Tough Love for the U.S. Economy
With housing markets unwinding by the day and distress signals flying throughout the rest of the economy, there is little doubt that we are facing a serious recession. The real question is whether it will be nasty but relatively short, or prolonged, shallow, and demoralizing.
The math is straightforward. From 2000 through 2007, total U.S. gross domestic product—that is, all goods and services produced—was $92.5 trillion in current dollars. Total U.S. purchases, however, were $97 trillion, a $4.5 trillion overrun, nearly 5% of the entire period's GDP. Those additional goods and services, of necessity, all came from overseas.
The excess purchases were mostly by consumers and were financed by borrowing. Consumer debt roughly doubled, increasing by $6.8 trillion, almost all of it secured by houses. The personal spending power extracted from houses—that is, net new-mortgage proceeds not reinvested in housing or in paying down housing debt—was $4.2 trillion, or nearly the same as the trade deficit. Personal consumption's share of GDP jumped from a long-term average of around 67% to 72% by 2007, probably its highest level anywhere, ever.
The borrowing was possible because housing prices more than doubled from 2000 through 2005. No obvious demographic forces drove the increase; instead, it was engineered almost entirely by Wall Street. The credit-propagation mechanism was the "shadow banking system"—hedge funds, investment banks, off-balance-sheet conduits, and the like—that by early 2007, according to the Federal Reserve Bank of New York, had a bigger lending book than the entire traditional banking sector.
JUICING IT UP
If some malignant demon had set out to destroy American finance, he couldn't have dreamed up a better method. To start with, leverage in the shadow banking world is extremely high, often as much as 100 to 1. Moreover, the favored instruments, such as collateralized debt obligations (CDOs), are highly illiquid, or hard to sell quickly. At yearend, Merrill Lynch (MER) was carrying nearly a quarter-trillion dollars of securities in its trading portfolio, but only about 30% of that could be valued solely by market prices. Even worse, the preferred method for financing positions was in overnight and other short-term money markets, so there are horrendous asset-liability mismatches. Finally, those highly leveraged, illiquid, short-term-funded positions are built from securities that themselves carry a high risk of default, primarily subprime and so-called Alt-A mortgages.
The focus on high-risk mortgages was not an accident. By mid-2004 the yield on prime mortgages had dropped so low that they lacked the juice for the fee-generating "structured finance" instruments favored by Wall Street. By 2006 high-risk mortgages accounted for more than a third of all mortgage originations. To ensure a steady stream of product, investment banks competed to buy up subprime lenders.
The shadow-banking fee machinery created its own demand, unleashing torrents of income even as it spread toxic assets throughout the world. Similar phenomena occurred on a somewhat smaller scale in highly leveraged corporate takeovers, commercial real estate, and auto loans. By 2007 financial-sector profits jumped to 30% or 40% of all corporate profits, depending on the data source.
Sadly, the great housing binge may turn out to be a near-total waste. The far-flung McMansions at the center of the boom are radically unsuited to a new era of energy scarcity. They also cut against an emerging trend to redistribute populations around midsize metro centers.
So far the federal response has been to try desperately to keep the squirrel cage spinning. Rebates to consumers, accompanied by loud exhortations to spend; a big upsurge in lending by nearly insolvent Fannie Mae (FNM) and Freddie Mac (FRE); swapping solid-gold Federal Reserve Treasuries for dicey subprime-backed bank assets; the new housing bill, which, risibly, will be financed by levies on Fannie and Freddie. Altogether, it amounts to roughly $2 trillion in Wall Street bailouts, almost entirely sub rosa. It recalls the Japanese cover-up of their 1990s bubble implosion—and Japan's economy has yet to truly recover.
It will be essential to shrink the hypertrophied financial sector. The first step:Force tough leverage constraints on regulated institutions while moving all risky exposures onto the balance sheet. The second would be to impose heavy capital penalties on lending to highly leveraged entities. A third would be to limit derivatives trading among regulated entities to fully margined, exchange-traded instruments. Finally, there should be legal bars against using federal resources to rescue unregulated entities. Innovation is wonderful, but as the last half-decade demonstrates, untrammeled financial innovation can be wildly destructive.
Pushing the U.S. economy back to a sustainable path has to be a core priority for a new Administration. Consumption has to fall, by at least 4% to 5% of GDP, and the money shifted to savings and investment. The U.S. is still the world's top manufacturing power—and probably the most productive—with huge opportunities to supply capital goods, from power plants to earth-moving equipment, for modernizing emerging markets.
No such shift will be accomplished without a tough recession. The adjustments are just too large. Any sensible new Administration should understand that shorter and sharper will be better than long and drawn out.