Tuesday, January 13, 2009

Deleveraging vs. Recession: Recognizing The Effects

I have noted with increasing concern a confusion in the general business media regarding what are the sources of our current economic difficulties. They are not just a bad recession. In fact, the recession, on its own, is probably simply of average depth and duration.

However, mixed in with the recession is a heretofore unseen deleveraging of the global economy. I first called attention to this phenomenon in this post in late November of last year. In it, I wrote,

"Since leverage, a function of debt, implies confidence in the future returns of loans placed with various enterprises, its unwinding corresponds to a loss of such confidence. The forced reduction in this leverage began, understandably, with the short-term borrowing instruments of both financial and non-financial instruments- commercial paper, most notably.

As this massive de-leveraging of fixed income instruments occurred, the simultaneous drop in real estate values and equity market values caused several consequences.

First, large-scale losses in US, and other nation's market, i.e., societal capital stocks, valued notionally, plunged. Those who previously owned the capital suffered large losses.

The second major consequence of the calamitous drop in price of many stores of value- real property, equity, debt- coupled with the deleveraging, was the cessation of bank lending. Thus, a financial crisis, partially unleashed by a narrowly-defined 'mark to market' rule in a single US law, Sarbanes-Oxley, led to the real effects on non-financial sectors of the US economy. As banks struggled to deleverage their assets in order to both conserve remaining equity from further losses, and abide by regulatory capital requirements, lending suffered. This became a self-fulfilling act, as, starved of normal, short-term operating liquidity, more and more businesses began to reduce operations and cut staff.

The third unforeseen consequence, then, to complete the circle, was the rising joblessness as the economy was already softening, of its own accord, by early 2008.

This last link in the circle of economic causes and effects has now driven a dramatic drop in consumer spending, due to: rising unemployment, lower home values as a source of personal household net worths, and lower financial asset portfolios as a source of personal household net worths."

Probably not since the 1950s have we seen such a secular deleveraging of American capital. I vividly recall, while in graduate school, reading articles on the Treasury's attempts to tax gains of foreign bond holders in the 1960s, which led to the creation of the Eurobond market.

I discussed with my business partner recently the evolution of capital formation, beginning with our early ancestors storing extra wood or food in caves. Early barter systems represented market-clearing mechanisms for surplus food or other primitive goods, allowing specialization to develop. With specialization came production for others, rather than mere personal survival consumption. In time, one person's surplus became another's borrowed capital for further expansion of production.

Somehow, through the centuries, capital creation became increasingly dependent not upon hard assets or saved money, but some analyst's or banker's estimation of the forward earnings power of an entity issuing debt or offering equity subscriptions.

Culminating in events including the famed technology equity 'bubble' of the late 1990s and the recent real estate bubble of the late 2000s, the financial community's allowance of increased leverage, via lending on ever-smaller equity bases, resulted in economic expansion which has to have been secularly due to that higher leverage.

This is important right now, because many people, businessmen and politicians alike, are running around declaring the coming of a second Great Depression any moment.

The President-elect has been engaging in economic scare tactics and fear mongering since this past summer's election campaign. Thus his reason for requesting- no, demanding- a $1T stimulus package.

But, in reality, the economic difficulties we currently face are a combination of two very different phenomenon.

On one hand, there is, based upon the NBER's December statement based upon job losses, a US recession which began in late 2007.

However, within this recession is a secular trend of economic shrinkage that will not be reversed by anything but a return to higher leverage. Thus, no amount of unleveraged economic 'help' will reverse these losses and the accompanying fall in GDP growth.

Seen from this perspective, the only way in which a new, massive Federal stimulus package can provide 'recovery' is to substitute government-issued obligations to return US societal economic leverage back to the dangerous, unsustainable levels at which it was before the current crisis.

How is it that leverage undertaken by the private sector, and judged imprudent, can now be replaced with government-sourced leverage, in the form of either: 1) more printed money, or 2) increased sale of government debt, without creating even more risk by spending the money in less accountable, measurable ways through political channels?

The simple fact is that, for the US economy to lower its capital leverage, and adjust to that lower leverage level, some jobs and business activity will have to simply vanish and not return. Whatever economic level we enjoyed, from which our current recession guideposts are measured, it logically follows that we cannot return there anytime soon unless we collectively decide, as a society, to try to raise financial leverage back to what it was.

If we decide this is unwise, then we have to accept that unemployment will be higher, and business activity levels lower, as the marginal, leveraged activities have been eliminated with the fall in financial leverage.

There is no other way around this fact.

Thus, the component of the current US economic weakness which represents simple, normal cyclicality is smaller than the overall, measured recession which includes the results of this deleveraging process. Any Federal programs which seek to, in a carefully identified and measured way, "fix" the economy beyond this normal cyclical impact, will be a disguised attempt to reflate our economy with added leverage through public debt and spending, rather than private resources and channels.

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