carpet while banks stopped lending. Fiscal discipline evaporated and government deficits ballooned. Government cash handouts to consumers provided temporary stimulus.

But none of it did much lasting good. Japanese economic growth slowed dramatically after 1989, down to the range of 1% to 2% on average. Japanese unemployment levels rose, and remain high. The Japanese social safety net, much of it based on the lifetime employment policies of large companies, frayed. The Japanese consumer, already cautious, became yet more thrifty. Once a mecca for the world's fashion brands, Japan today is singlehandedly causing a depression among European fashion companies. The Japanese economy shrank by 0.7% in 2008 as a result of the world financial crisis and likely has shrunk by more in 2009.

A natural question is whether the U.S. is headed for anything like Japan's 20 years of stagnation. It has suffered a painful stock and real estate market crash, not as proportionately large as Japan's, but nevertheless the worst since the Great Depression. The U.S. government has responded faster than Japan's, but in much the same way--bailouts and grade inflation (in the form of relaxed accounting requirements) for banks, a surfeit of deficit spending, a trillion dollar plus money print by the Fed, and cash given one way or another to consumers. The private sector response has also been similar. Japanese banks didn't make new loans, because of all the bad loans they didn't have to write down. The Japanese government liquidity that was dumped into the economy found its way to investments in Japanese government debt (i.e., the Japanese trusted only their government and wouldn't make private sector investments), and the carry trade, where yen were swapped for higher yielding currencies (like the U.S. dollar) and invested overseas. Today, U.S. banks don't make new loans because they still hold a lot of bad loans and cranky assets. Vast shiploads of the U.S. government's stimulus money is flowing into the carry trade and going overseas, or is being used for commodities and stock speculation. Some of the money loaned by the Fed to U.S. banks is being invested in U.S. Treasuries or is left on deposit at the Federal Reserve Banks. The net effect of these circular transactions is the outright transfer of money by the U.S. government to banks (in the form of interest payments less the minimal costs of banks borrowing from the Fed) for no reason other than that they are member banks.

In short, sloshing a lot of money around is a poor substitute for dealing with economic fundamentals. One begins to suspect that the Fed's and Treasury's secret intention is to stall for time in the hope that the economy somehow recovers. But evidence of recovery is limited, and such that exists indicates a slow recovery. The U.S. stock markets have risen some 60% since March 2009. But the Nikkei 225 also had sharp spikes during its secular decline of the last 20 years. Today's bulls seem to assume that because the market has been on a tear recently, it will always and forever rise. There evidently is no bull market on the learning curve.

The Japanese experience of the last 20 years contains a couple of noteworthy lessons. First, monetary policy doesn't have much impact when the financial system is dysfunctional. Pumping vast amounts of cash into banks and other financial firms has little benefit for the real economy if the cash is siphoned off into commodities and stock speculation, the carry trade, U.S. Treasury securities, or is held in anticipation of having to write off losses banks have been allowed to defer. The velocity of money--or rate at which it turns over--is effectively zero when the cash simply is sent back to the government, as is the case when American banks take federal assistance and invest it in Treasury securities or deposit it with a Federal Reserve Bank. For the velocity of money to be positive (a predicate to effective monetary policy), new loans need to be made. That's been mighty slow to happen.

Second, zero or ultra low interest rate policies won't necessarily spark an economic revival. Indeed, they may be unproductive. When the cost of borrowing is virtually zero, a lot of basically stupid activities begin to make mathematical sense in an ROI (return on investment) analysis. Thus, a lot of the federal stimulus has gone into commodities and currency speculation. Or else it has been used to gamble in stocks when the price-earnings ratio is signalling with a big, bright yellow light (see http://blogger.uncleleosden.com/2009/12/warning-from-price-earnings-ratio.html). Asset speculation won't revive the real economy. At the same time, savers--especially retirees who live on interest from their assiduously accumulated CD's--embrace thrift more than ever, reducing consumption when consumption is most needed by the economy. It's one thing to reduce the fed funds rate to lower banks' costs of borrowing in order to motivate them to lend. But when they won't lend because their books are full of rotten-to-the-core assets, reducing interest rates only cuts consumption without increasing lending. The Fed may be pushing things backwards.

Huge government deficits and big money prints can stave off a plunge into depression. They did in Japan, and they have in America. But they won't produce prosperity. That's the lesson that Japan of the last 20 years teaches, and the one that America hopefully learns before suffering 20 years of stagnation itself. Raising interest rates would impose at least the beginnings of investment discipline resulting from an actual cost of capital, which in turn would lead investors to question the wackiness of some of the stuff that's now au courant. Perhaps some funds would even be put to use in the real economy. Even if GDP growth were muted in the short term by increasing interest rates, money invested more intelligently could lay the foundation for long term growth. If Wall Street won't serve the socially valuable purpose of intermediation between savers and economic investment (as opposed to financial speculation), it should be bypassed. Stimulus money could be used for job creation and funding Main Street, as the Obama administration has lately proposed. From massive subsidies for the Erie canal and transcontinental railroad, to mail delivery contracts for nascent airlines, to investment tax credits and job creation measures of every stripe and variety, governments have intervened in the economy for the public welfare. Why stop now? Conservative purists and theorists would object, but their guys, Alan and W, really screwed things up. Why listen to a bunch of failures?

Additionally, immigration standards should be relaxed for highly educated workers from other countries that could bolster America's high tech and other industries. Taking other nations' intellectual capital provides a competitive boost of the first order. Those seeking to come here are ambitious and hardworking. They're exactly the people needed to revive the economy.

