"The Economy - There is no Such Thing as Normal"

Sydney M. Williams

Thought of the Day

“The Economy – There is no Such Thing as Normal”

August 12, 2011

When markets are in turmoil, as they have been the last few days, rational explanations make no sense. Everybody has an opinion as to why or where we are headed, but no one really knows. Talking heads on CNBC and Bloomberg make as much sense as listening to what they are saying with the sound speeded up. It is better to detach oneself, step back and try to make sense of the larger picture.

The financial crisis of 2008, and which continues today, was a function of too much debt – in financial firms, with consumers and in government. In the case of financial firms, debt rose as a function of financial innovation that gave confidence to traders that they could hedge any extra leverage. In the case of consumers, the motivation was a desire to live better, and was based on the belief that their homes would continue to rise. Government’s increase in debt was based on a concept of fairness, the lack of prudence in not paying for a war and a belief that homes and healthcare were undeniably basic rights. In all three cases, the Fed’s decision to keep interest rates unusually low had the effect of pouring gasoline on flames.

Missing from the list are corporations. During the LBO (leveraged buy-outs) and MBO (management buy-outs) booms of the 1980s and 1990s, many corporations took on enormous amounts of debt. Some companies never survived, but those that did learned to operate more efficiently. Many of their decisions at the time may have seemed inhumane, in that they involved thousands of lay-offs, but the businesses that survived permitted future growth in employment. Even earlier, beginning in the 1970s, many companies began to realize that there was a hidden time bomb baked into their pension (defined contribution) and health plans. Those that saw the handwriting on the wall – the looming future obligations of generous plans and an increasing retirement population – began moving toward defined contribution programs.

Jeremy Grantham, in his quarterly letter writes that the era of defined pension plans were “remarkably generous” and “represented a high point in corporate responsibility to employees.” That may be true, but those plans were terminated at the urging of investors like Mr. Grantham, as they impeded profitability. These generous entitlements were a principal cause of General Motor’s filing for bankruptcy two years ago. It is a reason why the Pension Benefit Guaranty Corporation has found itself so frequently dramatically underfunded.

The crisis was intensified by another factor, and that is changing dynamics in the work force, particularly the financial industry. Beginning at some time in the 1960s, the U.S. moved from a manufacturing society to a service society, which moved the workforce from higher-wage union workers to lower-pay service workers – the exception (in terms of income) being the growth of the financial sector. Two years ago the Peterson Institute for International Economics published a paper in which they concluded: “The bottom line is that the U.S. financial-services industry is a sector in structural decline [in terms of the numbers of people employed,] as is Wall Street.” It is not that the basic businesses of lending and servicing are in decline, it is because technology is replacing people. Financial companies have been the growth drivers over the past three decades, becoming increasingly profitable as innovative products gave them the confidence to increase their leverage. The credit collapse showed the vulnerability of banks to the leverage they had incurred. Dodd-Frank, in particularly the Volcker Rule, put the brakes on that trend. These changes imply lower returns on equity, but with diminished risk. Technology has meant that these services can be offered with fewer employees, suggesting that recent lay-offs at HSBC and Lloyds will only be the first of many more.



Another problem has been education that has failed to keep pace with changes in the work place, leaving millions of people unemployed or under employed, while thousands of jobs go unfilled for lack of qualified workers.

These are uncomfortable truths that the market and people seem to intuitively understand, but ones that Congress and the Administration do not.

Over the past decade, GDP was driven by massive increases in debt. The “new normal” recognizes that deleveraging, by definition, means slower growth going forward. There is no getting away from that truth. “The Democratic argument,” Daniel Henninger wrote in yesterday’s Wall Street Journal, “has been that the country could maintain its remarkable economic success while performing all these social goals, though with cutbacks in defense spending.” But they cannot,, unless they increase borrowings or raise taxes. While the debt ceiling has been raised, the recent debt downgrade serves as a waning shot about future increases. And simply increasing tax rates, without reform, will impede economic growth.

The silver lining in this perception is that states are beginning to recognize the limits of altruism. Tuesday’s election in Wisconsin, a notably liberal state, was a victory for reform and the battle to control public spending. (One should read Wednesday’s editorials in the New York Times and the Wall Street Journal to get two completely different takes on the same election!) Besides Scott Walker of Wisconsin, New Jersey’s Governor Chris Christy, Mitch Daniels in Indiana, John Kasich of Ohio, Rick Perry of Texas and Andrew Cuomo of New York among others have been tackling the thorny issue of entitlements. Most real reform begins in a grass-roots manner at the local level. If that is true, Washington cannot be far behind. The House of Representative, with 335 members, elected 95 freshmen in 2010. One should expect further, and perhaps more dramatic changes in 2012. That should bode well for a growing recognition that change is coming. Nevertheless, economic growth is likely to be anemic and Wall Street has little confidence that current policies are helping a growth agenda. Serious attempts at tax and entitlement reform would be a sign that Washington finally “gets it.”

The Peterson Institute concludes their report of two years ago by pointing out: “Creative destruction has always been seen by economists as a natural and, on balance, healthy part of the U.S. economy [more so than in European countries] because there has always been something new to fill the void left by failing industries.” That should be true of the future but, in order for that to happen, the private sector cannot be restrained. Creative destruction lends proof to the concept that there never is a “normal” in the economy.

As for the market, I have no idea when volatility will diminish, but it is interesting to note, as Laszlo Birinyi pointed out yesterday, that for only the second time in fifty years the yield on the S&P 500 exceeds that of the 10-Year U.S. Treasury Bond. Stocks may not be as cheap as they were in October 2002 or March 2009, but they are not expensive. Twenty-nine years ago this day, the DJIA made its generational low and the great bull market began. That won’t happen today, but it may be an omen.