Dear Friend of WISE,

Remember God is in control and we each need to seek Him for His will for our lives -  especially in this season.  I thought this sobering commentary by David Smick (which was sent to me by David Roth, Thank you David), would be a good read for our network.

We need to be harmless as dove's but wise as serpents.

 

A Never-Ending

Economic Crisis?

The 2008 meltdown was badly handled; the 2009 recovery may

be a bubble; portents for the future are worrisome indeed

By David M. Smick

THE GLOBAL economy has experienced a

brutal financial retraction not seen since

the 1930s. The value of virtually every

asset in the world was reappraised downward,

led by housing in the United States.

The situation has been like an unstoppable

force of nature. In response, most of

the world’s central banks, including the Federal Reserve in

the United States, slashed short-term interest rates to near

zero percent and flooded the financial system with liquidity.

World governments produced fiscal- stimulus packages

of mind-boggling size.

Global governments spent an astonishing $17 trillion

to support the world economy in the form of bailouts, guarantees,

and stimulus packages. To put this number in perspective,

$17 trillion represents one quarter of global GDP.

Global budget deficits jumped by 737 percent over the previous

year’s aggregate global government deficits.

In the 12 months following the outbreak of the crisis,

global trade declined by 25 percent, global investment by

15 percent, and global GDP by nearly $4 trillion, or an

amazing 6 percent. Global industrial production in the advanced

economies dropped a whopping 15 percent. Worldwide

unemployment rates have skyrocketed, nearly

doubling in the United States alone. Wage growth is nonexistent.

The Obama White House says things could have

been worse. It’s hard to see how.

It is also hard to see why, since hitting bottom in

March 2009, the Standard and Poor’s stock index has rebounded

by more than 60 percent, NASDAQ more than 70

percent, with emerging-market stock indexes jumping over

90 percent. The U.S. financial-services industry is up an

incredible 125 percent since March 2009. Global equity

markets are booming. This suggests better times ahead.

The question is where? In the United States, or elsewhere

in the world? The question is also whether this powerful

DAVID M. SMICK is chairman and CEO of the Washington,

D.C., advisory firm Johnson Smick International Inc.,

founder and editor of the quarterly The International Economy,

and the author of The World Is Curved, now in paperback.

30 A Never-Ending Economic Crisis?: January 2010

equity rally is based on sound economic fundamentals.

Clearly a certain type of financial bet, called a "dollar carry

trade," is at work. In a dollar carry trade, investors borrow

money in dollars at low interest rates to buy assets with

higher yields, often offshore. Here’s the danger: carry

trades have a history of appearing suddenly and then vanishing

just as suddenly.

A Goldman Sachs analysis argues that once the "sugar

rush" of cash-for-clunkers and other forms of stimulus

wears off, and industries replenish their inventories, GDP

growth next year will drop to a modest 1.5 percent rate. According

to the Federal Reserve staff forecast, 3 percent if

everything goes perfectly, which they admit never happens.

And even that projection is a dour one when you consider

this: the history of recessions is that the harder the fall, the

higher the rise. Growth rates of 5, 6, or even 7 percent after

a steep downturn are not uncommon. Therefore, a 1.5, 2, or

even 2.5 percent growth rate in 2010 would be stunningly

disappointing news. And not just disappointing; it would

have enormous implications for the size of future public

debt. That’s because the Obama administration’s budget

and tax-receipt forecasts assume that the economy will

grow at a much higher rate, next year and for years to come.

That would be nice. But unlikely. There are two fierce

headwinds that will most likely continue to hold back consumption

and make this recovery disturbingly weak: the

first is rising joblessness, and the second is the soaring

U.S. public debt itself.

The Jobless Crisis

The official U.S. unemployment rate has nearly doubled

since Obama was elected. The so-called household survey

shows an even worse jobless situation. To a certain extent,

the president inherited this situation. But he also has allowed

the perception to persist that if only we could get the

economy moving again, fueled by his stimulus package,

the jobless rate will quickly come down. Not so.

For the U.S. unemployment rate to drop from the 10.2

percent rate it hit in October to 5 percent over the next five

years, which should not be an unrealistic goal, the economy

would need to produce 250,000 jobs per month each month

straight, according to the analyst John Mauldin. What are

the chances of that happening? Probably zero. It’s never

happened before. Sadly, average official U.S. monthly job

growth the past two decades has been 90,000. Even during

the most spectacular year for job creation, 2006, average

monthly job growth was only 232,000. Therefore, reducing

unemployment to where it was before the crisis may be impossible.

