Wednesday, May 30, 2007

The Economy, Liquidity Sources, and The S&P's New High

Friday's Wall Street Journal featured a fascinating editorial by David Ranson and Penny Russell of H.C. Wainwright & Co. Economics.

Their contention summarizes thoughts I've had since my first year in graduate business school nearly twenty years ago. That is, private monetization has evolved, since the early 1960s, to the point where it's reasonable to question how much impact the Federal Reserve's decisions and actions now have on our economy.

As the S&P500 flirts with a new closing all-time high, it's prudent and natural to wonder if this is a spike, or simply a stop on the continued road upward, as the index mirrors a healthy, growing economy.

Back when the index hit its previous high, in March, 2000, just over seven years ago, its P/E was in the low 30s. I don't know the precise current P/E for the S&P500, but I've heard something in the neighborhood of 15-18 bandied about by various pundits on CNBC in the past few days. Thus, the value of the S&P has returned to its seven-year prior level, but on much healthier revenue and earnings, and growth thereon. As opposed to a quick runup in the index, based upon internet startup valuations, it's now a function of a broader, slower growth in real revenues and earnings.

What does this have to do with the Journal article? Plenty.

Some pundits believe that most of the reasons for this recent rise in the index, and equity markets in general, is merger and acquisition activity. Personally, I think it is more a case of gradual, grudging recognition by mediocre analysts and money managers that the US and global economies are, in fact, growing in a low-inflation, healthy manner, thank you very much. Now, as a result of the under-appreciation of this, some smart capitalists have been buying other companies. But I would say the M&A activity is a result of growth expectations on the part of the better investors, frequently at private equity firms. Not the cause of the market advances.

What is private equity, if not private monetization of value and liquidity?

Back to the article in the Journal. The authors contend that the effects on "real consumption" of a 100-basis point increase in short-term interest rates, driven by the Fed Fund rate, has decreased from 1.84% in the period 1945-59, to -0.01% in the period 1990-2004. They contend that, as recently as 1975-89, the effect was as high as 1.35%.

Back in my graduate business school days, we studied the Treasury's "Operation Twist," its attempt to manipulate the term structure of interest rates, in the face of the nascent Euro-dollar market. This began due to, as is so typical, unintended consequences of a tax policy. The Treasury levied a withholding tax on the purchase of debt securities, in an attempt to control monetization. The result was the development of an off-shore issuance market in dollar-denominated debt, free of the tax. Voila, the leaks in US monetary base control had begun.

Coupled with the gradual liberalization of the old (again, things we were still taught in graduate school in 1979) regulations (R and Q come to mind) governing installment credit and bank deposit creation, the US monetary base began to undergo a transformation from a tightly-controlled quantity to a more easily expanded one enhanced by private credit extension.

With the arrival of more general-purpose credit cards, ATMs, cash-management sweep accounts at brokerages, and more expansion of public-company debt, monetization went wild.

I've always thought that most people gave far too little credit, if you'll pardon the pun, to the ability in our society for the private, which is to say, non-government, sector, to issue large amounts of debt in ever-easier to use packaging.

If you recall your old classical theory of money, M=Q*V, the V, or velocity, has been revved up by devices such as credit and debit cards. Additionally, the Q, or quantity, has been changed in character, as, now, immense pools of private equity capital invest small equity stakes in acquisitions, and simply issue debt through the public markets to complete the financing.

Ranson and Russell believe that this marginalization of the Fed is a good thing, as its "medicine" typically consisted of either starving the economy of funding, or flooding it with the same. Feast or famine, unemployment or inflation.

Now, we have the entire financial sector engaged in the role of money creation. Think about that.

Which would you prefer, if you had to choose just one method of money creation? A somewhat closeted group of unelected, but very intelligent and educated people who divine the market via their analyses, and set an interest rate? Or dozens of private entrepreneurs, large and small, who issue debt and monetize value, hoping to guess correctly on the profitable uses of the value they have monetized with their own currencies- resold mortgages, corporate debt, LBO debt, credit card receivables, etc.

It's a testament to our economic system that, slowly, without much notice, the private sources of monetization have come to limit, if not eliminate, much of the long-term effects of Fed policy, while shouldering the risks associated with the management of the quantity of "money" in our economy.

To quote from the economists' editorial,

"Ready access to both equity and debt capital from a proliferating number of sources means that businesses are no longer forced to curtail their activities when the Fed impeded the banking system's ability to provide credit. And since businesses thus no longer needed to lay off employees, employees no longer needed to cut back on their spending."

The passage which I have bolded is crucial. Essentially, after a 46-year management of US value monetization by the Fed (1914-1960), private sources began to flourish as means to fine-tune and adaptively finance business liquidity needs.

Right now, we see a situation in which the old quote, "this time, it's different," is actually true. Instead of the Fed's blunderbuss firing at a sector such as subprime real estate lending, and taking out the entire economy, we have private credit creation selectively expanding and contracting, according to the risks and losses experienced in each sector.

Congress, with its witch hunt for culprits in the subprime meltdown, is years away from comprehending this. Ben Bernanke is not. I think he actually realizes the truth, as synopsized in Ranson's and Russell's insightful editorial.

The benefit of risk-bearing, private-capital-providing credit creation is now, a la Adam Smith, a sort of invisible hand, evolving without design, which is allowing our economy to weather various sectoral peaks and valleys with the risks spread, and no need for the entire economy to tank over one sector's collapse.

Thus, with this broader, risk-aware monetization of the US economy by private, as well as governmental sources, economic growth seems to be steadier, and the sources of the S&P500's recent gains more enduring.

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