The biggest step towards the world of modern finance was the abandonment of the Bretton Woods stability framework and fixed exchange rates that took place in the 1970’s and Nixon's final nail in the coffin for gold convertibility with the US Dollar.
It was not for the reason that most believe i.e. the creation of fiat currencies but because of the creation of a new era of financial complexity. Suddenly the world had a plethora of new financial variables - exchange rates, floating rate instruments denominated in euro-currencies and I do not mean the Euro of today but the euro market that originated for dollar based deals that were outside the US jurisdiction and based in London, financial futures and swaps etc. etc.
Not only was there an explosion in the number of variables but innovative financiers began to exploit relationships within this new web of financial variables eventually creating layers of derivatives etc. This opened up the era of financial arbitrage – and allowed the smart money to think they were getting a free lunch....
Thirty years later we know that the lunch was rather expensive.
The Free Lunch Seduction
I often find my thinking process stimulated by comments on Seeking Alpha. Such was the case with Morph366’s comment. We have gone through a period of nearly thirty years duration where the free lunch seduction has occurred. The ideal of working for a living was replaced by the ideal of dealing for a living. Americans bought into the concept that we could borrow our way to wealth and become rich by building houses and selling them to each other. We have outsourced what we considered “menial” labor (assembly, construction and customer service) to a flood of immigrants (many undocumented or “illegal”) and lower paid but well educated people in the former “third world” (mostly Asia).
Instead of borrowing to build the means of production, we borrowed more and more for consumption, and also for other non-productive ventures, such as buying stocks, real estate, complex financial derivatives, etc.. There is good debt and bad debt. Good debt is used to develop things of utility. Bad debt is used to increase consumption or to leverage further debt. Bad debt is what America has specialized in, on both Main Street and Wall Street.
I think a sports metaphor is appropriate. Twenty-five to thirty years ago, Americans thought they had a comfortable lead in the world economic game and felt they could “mail it in” for the next period in the game. The “all-stars” felt they could get by on show boating, on razzle-dazzle plays. As a result, a commanding lead has been surrendered to those who took the game more seriously. To get back in the game, team America must return to fundamentals, play hard as a team, and start making winning plays again.
The Wealth Effect
What has happened to the prosperity of the past thirty years? In fact, the prosperity, for most, was illusory. In early 2007 a typical American felt he (she) was making economic gains because they had a $250,000 house with a $220,000 mortgage, a retirement savings plan of $20,000, two recent model cars purchased on credit with $25,000 still owed, plus furniture, personal affects, vacations, etc. purchased on maxed out (or at least high carrying balances) credit cards. Our typical American felt they were enjoying all the trappings of wealth.
In fact, the balance sheet for this example was probably barely positive, even in early 2007. The market value of the cars was probably less than the balance owed, say $15,000. If the credit card balances totaled $15,000, the liquidation value of the “assets” purchased was probably half of those balances. The net worth would have been in the vicinity of $30,000.
Fast forward to early 2009 and the market value of the “$250,000" house is down (say about 25% to about $190,000). The retirement savings plan is cut in half. The gap between the amount owed and the market value of the cars has increased. The mortgage and credit card debt is little changed, while the personal “assets” are further lowered in value. The net worth is now in the vicinity of -$30,000.
While it is true that both snapshots (2007 and 2009) are simply “on paper”, the seduction of a sense of positive net worth has been cruelly smashed. The wealth effect has become a negative wealth effect.
The Indenture of America
Was has happened to our typical American? He (she) has in effect been put into indentured servitude. He (she) will have to work for several years to return to a positive balance sheet. Eventually, if the former behavior of living on credit is modified and there is economic recovery down the road, including a future rise in home values, our typical American will again have a positive net worth.
All this will happen, of course, if our typical American remains employed. Failing that, extended servitude or personal bankruptcy is likely, and the home could be lost to foreclosure. This is why a recovery based on saving the financial system alone will not succeed. Without jobs, there will be no recovery.
Lack of Economic Diversity
The free lunch seduction led to a lack of economic diversity. From the late 1940s to the mid-1960s, the financial sector produced an average of 12% of the earnings of the S&P 500. By the early 2000s, the financial sector exceeded 40% of the earnings of the S&P 500. This is shown in the graphs published in Simon Johnson’s article in The Atlantic Monthly, May, 2009.
Until the historic balance of economic diversity, with earnings (in a healthy economy) outside the financial sector reaching a level above 80% of all earnings, the lack of diversity will be a handicap. Production of tangible goods and services must become a higher percentage of GDP. We must lower percentage of GDP derived from paper pyramids of credit derivatives. Money should return to being a medium of exchange (the means to an end) and cease being an end objective in and of itself.