(Factor in state- and local-government layoffs in

2010 as a result of collapsing state- and local-government

finances and the employment situation looks even more

parlous.)

The most disturbing portent is that the economy lost

twice as many jobs in the third quarter of 2009—a time

when the economy, helped by the stimulus, grew at a

healthy 3.5 percent rate over the previous quarter, than

when the economy was contracting. A number of analysts

believe that the reason for this continued retraction is the

bond market. It costs about $314,000 in capital for the private

economy to create a job—versus about $1.2 million

per job created as a result of stimulus spending. The theory

is that public- investment dollars thrown at the stimulus

may have crowded out the delivery of capital to small

businesses in the private sector, which create most new

jobs.

This is only a theory for now. What is certain is that we

had better get ready for an American workforce full of longterm

anxiety and anger. And even if unemployment rates

start to come down, they won’t drop as much as they

should. That’s because the number of workers forced into

part-time status has soared and the average hours in a work

week have dropped. Thus, with any economic rebound, employers

will lengthen the work hours of existing employees,

not hire new employees.

If I sound too pessimistic, let me note for the record

that the U.S. stock market has surprised the world with its

performance. Economics is more an art than a science. So

maybe stock- market investors, collectively, are seeing

something the pessimists are missing: an explosion in "animal

spirits."

The economist Lawrence Kudlow foresees a "barn

burner" of a U.S. economic recovery just around the corner.

Kudlow is right, but only if this remarkable equity-market

rally has a positive "wealth effect" on consumers, particularly

affluent consumers who are responsible for more than

half of retail sales. That might happen, but the equity market

seems to be responding more to a perceived pickup in

global demand, spurred heavily by China, than to a robust

U.S. rebound.

Indeed, the risk here is that there will be an "equity

crash" when the predicted rebound does not come to pass.

It may be that the reason the Federal Reserve is leaving

short-term rates so low is that officials think the wealth effect

generated by the stock market may be our only hope of

a sustainable rebound. In other words, if the stock rally is

all you’ve got, don’t kill it, as tenuous as it might be as a

stimulus for consumption. If it lasts long enough, the carry

trade could also potentially attract more long-term investors

now on the sidelines. So for Fed Chairman

Bernanke, it’s a choice between the risk of another asset

bubble crash and a potentially slow, painful period of economic

and financial suffocation and rising public debt.

Here’s where things stand to date. As a result of the

crisis, U.S. consumers experienced a $13 trillion hit to

Commentary 31

their collective balance sheets through stock and real-estate

losses. That’s a horrifying number, given that the nation’s

gross domestic product is only $14 trillion. The good

news: Americans have gained about a third of these losses

back as a result of the stock market’s recent gains. Yet

housing prices remain problematic.

Today Fed officials say that the global stock market

boom since last March has restored about $14 trillion to

global wealth. But if this $14 trillion doesn’t have a sustainable

effect in turning around worldwide consumer sentiment,

there is little more the central banks and

governments of the world can do. With the exception of

China, they are largely out of fiscal ammunition. No wonder

they are investing so much hope in a change for the

better in the consumer’s mood.

The Public-Debt Crisis

The consumer’s mood is likely to be affected, and not for

the good, by the coming public-debt crisis. Take a look at

the Congressional Budget Office’s most recent projections.

Within a decade, the CBO says, the U.S. government will

be borrowing $722 billion just to pay an interest expense

of $722 billion. And that doesn’t include the likely borrowing

needed for shortfalls in Social Security and other

entitlement programs. We’re about to enter a fiscal trap,

chasing our tail just to pay off our creditors. That is an experience

heretofore confined to Third World regimes. Their

currencies lose all credibility, and they suffer from high

and crushing interest rates, only to end up wards of the International

Monetary Fund.

Indeed, the debt itself may be a reason for continued

weak consumption and the long-term under-performance

of the U.S. economy. This, of course, is the logic that buttressed

the 19th-century economist David Ricardo’s idea

that the mere fear of rising debt can inhibit consumer confidence.

Why should this be so? The anticipation of future

tax hikes to pay for the debt, or inflation and higher interest

rates to finance the debt, or the fear of both.

