There are a lot of opinions being floated about what is happening in the economy and what to do about it. How much would tax cuts help? Would they even help? What about small business stimulus for hiring, such as payroll tax reduction?
I do not pretend to have the answers. I did attend a very informative, thought provoking address last week by Brian Pretti, Senior Vice President and Chief Economist, Mechanics Bank. Most of the content below was inspired by Brian Pretti, with some of my own comments sprinkled within. Mr. Pretti made it clear that he does not purport to have the answers, but suggests that we ask the right questions and think about the key economic questions of today in the right context.
The reality is that nobody in government, academia or business really know definitively what the best path is, because we’ve not taken it before. This is not a business cycle-induced recession – that is pretty widely agreed – it’s a recession induced by a financial and “credit cycle implosion.” We’ve not seen that in modern economic times. The experience base and forecast models don’t provide much guidance.
Collapse of a Credit Cycle
Our economy depends on borrowing and credit, for better or worse, and that has been the lifeblood of the economy since the 1950’s. According to Federal Reserve data going back to 1953, there has been quarterly growth in private sector (consumer + business, which accounts for around 85-90% of GDP) use of credit for 60 years.
Two years ago there was $3.5 Trillion per quarter being borrowed. Now, for the first time in 60 years, the quarter to quarter rate of credit growth is negative! The private sector stopped borrowing and is both working down and defaulting on its debt, “deleveraging.” In ways, we should be grateful, in ways fearful.
So to counterbalance it, the Federal govt. is “leveraging,” adding a whole lot of debt to prevent further collapse – another good reason to be fearful (my opinion).
The Fed. Reserve web site showed last week that the banks are easing up credit restrictions on both large and small borrowers, but the borrowers aren’t borrowing. This isn’t like the early 1980’s when people didn’t borrow at stratospheric interest rates, they’re near zero and there’s still little borrowing. This isn’t just a supply problem, it’s a problem of demand for credit, too.
The last de-leveraging cycle was in the 1930’s. Notably, the last time adjustable rate mortgages were used widely in the U.S. was the 1920’s, after which they fell into disuse for about 60 years. Perhaps you’ve heard the old saying that we don’t repeat the mistakes of our parents, but instead repeat the mistakes of our grandparents…
After The Depression, the credit base grew between 1950-1980, but slowly compared with 1980 onward (the collective memory of The Depression was common, so people were unwilling to take on much debt). During that time we had shorter economic expansions (business cycles) and the economy was more volatile.
By the 1980’s the Baby Boom generation came of age, and started buying houses, flipping them, doing it again and again, enabled by what Mr. Pretti called “maniacal credit creation.” House prices just kept rising, and people believed it would always be so. So long as the credit to do so is easily obtained, it’s easy to keep perpetuating that cycle. Think of the period between the early 1980’s and just recently as a wild, drunken party – now, all that’s left is a vicious hangover. Mr. Pretti noted that the “build up over long credit cycles is virtuous, the end is vicious.”
Economic Volatility
Favorably, economic expansion cycles started to lengthen and become less volatile, which was of course a great thing for everyone globally. I personally remember writing about the reduced volatility somewhere back around 2004.
An important question: now that the private sector is de-leveraging, will economic expansions shorten again and become more volatile? Vast fortunes will be made and lost as people test hypotheses to answer this question.
The picture of the Federal Government piling on debt is not pretty and nobody likes the idea. The hope is that it can be short term only, then reversed before long – and before inflation kicks in and the dollar devalues against international currencies.
It’s a tactic with huge downside risk that can last for a generation. But, is there another choice to keep the economy from deeper problems and higher unemployment, since the private sector is not spending? The thinking goes that the Federal Government is all that’s left to spend money (a notion that is very frightening to most of us).
The Federal Reserve can’t stimulate economic activity by dropping interest rates – they’re already near zero. Tax cuts would only reduce federal tax revenue and increase the deficit if businesses and consumers don’t spend the money, but instead save it (what many economists expect to happen, especially in light of the credit issue above).
Side note: I have been an advocate of payroll tax cuts on new hires for over a year, but for some reason this never got traction in Washington. I understand the reticence to offer it on existing employees, but new hires wouldn’t cost the government, as it would be cheaper than having people on unemployment.
Unfortunately – and it’s creating a political firestorm – the stimulus money is not trickling down from Wall Street to Main Street. Main Street has gotten very little benefit from it, but there are those Wall Street bonuses waived in everyone’s face on the evening news. We citizens have a lot of valid questions and concerns.
There will be a lot of expected and unintended consequences for the govt. leveraging to replace the private sector. Everyone knows that some will occur, but what will they be, and when? Inflation and a U.S. dollar devaluation are concerns, but not universally agreed inevitabilities for the short term.
In Japan we saw a credit cycle bust in the 1990’s. In the 1980’s they were buying some of the world’s favorite trophies like Pebble Beach and Rockefeller Center, until the market peaked in 1990 — then K-Boom. When they went through the reconciliation, the business cycle shortened and got more volatile. So, in a post credit cycle bust economy, is this what we can expect? Maybe, maybe not. Fortunately for us, Japan’s experience is not necessarily indicative of our fate, as there are other differentiating factors.
Complicating the picture is the fact that we’re now just one country in a globalized economy, and not only is a lot of American industry gone for good, but when the economy improves, American industry is unlikely to build new plants in the U.S.
In short, easy answers are not apparent.
Implications for Merger and Acquisition Activity
Increased uncertainty and increased business cycle volatility may reduce valuations. The Good Old Days of 2006-2007 peak valuations may not be seen again for 25-30 years. Business owners who are contemplating transactions do themselves no favor by waiting, unless they can use the time to improve the business’s operation and/or buy out competitors.
There is ALWAYS high demand and valuation for the best companies in their industry. This factor is perhaps more acute now, since the good ones are few and far between and thus more desirable.
Consolidation of competitors will be increasingly important as the market “rationalizes” (eliminates) the excess of supply in certain industries that exceeds the demand. In other words, in many industries, there are just too many companies doing the same thing for the level of current demand, and in many cases, considering the economic factors above, that demand may not return to recent years’ levels .
Just as the Baby Boomers helped fuel the housing bubble, a Baby Boomer retirement wave is expected that will bring a lot of Boomers’ businesses on the market this year and in coming years. This may also depress valuations by introducing more competition for the given pool of buyers (not to mention with constrained access to credit).
Resources:
Deleterious Effect of Government Spending on Economic Growth, 2005, The Heritage Foundation http://www.heritage.org/Research/Budget/tst102505.cfm
The Necessity of Obamanomics – Labelling the president a tax-and-spender is facile given the challenges he faces. Wall Street Journal (must be subscriber to read full article)http://online.wsj.com/article/SB10001424052748704022804575041751435808716.html?KEYWORDS=necessity+of+Obamanomics