The Decline of America’s GDP
The real GDP of the U.S. has been following a declining trend line, as shown in the graph below. The black trend line shows a slight drop in GDP from 1947 through 2008. When we break the graph into two time periods, as indicated by the vertical black line, we see that there was only a slight drop in GDP 1947-1982 (red line). The steeper drop in the GDP trend line has occurred since 1983 (blue line). This coincides with the dramatic rise in the share of S&P 500 earnings accruing to the financial sector. I can attribute no cause and effect from this observation alone, but the correlation, be it coincidence or not, is clear.
click to enlarge images
It would not be unreasonable to propose that the contribution of financial sector endeavors to GDP is less than some other sectors of the economy. Banking is included in GDP only as profit and salaries. Buying and selling of stocks, other financial securities and most other assets are also not included in GDP. On the other hand, all the costs of putting together a widget are part of GDP.
The following graph indicates that the S&P 500 earnings rose along the same general trend line as GDP from 1947 through 1982. Then earnings growth underperformed GDP growth for a period of the time after 1983. So S&P 500 earnings behavior does not offer clear support for a lower “effectiveness” for the financial sector with respect to GDP looking at the first following graph.
However, a second graph that looks at S&P 500 earnings from 1988 through 2007 tells a clear story. In that graph, the higher slope of the earnings trend line indicates that, as financial sector earnings became an ever larger portion of all earnings, GDP growth did not keep up with earnings. This is a basis for arguing that the financial sector has inefficiency in contributing to GDP.
An argument might be made that resources consumed by the financial sector “froze out” other sectors from access to growth capital that could otherwise have been available. Capital consumed in creating leveraged financial instruments with the sole objective of making money could well be less efficient in producing goods and services that would increase the GDP, than would investment in the means of production, which should have a higher multiplier effect.
There has been a massive shift of wealth from the middle income population and the poor to the wealthy in the past 30 years. This can be seen in the changes in income distribution. The following quote from Robert Reich discusses this:
As economists Thomas Piketty and Emanuel Saez have shown, in the 1970s the top-earning 1 percent of Americans took home 8 percent of total income; as recently as 1980 they took home 9 percent. After that, total income became more and more concentrated at the top. By 2007, the top 1 percent took home over 22 percent. Meanwhile, even as their incomes dramatically increased, the total federal tax rates paid by the top 1 percent dropped. According to the Congressional Budget Office, the top 1 percent paid a total federal tax rate of 37 percent three decades ago; now it’s paying 31 percent.
The last time we reached this level of wealth concentration was in the late 1920s, just before The Great Depression. I like the metaphor comparing the economy to a poker game. (I know I have heard this from someone else, but I do not remember who, so there is no attribution.) In a poker game, the table is at first filled with many players. As the game progresses, the chips can become concentrated in fewer and fewer hands. If eventually all the chips are held by one player, the game is over.
In the following two graphs are shown the rising difference between average and median family incomes. This is an effect of the polarization of the distribution of income since the early 1980s; a small number of very high incomes increase the average, but have little impact on the median.
An example of the where the growth in high incomes has come from can be seen in the following table, data taken from the Goldman Sachs 2006 annual report.
Goldman Sachs may not represent the average for the financial sector, but they surely provide an example of income distribution that is hard to justify. Just how many goods and services of utility did these Goldman Sachs employees provide? With the average financial sector pay reaching as high recently as 180% of the average for all sectors (see the Simon Johnson graph earlier in this article), we can revisit the question of efficiency of the financial sector in increasing GDP.
One effect of the very high income levels in the financial sector would be that income that otherwise would end up as corporate earnings is, instead, used to increase the personal income of employees. We have seen in the Simon Johnson graph (earlier in this article) that financial sector average income per capita has been as high as 180% of the average of all incomes. Thus, the amount of earnings for the S&P 500 would actually have been higher over the last 20 years had financial sector compensation continued the historical pattern (prior to 1983) of tracking the average of all compensation.
The following graph shows the amount that the S&P 500 earnings would have been increased (plotted by quarters) had financial sector compensation had the same value as all compensation, with the difference accruing to corporate earnings. Remember, this was the case before 1983. If this had happened, the difference between corporate earnings growth and GDP growth would have been even greater than shown earlier. It is clear that domination of the financial sector and rapid growth in that sector diminishes growth of the economy as a whole.
The Seduction of the Example of the Successful
Another seduction is the idea that if a few become wealthy, it proves the hypothesis that anyone can get wealthy. In fact, it is my hypothesis that the utility of concentrated wealth is often diminished compared to distributed wealth. A thousand millionaires have much more economic potential than one billionaire. The very concept of capitalism is that competition produces efficiency and growth. That concept is handicapped when wealth is highly concentrated.
It is a seductive idea that because one person has accumulated wealth you can also. In fact, the accumulation of great wealth by one person diminishes the opportunity of wealth accumulation by others. (Recall the poker game metaphor.) One means of trying to diminish this effect by means other than direct confiscation (read: higher taxation) leads to the next seduction, monetary expansion.
