We came right up to the edge of the economic abyss after a year of an accelerating economic downturn and have managed to avoid it but are not out of the woods yet. The risks of a double-dip are growing but the likelihood of a weak recovery and poor job creation is high. A key problem is and was the financial crisis and credit market collapse which has created major lingering problems that will be with us for years. Beyond that a two-decade over-accumulation of debt, drastic declines in Savings and under-Investment have created long-term problems for getting back to sustainable long-term growth. Here we survey the current state of the economy, wade thru the details of the Financial crisis, especially the role of Synthetic Structured Debt and the business performance of the Finance Industry. Then we roll forward to examine the long-term damages created, how we need reduce private debt and what our prospects for reduced long-term growth are. Or, given the decisions to invest in our future and address broader policy problems, how we can return to a path of longer-term high growth and prosperity.
Skirting the Abyss: From Economic Downturn to Financial Crisis to Long-term Malaise
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4. Two major sources of confusion – assuming a calm economy is the normal state and being surprised by storms. - and not appreciating the underlying patterns! The Economy follows the same recurrent patterns, driven by the same forces and governed by the same relationships but the actual behavior varies considerably. The challenge is to understand the structure and relationships and monitor the changes in the forces to anticipate what’s coming.
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6. The economy has bottomed and is starting to “recover” but employment lags and will lag for many reasons
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14. To understand the performance outlook follow clockwise around the economic life cycle and read off the line… Consumption growth of 2.5-3.0% implies GDP growth of 2.0-2.5%, the outlook for next year. 2.5% GDP growth means Employment growth of <2.0%; really need 4% GDP growth. This is a weak and atypical recovery ( typical post-war recovers are 6% real growth ) but means that Employment growth will be poor and Unemployment stubbornly high. Especially given that long-term forecasts (OMB/CBO) call for growth in the 2.2-2.5% for the decade. Investment (real estate and business) won’t pick up without strong growth, though residential tends to lead a recovery it’s weakened and in repair mode for a long time. To see a surge in Investment spending would require GDP growth north of 4%, or better. So not only Employment will be weak so will Investment and Capex spending (implying weakness in the Tech and Equipment industries).
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17. Even though the structures and patterns are the same sometimes the FORCES are beyond expectations … in 2008 a rising storm turned into a Tsunami when the credit markets broke Even so there were plenty of warnings both about the structural risks on structured, synthetic debt AND the metastasizing weaknesses in the Credit Markets …. But nobody believed the warnings or prepared to meet them. Call it complacent “business-as-usual” syndrome.
18. We got within 24 hrs. of a credit market collapse that would have made the Great Depression like a cakewalk Edge of the Abyss Arrest
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20. We need to look at some dry but real numbers to understand the contagion and consequences: [10Yr Treasuries (TNX), 3Mo (IRX), LIBOR (London Inter-bank Rate), TED (LIBOR-IRX)] From 01-04 rates declined with economic weakness but s.t. rates climbed rapidly from 04-07. L.T. DID NOT! Beginning in mid-07 both slowed as the economy did, s.t. more rapidly driving up the Yield Curve (TNX:INX). LIBOR followed a similar pattern During the Crisis rates dropped to near zero. The Yield Curve spike was a measure of how broken the credit markets were. Zooming into 07-10 TED was very elevated – meaning banks weren’t willing to lend to each other At the height of the crisis there was a tremendous spike meaning banks were betting on each other to default and go BK!! The spread has come down enormously so credit markets are trusted and working again Rates are still low – because of policy s.t. and weakness + policy l.t.
