"Deleveraging = Difficult and Slow Recovery"

Sydney M. Williams

Thought of the Day

“Deleveraging = Difficult and Slow Recovery”

June 7, 2011

Excess leverage was the root cause for the financial crisis of three years ago. Deleveraging is the only response. Had government not intervened in the fall of 2008, the global financial system might well have collapsed. We will never know the truth of that statement, but no thinking person would want to reenact those days to find out for sure. Stories this morning suggest that the Federal Reserve will back a 3% surcharge on banks, taking Tier 1 capital ratio requirements for some large banks to 10%. Placing a governor on banks is necessary, after the risk they placed the country in, but the consequences will be higher interest rates and slower economic growth.

In terms of massive future financial obligations, the private sector is far ahead of the public sector. Three decades ago, companies could see the end game in defined benefit plans, so began converting to defined contribution plans. In terms of operations, nonfinancial corporations began deleveraging a few years ago, so entered the recession in reasonably good shape. However, for the rest of the economy it was akin to driving a Deux Chevaux on a German autobahn – one small move and you were dead. Between 2000 and 2008, mortgage debt in the U.S. increased by 112%, from $6.9 trillion to $14.6 trillion. Credit card debt increased 73%. Yet GDP rose only 40%, a visible manifestation of debt driven economic growth. Many banks spent the decade making increasingly dicier bets, in some cases increasing their leverage so that, including off balance sheet obligations, capital ratios fell to two percent or below. Leverage utilized by government sponsored entities such as Fannie Mae and Freddie Mac approached 100-1. The small boy was right, the emperor was naked.

The credit crisis slammed the brakes on consumer borrowing, accentuating a recession already underway. As banks, corporations and consumers deleveraged, the debt water table remained essentially the same; the shift descended onto the shoulders of the federal government. The decision by government to step into the breach was noble and correct in the fall of 2008. We can argue about the tools employed, but it is hard to argue as to the necessity for intervention at the time. But it is also important to recognize that deleveraging is necessary and, by definition, means less economic growth and higher unemployment. You can put molasses on a turnip, but it is still a turnip.

Government stimulus spending of more than $800 billion in 2009 did little to alleviate the situation, other than to postpone a day of reckoning for the States. That day of reckoning has arrived. Indicative of the financial plight we now face, the Wall Street Journal notes this morning that Jefferson County, Alabama is being forced to consider laying off a third of their employees. We are facing a labor market that seems incapable of expanding fast enough to absorb the roughly 100,000 new entrants each month, not to mention alleviating the estimated seventeen million under and unemployed. Because of the level of federal debt, we no longer have the options we had in earlier crises. In 2000, U.S. federal debt was roughly 35% of GDP; today it is over 90%. This ratio is the highest since World War II when 16,000,000 Americans served in the Armed Forces, the equivalent of 40,000,000 today. The comment from screenwriter Billy Wilder comes to mind: The situation is hopeless, but not serious.”

Small business is the engine of economic growth. The government could do more in terms of raising confidence and providing tax incentives for these enterprises. The bulk of small business’ capital needs are satisfied via bank lending. And therein lies the rub. Speaking at the Peterson Institute for International Economics last Friday, Federal Reserve Governor Daniel Tarullo suggested that the Federal Reserve may consider tightening reserve requirements for U.S. banks with assets in excess of $50 billion beyond those required under Basel III. “A post-crisis regulatory regime,” he said, “must include a significant macroprudential component.” That component, utilizing sliding scales, would raise capital requirements based on size of the bank and the degree of risk correlation of its assets. Higher capital requirements, of course, mean fewer funds available for lending. Shrinking supply generally foretells higher prices. But it is the price we must pay.

In the meantime, the American banking industry has been consolidating. At the end of 2007, there were 8,542 banks. At the end of 2010, there were 7,666, suggesting 876 banks either failed or had been merged during the past three years. In 2009, thirty-four banks had assets in excess of $50 billion and 117 had assets in excess of $10 billion, indicating that most banks are small and so of little risk of creating systemic failure. And big banks continue to get bigger. A consequence of the financial crisis (intended or not) has been that big banks have become bigger. As of December 31 2007, banks with more than $50 billion accounted for 64.5% of banking assets; by the end of 2010 those banks held 68% of such assets. It is banks like Citigroup, Bank of America, JP Morgan and Wells Fargo – banks with assets in excess of $1 trillion – at which the more stringent reserve requirements are aimed. Adhering to the new rules is considered imperative to preserving the system, but the consequence will be higher interest rates and slower economic growth.

This view may seem unduly pessimistic. After all, consumer and bank deleveraging have been underway for two and a half years. And one should never underestimate the creativity and entrepreneurial spirit of Americans. As I have written before, just because the path ahead may not be visible does not meant it is not there. But we need the federal government to get on board: acknowledging its enormous debt and proscribing a way to reduce it, instilling confidence and easing the way for small businesses to continue to grow and to hire. Unless the administration chooses to inflate its way out, deleveraging will persist, suggesting at best only modest growth. In this time of fiscal and economic fragility, the nomination of former utility executive and environmental advocate John Bryson as Commerce Secretary sends exactly the wrong message.