As the “Greatest Deleveraging in the History of the World,” continues along a bumpy road, with the bumps created by well-meaning political leaders, one must sit back and ask what we can learn from the past in order to better understand the present.
I would relate current US fiscal and monetary policy to a form of Asian (con)Fusion, which is leading to what I would call bi-modal financial markets.
Many of us have eaten at a Chinese, Japanese or even Thai or Vietnamese restaurant before, but once in a while you may have stumbled upon an Asian Fusion restaurant. The Fusion refers to either the offering of multiple types of Asian cuisine or the melding of those Asian cuisines into a single dish….much as we find in US policy today.
Let’s start with what the US told Japan when its banks faced massive credit problems from declining asset values in the 1990s. Quite correctly, the Americans told their democratic counterparts in the Far East to let the sick banks fail and make room for a repricing of risk – in essence, a clearing of the market so it could function efficiently again. The Japanese politely said “no thank you” and considered the socio-political costs of a major bank crisis to outweigh the quicker resolution of economic problems.
Facing a similar dilemma in 2008-2009, the US Government looked back at what it told Japan in the early 1990s and just as quickly went for the same ‘zombie bank’ solution instituted by Japan against the urging of the US Government. What goes around comes around, and the US now faces a similar bout of low, slow growth for an extended period of time, while all players in the economy (except the US Government) do their best to deleverage in their own way.
Want to see banks lend money for business, real estate purchases, etc? Sorry, with hidden losses of unknown ultimate size on their balance sheets, large banks are not about to ease the lending spigot. And, smaller banks, paying for their rush to yield (higher risk, RE development loans in many cases), have neither the current capacity, nor any real hope of raising capital to offset losses.
Oh, but if we kept interest rates close to zero, surely banks will lend and the economy will be kick started? At least that is what the Federal Reserve thought. Of course, the reality goes back to the type of lending being discussed.
Corporate bond markets are their healthiest since the Lehman closure of 2008, as these large companies provide public information and have a greater, more diversified economic footprint than smaller companies. Bank lending to those smaller companies continues to shrink, despite zero short term rates. So, I guess Chairman Ben gets a 50% on his report card – still an ‘F’ according to typical grading scales. And more quantitative easing – buying US Treasuries to help out his fiscal “compadres” – would produce the same result, while easing the way for cheaper Treasury issuance (nothing beats the terms you can give yourself on a loan).
But, what if the US instituted the Chinese policy of mandating loans to businesses? It seemed to help keep China out of the global recessionary soup, right? So far, so good, but we all know many of those banks are government run and many of those loans were made to government run enterprises. And, besides, it takes some time before a bank knows that it has actually made a bad loan.
Undaunted, the US Government is in the process of providing incentives for banks to lend to small businesses.
Some banks say, ‘no thank you,’ not trusting a Government that might change the rules of the game and make senior management’s lives miserable. While, other banks, thirsting for a lower burden from the TARP funds they received to keep ticking, will take the bait. How effective this program will be to kick start the economy remains to be seen (small businesses do tend to move quicker in adding to payroll than more conservative, slower moving, large companies). However, has anyone done an analysis of what unintended consequences the success of the new small business lending bill may bring? Will it be a Chinese style temporary surge in economic activity or only a blip on the radar screen of economic growth?
The lessons to be learned from the US’ Asian (Con)Fusion economic policy are this:
1 – “The Greatest Deleveraging in the History of the World” continues, only slightly impeded by governmental efforts to borrow against future economic growth (that’s what a loan/bond really is) or coerce/convince others to do so as well. In other words, this is a trend that will take time to play out and will eventually reassert itself after the effectiveness of government roadblocks decline. However,
2 – There exists the possibility that these and future Government efforts to accelerate economic growth may succeed in the short term and cause some rather severe disruptions in financial markets. Thus,
It is highly likely that we are facing bi-modal financial markets at this time. Put simply, markets can do quite well, or quite poorly with a greater probability than expected by all those fancy Markowitz efficient frontier models. With that in mind, it is more important than ever to stress test your company’s portfolios for ‘worst case’ scenarios (you can stress test for ‘best case’ scenarios, but ‘best case’ results are typically not a concern). There are many ways to do this, from several different perspectives such as market value changes, credit write downs, spread changes, yield curve changes, inflation/deflation impacts on both sides of the balance sheet, etc.
Finally, with the US Government’s continued policy of Asian (Con)Fusion, perhaps we all should keep in mind a few of the quotes from the great Chinese philosopher, Confucius:
"To know your faults and be able to change is the greatest virtue."
"Knowledge is recognizing what you know and what you don’t."