Tuesday, November 17, 2009

Doug Dachille On CNBC This Morning

This morning's guest host on CNBC has been the very lucid and insightful Doug Dachille.

For the first time in nearly a year, since the beginning of the various federal government bailouts, I heard someone articulate the same view that I've had. That is, Dachille said, explicitly, that what we have had occur in the past year is the substitution or replacement of private capital with public, government-supplied capital.

On the subject of leverage, Dachille echoed my own thoughts in this post from January of this year. In it, I wrote,

"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.

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."

Dachille went on to observe that the US economy, being overleveraged for years, had been growing unsustainably fast. When asked if bank lending was too conservative, Dachille replied that it had, finally, returned to 'normal,' prudent credit standards.

In contrast, he noted, now public funding was too plentiful, having driven down rates to zero. He then provided a really interesting insight, i.e., that as, if and when banks do begin to lend again, the Fed will lose its free funding of its enormous asset purchases, and have to begin selling those assets. This will drive prices of those fixed income instruments, such as mortgage-backed bonds, down, effectively raising interest rates.

Overall, Dachille communicated a sense that the current US economic 'recovery' is somewhat false, predicated, as it is, on continued excessive leverage.

Of all the pundits I've heard for a year, Dachille is the only one with sufficiently clear understanding of the credit markets to simply see federal, state and local funding for what they are- the replacement of excessive private capital creation and lending with public funding.

As such, he pointed out, there is a real danger. When households provide capital, it is from their savings or credit against assets. When governments provide capital, it is from future tax receipts.

If the public funding goes wrong, he warned, it can only be repaid through much higher taxes.

The only thing missing, in my opinion, in Dachille's comments, was to note that government-supplied capital is politically-allocated, which is much different than how individuals allocate investment capital, thus distorting the economy.

But, in a way, he got to the same point by labelling the current US economic situation as unreal and distorted by so much public investment. That we really don't know what real growth or risk is when the Fed floods markets with zero-interest money.

Taken together, Dachille's remarks suggest an economic situation which simply can't be good in the long term, no matter what short term liquidity has done for equity markets in the past few months.


Anonymous said...

Great job summarizing and elaborating my key points.

C Neul said...

Assuming you are Mr. Dachille, thanks for your comment.

Let's hope these points become more widely understood before calamity strikes, either financially or politically, or both.