Public-opinion polls tell the tale. Americans are experiencing

deep feelings of anxiety, and not solely because

of short-term concerns about recession, double-digit unemployment

rates, or lack of health care. They are worried

about a pending national fiscal nightmare that could doom

the U.S. economy to slow growth and second-rate status.

Our public debt already amounts to nearly $40,000 for

every living American, or $160,000 per family. And the

burden is quickly rising.

Because the U.S. fiscal situation is unlikely to significantly

improve any time soon, some analysts are predicting

that hyperinflation is just around the corner. The

Federal Reserve will be forced to monetize today’s mountain

of debt. This is the thinking of the so-called Austrian

School of Economics—that regardless of the size of the output

gap, inflationary expectations will soar once the economy

begins to recover simply because of the Fed’s huge

monetary overhang.

These analysts make an interesting case. The inflation

argument could be described as having a cinderblock

at the other end of a long conference table attached to a

large rubber band. You’re at the far end of the table and

you keep pulling on the rubber band, but the block won’t

budge. Then you hit a tipping point and the block flies

across the room, hitting you in the face.

And yet it is difficult to find examples of hyper-inflation

unaccompanied by aggressive wage inflation. With

today’s unemployment, it is difficult to imagine upward

pressure on wages any time soon, certainly not before 2012

at the earliest. Unit labor costs just experienced their

biggest decline since 1948.

The Fed is betting on exactly this: several more years

of a disinflationary threat followed eventually by a potential

upsurge in inflationary expectations. But nothing about

this scenario can be taken with any certainty. In the 1990s

the Japanese were betting that given the size of their monetary

overhang and their massive debt, inflation would

eventually soar. That never happened.

One has to be sympathetic toward Bernanke’s predicament.

To confront the financial crisis in 2008, the

Bernanke Fed quickly flooded the paralyzed, creditstarved

financial system with liquidity through a variety of

new and highly creative methods. The Federal Reserve has

more than doubled the size of the liabilities on its balance

sheet. The idea was to avoid the mistake of passivity committed

by Fed officials in the 1930s. But what long-term

unintended economic consequences these policies will

present in the future, nobody knows.

What we do know is that despite today’s massive liquidity,

the monetary stimulus so far has had a surprisingly

The United States is about to enter a fiscal trap, chasing its

tail just to pay off its creditors. That is an experience

heretofore confined to Third World regimes.

32 A Never-Ending Economic Crisis?: January 2010

muted effect on the real economy. That’s probably because

the velocity of money—the speed with which money is demanded

and changes hands—is declining. The question is

whether this decline in the velocity multiplier is having the

same effect as if the Fed reduced the money supply, limiting

the economy’s oxygen supply.

Here’s the great mystery. The bold monetary stimulus

may have helped stabilize the financial system, but its effect

on prices has been modest. For example, despite the

Fed’s aggressive actions, from August 2008 and for the following

12 months, the Consumer Price Index in actual percentage

points dropped more than three times as much as it

did during the comparable period during the Great Depression.

That is worrisome because if the situation were to persist,

housing prices would find it difficult to reach bottom.

Sensing these persistent disinflationary pressures, the

Fed has kept short-term rates at near zero. Yet long-term

rates, the 10-year Treasury bond, have nearly returned to

their pre-Lehman collapse levels. Many market participants

believe that today’s 10-year Treasury rate reflects

less a confidence in a coming U.S. economic boom than a

fear of a coming Armageddon of public debt as the Treasury

continues to auction off ever larger amounts of government

paper.

The state of U.S. monetary policy has never been more

confusing. The San Francisco Fed just came out with a

study concluding that the Fed funds rate would need to be

4 percent lower to have any meaningful effect in reducing

the unemployment rate. That rate is already near zero percent.

Their conclusion is that every $800 billion added to

the Fed’s balance sheet is equivalent to a 1 percent drop in

the short-term rate. So the study concludes, believe it or

not, that the Fed needs to add a couple of trillion dollars

more to its already bloated balance sheet.

Such thinking is not completely deranged. That’s because

the Fed’s fight to counter disinflationary pressures

occurred at precisely the time that China, using a massive

emergency government- lending program, was stockpiling

commodities. China’s actions sent most global commodity

prices, including oil, through the roof (although, as far as

oil is concerned, global speculators and today’s liquidity

conditions added significantly to the rise in prices). Thus,

at the height of the financial crisis, Chinese actions helped

push up global commodity prices—and they may unwittingly

have kept the American economy from going over

the disinflationary edge.

