A retrospective on the crisis and thoughts on where we are headed

Daily Commentary

Summary: Today, I am not going to write about a specific topic but rather put together some random thoughts on the direction of the global economy. Next week, I will have some big things to say about the Fed and it’s upcoming meeting. So I thought this would be a good time to reflect on the big macro picture going forward and in retrospect.

Five years ago, the depths of the credit crisis began with the failure of Lehman Brothers. There have been a lot of retrospectives on this event since then, including a good one I ran across on Keith Kennessey’s website. As I sit back and reflect on what occurred five years ago, what the mood and conditions are today, and what everyone is saying in retrospect, my overall sense is that the acute crisis has passed. And that’s both positive and negative.

First, five years ago, we were on a course that could have led to another Great Depression. But so far, we have avoided that kind of outcome on a wider scale. And in that sense, then, we have been successful. However, when you look at what has happened in Greece or Spain, Portugal or Ireland, you realize that a Great Depression has occurred; the economic pain just hasn’t been as widespread as it was in the 1930s. Moreover, the fact that we have escaped the worst means that a lot of structural and institutional challenges remain overlooked and will remain overlooked because these are the kinds of things that get changed only during the urgency of crisis.

I will give you one example from the U.S. Think about the banking system for a second. Right now, just 12 institutions control roughly 70% of all assets in the banking system. Just 86 institutions control a full 90% of all assets in a system that includes 8,000 financial institutions. That is a very concentrated system, more concentrated in fact than it was before the crisis. JPMorgan Chase, an amalgam of Chemical Bank, JPMorgan and Chase Manhattan before the crisis, now also controls the assets of Bear Stearns and Washington Mutual. Bank of America, an amalgam of sundry mergers from the super regional Nations Bank as well as Bank of America and Security Pacific, now controls the assets of Merrill Lynch.  Wells Fargo, an Amalgam of Wells Fargo and Norwest, also now controls the assets of Wachovia. This is just a sample off the top of my head of how concentrated the U.S. financial system has become.

When the crisis was hot and heavy everyone was talking about the ‘too big to fail’ problem and how to address it. Rather than addressing it by dealing with the underlying problem of increasing systemic concentration, the U.S. decided to use a legislative and regulatory fix in the form of Dodd-Frank. And while it is impossible to determine how effective this legislation will prove to be, it is definitely still the case that the U.S. system is more concentrated than ever. With the acute crisis behind us, no one will want to tackle that problem, the problem of undercapitalization or any of the other nagging issues.

That’s what I mean when I say it is ‘bad’ that the acute phase of crisis has passed; it takes away any sense of urgency about systemically important issues. And this is just as true in Europe regarding the defective euro zone setup. The result is that we are moving into this multi-year recovery period with some rather faulty underlying systemic and institutional architecture.

If you look at the way the crisis has been handled, what you see then is an attempt to alleviate the symptoms of distress first and foremost and then a recalibration of systemic or institutional issues only to the degree they alleviate immediate symptoms of distress. In Europe, for example, we have seen a lot of bailouts and even sovereign debt haircuts. However, the bank undercapitalization issues remain in the periphery in countries like Spain and Italy as well as in the core in countries like France and Germany. In the U.S., now that banks seem more stable, we are seeing some belated attempts to prosecute institutions for fraudulent mortgage activities. But, six years after the housing bubble popped, I think the moment has passed for any effective law enforcement on those issues.

Meanwhile from a real economy perspective, despite a cyclical rebound, the policy space remains constrained. Low interest rates, quantitative easing and deficit spending have been used to help alleviate the private sector debt burden while private agents deleverage. However, the economic pain has been so great that these tools have long since become vehicles to attempt releveraging rather than alleviate the burden of deleveraging. And what that means is that across the board in North America and Europe, the deleveraging phase is over. Even as policy space in the form of deficits, policy rates and unconventional monetary policy, remains limited.

My concern for some time has been twofold. First, I have been concerned about how effective these policies would be on a cyclical basis, meaning how likely they were to increase GDP and promote economic growth. Second, I am also concerned about whether these policies will run into secular issues when the next cyclical downturn begins. The stimulus has been massive but the economy is still weak and most of the debt burden still remains. What this effectively means is that we need to see at least 3 or 4 years more of growth in order to permit policy makers to recharge – to lower deficits and normalize monetary policy. If recession hits before that time anywhere in North America or Europe, the ability to extricate the economy from another deleveraging cycle would be severely hampered. Indeed, this accounts for much of the difference between the US and Europe as the U.S. has had a more durable and successful reflation effort  while Europe went with front-loaded austerity.

I believe we have hit peak stimulus. QE3 and the OMT were ‘peak stimulus’ in the U.S. and Europe respectively. From here on out, the economy will not receive anywhere near the boost it has had from policy stimulus such that, to the degree we get growth, it will need to come from consumer and capital spending predicated on wage growth. I do not see any signs of this wage growth in the U.S. nor do I see it in the European periphery. This suggests to me that these economies are still very much dependent on policy stimulus to achieve even the low levels of economic growth they have registered.

Therefore, my macro view, while positive, is dimmed by the secular challenges we face while policy stimulus is removed.

Next week I will have a lot more to say about monetary stimulus in the U.S., particularly regarding the Fed’s quantitative easing and forward rate guidance plans. I think we are experiencing a fundamental shift in monetary regimes and this month’s FOMC meeting will be extremely important in signalling the change. Stay tuned.