John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy
Over the past 13 years, the S&P 500 has
underperformed even the depressed return on risk-free Treasury bills.
Real U.S. gross domestic investment has not grown at all since 1999,
and even as a share of GDP, real investment remains weak.
The ongoing debate about the economy continues
along largely partisan lines, with conservatives arguing that taxes
just aren't low enough, and the economy should be freed of regulations,
while liberals argue that the economy needs larger government programs
and grand stimulus initiatives.
Lost in this debate is any recognition of the
problem that lies at the heart of the matter: a warped financial
system, both in the U.S. and globally, that directs scarce capital to
speculative and unproductive uses, and refuses to restructure debt once
that debt has gone bad.
Specifically, over the past 15 years, the global
financial system - encouraged by misguided policy and short-sighted
monetary interventions - has lost its function of directing scarce
capital toward projects that enhance the world's standard of living.
Instead, the financial system has been transformed into a self-serving,
grotesque casino that misallocates scarce savings, begs for and
encourages speculative bubbles, refuses to restructure bad debt, and
demands that the most reckless stewards of capital should be rewarded
through bailouts that transfer bad debt from private balance sheets to
the public balance sheet.
What is central here is that the government policy environment has encouraged
this result. This environment includes financial sector deregulation
that was coupled with a government backstop, repeated monetary
distortions, refusal to restructure bad debt, and a preference for
policy cowardice that included bailouts and opaque accounting.
Deregulation and lower taxes will not fix this problem, nor will larger
"stimulus packages." The right solutions are to encourage debt
restructuring (and to impose it when necessary), to strengthen capital
requirements and regulation of risk taken by traditional lending
institutions that benefit from fiscal and monetary backstops, to remove
fiscal and monetary backstops and ensure resolution authority over
institutions engaging in more speculative financial activities, and to
discontinue reckless monetary interventions that encourage financial
speculation and transitory "wealth" effects without any meaningful link
to lending or economic activity.
By our analysis, the U.S. economy is presently
entering a recession. Not next year; not later this year; but now. We
expect this to become increasingly evident in the coming months, but
through a constant process of denial in which every deterioration is
dismissed as transitory, and every positive outlier is celebrated as a
resumption of growth. To a large extent, this downturn is a "boomerang"
from the credit crisis we experienced several years ago. The chain of
events is as follows:
Financial deregulation and monetary negligence
-> Housing bubble -> Credit crisis marked by failure to
restructure bad debt -> Global recession -> Government deficits
in U.S. and globally -> Conflict between single currency and
disparate fiscal policies in Europe -> Austerity -> European
recession and credit strains -> Global recession.
In effect, we're going into another recession
because we never effectively addressed the problems that produced the
first one, leaving us unusually vulnerable to aftershocks. Our economic
malaise is the result of a whole chain of bad decisions that have
distorted the financial markets in ways that make recurring crisis
inevitable.
Once we abandoned Glass-Steagall, removing the
firewall between traditional banking and more speculative activities,
and allowing those activities to have the effective protection of the
U.S. government, it was only a matter of time until a credit crisis
would unfold. My 2003 piece Freight Trains and Steep Curves
detailed the problem: "So the real question is this: why is anybody
willing to hold this low interest rate paper if the borrowers issuing
it are so vulnerable to default risk? That's the secret. The borrowers
don't actually issue it directly. Instead, much of the worst credit
risk in the U.S. financial system is actually swapped into instruments
that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam."
The ability to use the Federal government as a
backstop for risk-taking was the central element in creating the
housing bubble. As long as a borrower was physically breathing, you
could make a mortgage loan without really worrying about whether the
loan could be paid back. By the time it was packaged up, tranched out,
and securitized either by a bank or by Fannie and Freddie, all of which
had the government backstop, the loan was somebody else's problem.
When the bubble crashed, our policy makers made their crucial mistake -
first through the Bush Administration, and then continued by the Obama
Administration - they failed to require bondholders to take losses on
bad loans.