21. Credit and financing is the economy’s circulatory and respiratory system – without things STOP
22. THE fundamental structural change between 1980 and now was the creation, growth, exponentiation and metastasis of structured, synthetic financial products …. … A General Purpose Technology mal-adapted, unlike say steam engines or fractional h.p. electrical motors. THE fundamental structural change between 1980 and now was the creation, growth, exponentiation and metastasis of structured, synthetic financial products …. … A General Purpose Technology mal-adapted, unlike say steam engines or fractional h.p. electrical motors. SSD’s changed the business model from loan to invest to originate to sell …changing literally millenia of incentives from borrower quality to ability to pump volume to the next sucker in line. A GPT turned into a financial contagion
23. Rocks, Ponds, Ripples: Welcome to FinEngr World LINKS Asset Classes Currencies Equities Bonds CDO(N) CDO Commercial Paper “ Normal” Alt-As Sub-prime Investors Hedge CDO/CLO Ibank CDO1…N Bank(s) MBS/CDO Originator (Loan) Initial Asset Big Rocks Boulders
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36. What has grown at far above LT economic growth rates is total private debt – Consumer, Business but especially Finance Overall total debt, private and public, grew at a relatively low rate until the mid-80s, though Public debt decreased relative share. Beginning with de-regulation Consumer and Business debt accelerated while Finance debt – largely used for internal industry speculation? – metastasized! The relative growth behaviors are even clearer when looked at as GDP multiples. Until 1985 Consumer:GDP was about 0.6 and then exploded this decade to ~ 1.0. Business debt grew from .3 in 50 to .6 in 85 and then. Meanwhile Finance debt went form 0.1 to 0.3 and then exploded to ~ .9 by 2000 and then soared to 1.2 by 2008! In other words the biggest growth in debt occurred this last 2+ decades for entirely non-productive uses. Total Non-finance Debt grew over 120% from 1945 to 2008 with Household debt growing about 63% and Business debt 24%. Yet by 1997 Household debt had “only” grown ~30% and Business debt by 13%. In other words the real acceleration occurred in the last 15 or so years. The Grasshoppers definitely decided to partay! Financial debt is entirely a different story. Since 1945 it has grown about 1200%. From 1945 to 1983 it grew less than 10%. But beginning, coincidently of course with De-Regulation, it grew to 266% by 1990, to 678% by 2000 and to 1200%, almost a doubling in eight years, by 2008. The beginning coincided with De-regulation but the the explosion coincided with the growth of Structured Synthetic Debt and Financial Engineering. None of which seems to have contributed to the long-term health of the overall Economy.
37. TANSTAFFAL – what did playing Grasshopper cost us? Our future growth possibly!? Until approximately 1993 GDP, Consumption, Savings and Investment all grew roughly in line with each other, with Savings running ahead. Then we began a secular decline in Savings as Grasshopper Syndrome triumphed though Investment was artificially stimulated by two major bubbles (Tech and Housing – both funded by Financing, not Savings). Not surprisingly there is a strong inverse relationship between Savings and Consumer Debt. As the latter exploded the former began its secular decline. Looking at the L.T. trends in YoY growth rates shows us Savings averaging 5.0%/Yr until ~ 1984 when it began its decline followed by a trip off the cliff beginning around 1998. Nothing’s so expensive as keeping up with the Jones except borrowing to do it! In the short-run reduced Consumption reduces Demand but in the long-run Aesop was right. Long-term sustainable growth results from Savings turned into Investment. Basically when we quite saving and then started borrowing to consume we ate our seed corn, damaged the farm and made it really hard to keep growing new jobs.
38. Disabusing some more mis-understandings: in the short- and intermediate-terms government spending, deficits and debt are NOT the problem you think Start with some historical realities on the Deficits. The problems of the 70s grew them but we were recovering until the 80s when they were enormously accelerated. In the 90s we paid them down, partly thru the “Peace Dividend”. This decade though completely destroyed that frugal legacy before the downturn began and the Crisis happened. The Stimulus is a small and disappearing part of the LT deficits. The primary sources are revenue shortfalls from the downturn, Bush’s tax cuts (far and away the biggest and growing factor) and Iraq/Afghanistan. A return of growth AND eliminating the tax cuts would make it manageable. The inherited deficits are reduced in the current, 2011 budget proposals, and largely reduce the intermediate impacts of inherited problems. The real problem is long-term deficits and accumulated debt. In any case, while not good, the current deficits and intermediate outlook is not out of line with either affordability or int’l comparisons.