But now these Chinese-induced commodity bubbles,

initiated by a country with enormous industrial overcapacity,

may not be sustainable. Even the Chinese are worried

about financial bubbles. In August, for example,

Beijing announced a modest slowdown in its government

lending program. And what happened to commodity

prices? They tumbled. This suggests that commodity prices

were merely responding to Chinese stockpiling. Today the

Chinese have enough steel- and iron-ore-producing capacity

to meet the needs, incredibly, of the United States,

Japan, Russia, and the 27 nations of the European Union

combined. With the U.S. consumer forced onto the sidelines,

the world now seems to be looking to China, a rapidly

aging society with no social safety net, to make a quick

transition to a consumer-led economy. That seems a

stretch. Chinese state-run banks and corporations may be

loaded with cash, but Chinese consumers are not.

The Banking Crisis

The economics profession and most of Wall Street remain

deeply divided over the long-term significance of the

George W. Bush/Barack Obama effort to spend $700 billion

bailing out the banks. Here’s the troubling part of the bankbailout

story: other nations have followed in America’s footsteps,

with major and growing government involvement in

their banking systems. As a result of governments’ growing

presence in financial affairs, the world of banking will

never be the same.

Today we have a dollar-based global financial system

dominated by roughly 25 government-subsidized international

megabanks, with some of the biggest owned by

China. These giant financial institutions control roughly

$50 trillion in bank assets. That’s 60 percent of the world’s

total bank assets. Unfortunately, today only five of these 25

megabanks are American-owned, according to Leto Market

Insight. We now have a global financial system largely controlled

directly by foreign banks and indirectly by their

governments.

When the history of this period is written, it is likely

that Barack Obama and George W. Bush will probably be

lumped in the same category on the subject of the banking

bailout. Both offered the big Wall Street banks an incredible

$700 billion in taxpayer funding with no stipulation

that the banks actually lend the money, which today they

aren’t doing.

Before the outbreak of the financial crisis, the U.S.

financial-services industry represented an incredible 40

percent of corporate profits and 30 percent of the stock

market’s value. This, of course, was an unsustainable situation

that made little sense. The question is, what will replace

this large hole in our GDP left by the shrinking of

our financial-services industry? For a number of years,

there probably will not be a replacement.

The perception now is that Washington has entered a

new era of "political banking." The well-connected receive

all the breaks. The U.S. Treasury bailed out the banking

sector so that it could start lending again. But the big banks

aren’t lending; they are buying securities as a means of bol

Commentary 33

stering their balance sheets and profiting from the steepening

yield curve.

In other words, just as the Japanese banks in the

1990s, they can borrow from the central bank for next to

nothing, because the large Wall Street banks have access

to the Fed’s discount window for cheap loans. Even a highrisk

firm like Goldman Sachs now has access to the U.S.

taxpayer safety net via the Fed’s discount window. The

banks use that borrowed money to buy guaranteed government

debt, taking the difference in yields as riskless profit.

There is a reason the banks aren’t lending: they don’t

have to add to their reserves when they buy government securities,

which they would have to do if they lent to job-creating

businesses in the private sector. While the U.S.

banking industry’s current practice of buying securities and

not lending may help repair bank balance sheets, the situation

is killing the U.S. economy. As an alternative to seeking

bank financing, America’s large corporations thankfully

have had access to a healthy corporate bond market. They

sold more than a trillion dollars in bonds in 2009, the fastest

pace on record. But that has not been the case for mediumand

small-sized companies, and entrepreneurial start-up

ventures, which have been credit-starved since the outbreak

of the financial crisis. President Obama himself has said

that these smaller firms and start-ups are responsible for 70

percent of our economy’s net new jobs. But they are barely

on Washington’s radar screen, even as the unemployment

rate soars.

In October, a Japanese official visited my office in

Washington and asked this provocative question: "Why

didn’t the U.S. Treasury, when the healthy bailed-out banks

such as Goldman Sachs and J.P. Morgan asked to return

their TARP bailout money, insist that the banks first spend

the next three years lending the TARP money before returning

it? Wouldn’t it have been better to save the economy

first and then repair the bank balance sheets? Why

wouldn’t American policymakers have learned from

Japan’s mistakes in the 1990s?" Of course, the healthy

banks returned the money precisely because of the fear

that if they kept the money, Washington would question

their bonus and salary structure. As a result, banks are

lending the smallest portion of their deposits in 15 years.

