I am neither a great economist nor a great markets thinker. I am, however, one who has spent over 20 years in or around the markets and have a pretty intuitive sense (IMHO) of what's going on. There is a lot of noise out there, and I'd like to try and bring a little intuition to today's landscape and to shine a light on the trade-offs our policy-makers face as we try and navigate out of the current mess. I will use the credit crisis as the launching point, raise some of the ripple effects of this contagion and ponder the dilemma faced by the Treasury, the Federal Reserve, Congress and propose steps we might take to improve our prospects.
1. The Credit Crisis
Background: The break-down of the credit markets has triggered fear and uncertainty across financial markets the world over. The crisis has triggered a profound liquidity crunch not just among vehicles supporting mortgage debt, but across a wide array of asset classes. And this has been reflected in the trading of asset-backed securities derivatives like the ABX, and the fact that supposedly "super senior" securities are trading at 80 cents on the dollar (does super senior really mean, like, BB?). And the impact is felt not only in the realm of liquidity, but in the area of financial statement integrity. Where do all of these assets live? And what about some of the more complex derivatives supporting them? We know that Wall Street firms are holding lots of this paper. How are these assets being accounted for? If one really marks their books to market and adjusts for the "Tier 3" mark-to-model securities, is Wall Street effectively bankrupt? Inquiring minds want to know.
Impact: Mortgage lenders are scared and many aren't lending at fair and logical rates to even prime borrowers. Favorable debt markets that supported the multi-year spate of private equity buyouts has ground to a halt. Stocks across the global financial services industry have been hit hard, as announced bad news, anticipated bad news and uncertainty create an environment of pure fear. The US Fed has dropped rates to inject liquidity into the system, even in the face of an historically weak dollar and an economy that is at or near full employment and growing at above-trend rates. This has raised the issue of "moral hazard" and concerns that the Fed and Treasury are synthetically engineering a bailout of the banking sector. The crisis has also had a dramatic effect on both investors' and consumers' mind-sets, raising questions about the integrity and security of our financial institutions and related markets and the quality of the current accounting regime. This has shaken consumer confidence and created an environment of mistrust, uncertainty and volatility. The Fed, Treasury and accounting policy-makers are, in short, between a rock and a hard place.
2. The Dollar
Background: The US is the debtor to the world, and the problem has only gotten worse. Hundreds of billions spent on unproductive activities in Iraq coupled with a lack of faith in the fiscal prudence of the current US Administration has placed downward pressure on the greenback. This pressure has only accelerated in the wake of the credit crisis, as the integrity of US dollar assets has been questioned as well as the likelihood that the Fed will continue to walk rates down until the liquidity crunch abates. This makes holding US dollar assets increasingly unattractive on both absolute and relative bases, and when taken together with the uncertainty concerning US war spending, Fed policy and fiscal responsibility, it just doesn't provide an investor, be they domestic or foreign, with much incentive to go long the dollar.
Impact: A plunging dollar makes imports increasingly costly to the US consumer, putting upward pressure on retail prices and downward pressure on retail demand. This has the effect of putting the brakes on the retail component of GDP growth. It also makes it less likely that the persistent and rising US deficits will continue to be willingly sopped up by foreign central banks, causing interest rates on longer-dated securities used to fund our deficits to rise. This will, in turn, cost the US taxpayer more to simply fund the current level of indebtedness, not to mention the likely increases arising from continued war spending and entitlement programs. And higher rates on longer-dated instruments will also make private sector capital projects more costly to fund, placing a further damper on business spending that will cyclically wane in the face of weakening consumer demand. None of this is good for the US's near-term GDP prospects, yet this weakness is happening just as inflationary pressures are building in the system.
3. The Price of Energy
Background: Oil prices are near their all-time inflation-adjusted high, causing prices at the pump to elicit "sticker shock" from the historically spoiled US consumer (as prices in Europe and other parts of the world often include an energy tax, rendering prices often 2x or more than those in the US). With China and India (but China in particular) taking up an increasing share of global oil production, demand-driven inflation is likely to be with us for a long, long time.
Impact: This is yet another inflationary pressure, and in a sense almost immunizes the effects of a Fed easing. While the US economy is becoming progressively less dependent on oil as a percentage of total output, it is still a big number and has a material effect on both retail prices and consumer psychology. Even with tremendous investment in alternative energy, the impact of these news technologies is unlikely to have a marked effect on our oil consumption any time soon. US consumers are loathe to give stuff up, but if retail energy prices remain at their historically high levels or move even higher it will cast a pall upon our growth prospects (particularly durable goods) while possibly catalyzing inflation. A bad ingredient in an already troubled stew.