The Monetary Expansion Seduction
Since Alan Greenspan “saved the world” with a massive liquidity response to the 1987 stock market crash, the Fed (and other central banks) have responded to every shock, large and small, with easing and monetary expansion. This type of response is appropriate when the crisis is one of liquidity but has little merit when the problem is one of solvency. We have been seduced into believing that we can be rescued from ill-conceived risk taking ventures by government and central bank action. We have been seduced by the “mother of all moral risks”. This has severe consequences, as the Japanese can witness. Gary Dorsch has written a comprehensive indictment of easy money policies.
Monetary expansion to address ill-liquidity can be targeted and controlled, so that limited inflationary impact can be realized. On the other hand, monetary expansion in response to insolvency issues across a significant scope of economic activity (like a banking system), is difficult to quantify, difficult to control with respect to long-term effects and, as a result, can have uncertain long-term consequences.
The increased monetary supply can be absorbed for an extended period of time by deleveraging. If the monetary expansion is kept short of the amount needed to actually off-set the impaired assets (the insolvency), economic activity is suppressed and deflationary pressures exist.
If the increased monetary supply is in excess of the amount needed for deleveraging, the outcome can be a painful surge of inflation down the road.
The difficulty in controlling the monetary expansion process is why an exact accounting of asset impairments (such as in bankruptcy) is necessary. Japan did not do such an accounting and has paid the price (under-expanding the money supply and stalling their growth) for more than 15 years. Sweden did such an accounting and their banking crisis (and aftereffects) passed quickly. Other countries have suffered run-away inflation when they avoided needed accounting. We still can do such an accounting, but statements from the new administration and the Fed, plus the relaxation of accounting rules (“mark-to-market”) are making the needed accounting look less likely.
We are being seduced to believe that we can solve the crisis with “easy money” and do not need to address the systemic defects that caused the current crisis. The good news: It is not too late to change course.
The Seduction of Leverage
Related to the seduction of monetary expansion, is the seduction of leverage. As leverage has become much greater in the past 25 years, the occurrence of defaults has exploded to levels not seen since the Great Depression. From gigantic derivative schemes on Wall Street all the way down to ill-advised (and fraudulent) mortgages on Main Street, the opportunity for quick profits on origination of and “flipping” assets (be they houses or derivatives), has seduced America with the siren song of easy profits. The greedy view was 1-10% capital and 90-99% credit would produce 10-100% profit with a 10% gain in asset value. When the asset instead fell 20%, the entire deal was in default.
The following graph (from Felix Salmon ) shows default rates since 1920. While your attention may be drawn to the spike to almost 16% default rate in 1932-33, the “weight” of defaults for the 24 year period 1920-1944 is actually a little less than the 24 years from 1982-2006. This has been determined by estimating the areas under the two curves. This calculation does not include the drastically higher default rates experienced in 2008 and expected for 2009 and 2010.
America, from Main Street to Wall Street, has been seduced by a free lunch mentality with regard to the use of capital. Too many came to believe that credit used for consumption or purchase of non-productive assets provided a pathway to wealth. Too few followed a path involving the use of credit to build new and improved means of production, which would have created an economic multiplier effect and true wealth.
Our government has followed a hazardous fiscal policy based on the concept that the stimulation effects of deficits could grow the economy. Growth would balance the budget. There may be times when that can occur, but we have just seen one time period where that idea was fallacious.
On Main Street, reckless borrowing by some for homes they could not afford, created a bubble of mortgage defaults, enabled by overbuilding and poor underwriting practices by mortgage brokers. Credit card debt, always a potential problem, just compounded the personal credit crisis situation.
On Wall Street, pyramids of debt, based on equity in bubbling real estate among other assets, were compounded further by highly leveraged derivative instruments, producing complex structures of interrelated obligations that could not support their own weight. The motive seems to have been, for many of these instruments, to do deals for the fees, not for deriving longer term benefit.
What we have witnessed in America is more and more monetary actions which are not part of, nor contribute directly to GDP – loans, securitized instruments, interest, appreciating assets. We have confused these with “real” accumulation of wealth.
Have you ever wondered why reselling of an asset is not in GDP? Well, it is obviously not relating to real economic growth.
America stopped saving, not because we were not a nation of savers, but because we felt we could make money in other ways. We were seduced. Saving should be a reservoir of potential production (GDP). We have been making money by buying and selling assets in a non-productive manner (stocks, financial instruments, real estate, etc.) When the value of these burst, we lost a significant portion of our GDP potential. The bottom line is we mistook money, conspicuous consumption and non-producing assets for wealth.
America, we have been seduced by mammon. It was a wild and thrilling night. But now it is morning. Mammon has fled. And we have to look at ourselves in the mirror and wonder how we could have been so gullible.