There are good reasons for the Fed to pull back from its unprecedented liquidity dump of the last year. But that's not enough. The Fed should impose much more stringent bank capital requirements. It should also make banks book the losses that remain swept under the carpet and greatly improve their risk management controls. Capitalism works only if responsibility and accountability are part of the picture. The government, by intervening, prevented market forces from imposing full responsibility and accountability on Wall Street. The government's subsequent kind and gentle treatment of the reckless few, who caused so much harm to so many, leaves open the possibility of future morasses. Such morasses have been Japan's experience for the last two decades, and they portend America's future unless risk, as well as reward, falls on the high and mighty along with everyone else.

How to Heal the U.S. Economy

Today, November 13, 2007, the business news was dominated by the mortgage mess. Recently announced bank losses make clear that the Federal Reserve's interest rate cuts in September and October haven't made the boo boos go away. Instead, they've returned with a vengeance, bigger than ever, and are knocking chief executives out of corner suites. All predictions are for further losses this current quarter and next year. While the Federal Reserve expects an economic slowdown, but no recession, many private sector prognosticators are more pessimistic.

Clearly, the financial services sector is wagging the entire U.S. economy. The New York Times reported on Sunday, November 11, 2007, that the financial sector accounts for 31 percent of all corporate profits in America. That's too much. You can't build a thriving economy on financial services. Banks don't produce anything tangible--you can't eat a financial service, wear one or seek shelter under one. Financial services are simply an adjunct to the true heart of any economy--the production of goods. People survive by extracting resources from the environment around them. That's why the production of goods remains the foundation of true economic strength. (If you don't believe this, think about China.)

Financial services firms are unquestionably necessary in a modern economy. They facilitate the process of economic exchange on a large scale, across long distances and even over international borders. They pool excess savings and make it available to businesses that hope to make productive use of it. They provide investment services to those who hope to save for the future.

But, as any good economist will tell you, there is a limit to the value of anything. Too much of anything and it loses value. The first bite of Belgian chocolate is much better than the 20th bite. And so, too, with financial services. Financial services firms used to make their money by providing savings and investment vehicles for the thrifty, underwriting offerings of securities for companies that needed capital, and making loans to businesses and other borrowers that were creditworthy. Today, financial services firms are obsessed with booking fee income, even if it means creating and selling opaque, complex, risky and illiquid investments that ultimately are causing a lot of pain and doing little or no good. The recklessness of the bankers involved in this stuff has resulted in hundreds of billions of dollars of accrued or likely losses. That's still a lot of money, even today.

Financial losses such as these cannot be eliminated. The only question is where they will land. They've been landing on hedge fund investors, banks, mortgage lenders, mortgage brokers, and last, but certainly not least, homeowners. And if there is a government bailout, as some on Wall Street and in Washington are crying for, losses will land on the taxpayers.

The subprime mess is the product of taking financial services too far. We don't need this much financial engineering. We don't need this much investment in real estate. Trying to turn people with poor creditworthiness or no creditworthiness into homeowners is like trying to build a house in a rain forest with mud bricks. And the worst part of it is that this was national policy. Homeownership was encouraged, not only for its supposed civic benefits, but because a rising real estate market would provide home equity that consumers could tap into in order to continue their merry escapades at the mall.

But you can't build wealth by creating asset bubbles. Home prices and equity can't rise continuously forever. Why all the brilliant and highly educated people on Wall Street couldn't figure this out is a very good reason not to rely on financial services to be a future engine for the U.S. economy. These are not people who should receive government subsidies or bailouts. The financial services firms should be forced to take responsibility for their actions, and book their losses.

The wealth of the U.S. is shrinking, with the dollar dropping in value and foreign capital quietly exiting with scarcely a tip for the hat check girl. Given our zero percent savings rate, America's limited capital base shouldn't be funneled toward more financial engineering or further attempts to make home loans to the non-creditworthy. Instead, it should be guided toward production.

America is a creative nation. Its creativity has made it the science and technology center of the world. More Nobel Prize winners in the sciences live and work in the U.S. than anywhere else. The Silicon Valley is a magnet for geeks from all corners of the globe. Formal and informal venture capital is available for almost every manner of tinkerer and garage-based technology startup. With its advantages in science and technology, America is a natural for the production of high tech products. Biotech is another area of great potential. Entertainment, including movies and television programming, is a major export. Okay, 98% of it is dreck, but it's better dreck than the movies and TV programming other nations produce. With global warming and industrial pollution in the third world rising, pollution control and environmental protection technologies are another area where America could do well. America is perhaps the world's largest producer of commercial aircraft.

International trade agreements make direct government subsidies of particular industries problematic. But let's stop diverting undue amounts of capital into real estate. It's only encouraged a degree of financial engineering that was too clever by half--and then half again. And we should require adult behavior from Wall Street. The Fed should keep the overall financial system liquid enough to function. But it should require losses to be booked, and managements to be held accountable. We have a crisis today in the financial markets because of a severe misallocation of capital caused in part by government policy and in part by monumental misjudgments by financial services firms. Extending or perpetuating that misallocation will prevent the U.S. economy from healing. The pimply-faced kid in a garage attic working on a pocket-sized device that makes phone calls, brews coffee, browses the Internet, picks up the dry cleaning, takes photographs, writes a novel, cooks a meal, displays TV programs, and drives your car automatically using GPS, is the future of America. He shouldn't have to compete for capital with a bunch of real estate speculators who have access to government subsidies.

Animal News: cows flee McDonalds. http://www.wtop.com/?nid=456&sid=1291604. Who can blame them?