I am not one to use terms like "perfect storm" or "six-sigma events" or anything like that (since I think - sorry, I KNOW - the reality of fat tails and non-normally distributed risks), but it is pretty amazing that today's credit crisis is happening in the wake of some stuff that is totally unrelated to it but sharply impacted by it. Runaway Chinese growth and its insatiable demand for oil is not a driver of our credit crisis, nor is our war in Iraq. However, when you overlay the credit crisis on top of these two things it highlights the interconnectedness of today's flat world. Yes, China growth and war in the Middle East does impact the credit crisis, putting our policy-makers in an almost impossible spot. Focus on stable prices, protect the dollar and avoid the temptation to lower rates and let the credit markets roil as they must? Ok. But the short-term pain is simply neither socially nor politically feasible. We can argue all day as to whether or not this is right, but I am a pragmatist and I know that wasting my breath in this area is fruitless.
The Fed will do what it thinks it can do to dampen the impact of the locked-up credit markets, but the reality is that its power just ain't what it used to be. Regardless of what they do there's going to be lots and lots of pain felt by many, both inside and outside the US. We are at a time when trust in our Government, our financial institutions and our markets are at a generational low, yet we need this trust now more than ever. How else are we going to navigate an environment of forced low short-term rates, rising long-term rates, falling GDP prospects, a historically weak dollar and inflationary pressures all rolled into one? Poor navigation will lead us right into the dreaded place we found ourselves in during the latter part of the 1970's - stagflation. In short, hell on earth.
If one takes as a given that the Fed will lower rates as need be to inject liquidity into the system, what is to be done about today's confluence of adverse events? Well, here are a few ideas. I know I said I was pragmatic, but allow me to venture a bit into fantasy land. Because without a little fantasy, what would life be like, anyway?
- Stop the war. The economic destruction of the war can't be overstated. It is diverting hundreds of billions of dollars to unproductive uses, crowding out private sector investment and placing upward pressure on long-term interest rates that will have an increasingly material effect as the dollar continues its descent. The issue is social, psychological and economic. And there is no clear end in sight. The mere drawing of a line in the sand with clear time lines (and, therefore, knowable economic impacts) will have an immediate and positive effect on the markets.
- Stop stupid spending (over and above the dollars spent on the war). For some reason profligate spending has peaked during an Administration that ran on a platform of small, fiscally restrained government. Anyway, there is enough pork tossed around to feed several countries. All worthless spending needs to stop. There are plenty of productive areas in which these dollars could be diverted, be they science and math education, creating the proper incentives to fix the health care and social security systems, supporting immigration of talented and motivated individuals wanting to settle in the US, investments in alternative energy technologies, etc. The list goes on and on. And cutting or neglecting this stuff while investing in a war is just plain stupidity.
- Keep taxes low and encourage investment. David Malpass of Bear Stearns wrote a very good piece in Saturday's Wall Street Journal addressing this very issue. He provided a lot of interesting history but his punch line, creating certainty regarding low future tax rates and employing policies to make investments in dollar assets attractive, is right on target. His article specifically addressed the issue of how to stem the seemingly endless decline of the dollar, and is one of the key planks in my platform of helping extricate ourselves from our current economic plight (blight?).
- Fix the health care system - now. And while I'm on my fantasy kick - how about social security as well. While the three items above are really important and will have a very real impact on the markets, psychology and possibly even the dollar, health care and social security are the two biggest long-term challenges facing our citizenry. Talk about crowding out private sector investment and placing upward pressure on long-term rates! The trillions of IOUs and squandered resources will kill us if failure to address the first three prescriptives don't. In addition to neither being a great economist nor a great thinker I am certainly not a politician, great or otherwise, so I'll leave this issue right here. But I do know that someone, somehow, sometime soon is going to have to sacrifice their popularity and launch a full-out assault against these issues. Otherwise, we're just screwing our children. And I love my children. More than anything.
Hopefully this stitching together of seemingly disparate issues into a common fabric has been helpful. I'd love nothing more than to see a few (or more) of the prescriptives followed in an effort to get us out of this mess. Hopefully someone out there is listening. Hopefully.