A year ago, leading bankers like Chase’s Jamie Dimon

and Goldman Sachs’s Lloyd Blankfein and others would

have lost their jobs had Washington forced the banks to

clean their balance sheets of their toxic assets, as was the

Treasury’s original game plan. This would have been risky.

There would have been blood on the floor. But the result

would have been a leaner, cleaner banking sector far more

amendable to lending. But the big cleanup never happened.

Politically inspired timidity carried the day. Banks

that are too big to fail are simply too big. Washington seems

unwilling to confront the financial-services industry in the

right way.

The Innovation Crisis

The broader question is whether America has the means

of getting itself out of its economic malaise. It is risky to bet

against the American spirit of creative problem-solving.

After the Second World War, a victorious America grew out

from under a massive debt that totaled a whopping 125 percent

of GDP. But that was after four years of pent-up demand

followed by unprecedented optimism. By contrast,

consumers today are in a gloomy period of long-term

deleveraging. A year ago, Washington thought it had a

credit supply problem, so it bailed out the banks. Turns out

we also had a credit demand problem. Consumers aren’t

borrowing. At the same time, their fundamental economic

expectations may have been reduced. People are experiencing

a new, less materialistic sense of well-being.

If this is the new era of reduced consumption, Washington

has no choice but to try to stimulate private investment

and innovation. Private investment is key, but private

innovation entails risk-taking. And my great fear is that we

have moved from a period of reckless financial risk-taking

to a situation even more dangerous, with no financial risktaking

at all as our efforts increasingly focus on stability

as an end in itself.

Today if you are a brain-dead, bailed-out bank, financing

is not a problem. But if you are out there alone with

a brilliant idea that could someday employ thousands of

people—if you are, in other words, the next Google—obtaining

financing will be tough because the normal avenues

of risk capital will assume you’ll find it difficult to pull off

a successful stock offering.

The good news is that deep economic recessions have

a history of producing aggressive bouts of innovation. The

Obama administration needs to encourage this process. It

needs to pivot quickly to devise policies that help reignite

the investment-led engines of our economy.

The big cleanup never happened. Banks that are too big to

fail are still too big. Washington seems unwilling to confront

the financial-services industry in the right way.

34 A Never-Ending Economic Crisis?: January 2010

We also need to become serious about manufacturing,

which in the United States hit a low of 13.7 percent of real

GDP in 2008. In the recent fast-buck era of financial leverage,

we have forgotten that a large percentage of America’s

research and development, and of our science and technology

labor force, comes from firms engaged in manufacturing.

This is why the mind boggles that the stimulus

package didn’t have a huge investment tax credit.

A more vibrant U.S. manufacturing sector requires a

predictable global-trade and currency system that reverses

today’s steady march to a new mercantilism. Like never before,

the world needs a new Bretton Woods-style international

agreement to provide a financial doctrine of stability.

Washington wants to create more jobs. But that means

coming to terms with how private-sector jobs are actually

created. The issue here is not just size but also age. According

to the Census Bureau, nearly all net new jobs since

1980 have come from start-ups in existence five years or

less. Jobs come from the deployment of innovative ideas

by start-ups that thrive in a dynamic climate of economic

buoyancy.

Innovative risk-taking is a delicate process difficult to

nurture. The next Google cannot be legislated into existence.

Innovative breakthroughs entail the unpredictable.

There is an elusive almost metaphysical process that makes

planning and certainty difficult. Something as common and

essential as the ballpoint pen was conceived by an insurance

executive on his vacation. The automatic transmission,

invented by a struggling supplier, had little to do with the

massive engineering departments of Detroit’s automakers.

What Washington can provide is a climate conducive

to innovative risk. But that is not in the cards in today’s

partisan climate, where the tax, regulatory, and financial

futures are as terrifyingly uncertain as at any time in postwar

history.

In the end, at the heart of any economy are people.

Economies are influenced by more than numbers, by more

than the size of central-bank liquidity injections or the size

of a fiscal-stimulus package. They are ruled by psychology.

They are ruled by the speed with which people are

willing to work with the liquidity the central bank provides.

That’s why, at the end of the day, the definition of liquidity

comes down to one word—confidence.

If America’s leaders are unable to instill that confidence,

the American people are certain to find new ones who can and will.

 

Thanks,

Charles