Every major bank is funded partially by
depositors, but those deposits typically represent only about 60% of
the funding. The rest is debt to the bank's own bondholders, and equity
of its stockholders. When a country like Spain goes in to save a
failing bank like Bankia - and does so by buying stock in the
bank - the government is putting its citizens in a "first loss"
position that protects the bondholders at public expense. This has been
called "nationalization" because Spain now owns most of the stock, but
the rescue has no element of restructuring at all. All of the
bank's liabilities - even to its own bondholders - are protected at
public expense. So in order to defend bank bondholders, Spain is
increasing the public debt burden of its own citizens. This approach is
madness, because Spain's citizens will ultimately suffer the
consequences by eventual budget austerity or risk of government debt
default.
The way to restructure a bank is to take it into
receivership, write down the bad assets, wipe out the stockholders and
much of the subordinated debt, and then recapitalize the remaining
entity by selling it back into the private market. Depositors don't
lose a dime. While the U.S. appropriately restructured General Motors -
wiping out stock, renegotiating contracts, and subjecting bondholders
to haircuts - the banking system was largely untouched.
The failure of our policy makers to restructure
debt resulted in the worst of both worlds - an economy where banks were
relieved of the need for transparency (thanks to accounting changes by
the FASB), and yet homeowners strapped with bubble-sized mortgage
obligations saw very little in terms of debt restructuring. The reason
we never got any economic traction in this "recovery" is that these
debt burdens remain in place. While we certainly don't advocate
"freebie" principal writedowns - which would almost surely result in a
tsunami of strategic defaults, we've long proposed what we've called Property Appreciation Rights
as a way to partially substitute mortgage principal for a marketable
claim on future appreciation. Failing any meaningful debt
restructuring, however, we've got a financial system that continues to
operate with a confident government backstop for risk taking, while
aggregate demand remains suppressed by a burden of existing debt.
Economists define a standard of living as the amount of goods and services that people in the economy can consume as a result of the work they do. They define productivity as the amount of goods and services that people in the economy can produce as the result of the work they do. In the long run, a rising standard of living requires
rising productivity, which in turn requires the economy to accumulate a
stock of productive investments - factories, machines, inventions,
education, and so forth. In the short run, the benefits of productivity
growth can be retained through profits in a way that prevents those
benefits from being enjoyed by workers, but even then, redistributing
wealth can only achieve limited improvements in living standards. Over
time, an economy that squanders its scarce savings will predictably
suffer for it.
Tragically, nobody seems to have learned a thing
from the dot-com crash, or the tech crash, or the housing crash. Wall
Street continues to beg for monetary interventions to reward
speculative trading, even though these rewards have repeatedly proved
to be short-lived. What investors don't seem to appreciate is how much
of our nation's scarce savings have been burned to ashes as a result.
I really don't mean to pick on Facebook. It's a
neat company, a neat platform, and I respect Mark Zuckerberg's
charitable initiatives. But the example is too instructive to miss, so
let's think about it as a business and as a major recipient of
investment capital. If you go on Amazon or Ebay, you want to stay
in order to buy something. That's a fine business model, and network
effects work in your favor because there are a lot of sellers on the
other side. If you go on Google, you want to find what you're looking
for and then leave, which is a situation where advertising is welcome,
and has also worked as a business model (though with a surprising lack
of competition given that the business is based largely on a single
eigenvector calculation). But consider Facebook. If you go on Facebook,
your whole intention is to stay on Facebook for a while, but not to buy something. Here, network effects work against advertising because responding to the ad pulls you away
from the network. On that platform, advertising is a nuisance, and if
you're forced to tolerate advertising, you'll eventually migrate to a
platform without it, so retention will be challenging. And yet, somehow
the investment bankers were able to price the company at $100 billion
on offering day. Perhaps the IPO proceeds will bring us more games,
more photo apps, and more ways our kids can pass their time online,
instead of developing some useful knowledge or skill. I'm all for
down-time and social networks in moderation, but it's discouraging when
this is the stuff that historic IPOs are made of - that this is where
massive amounts of savings are allocated on the basis of a "wait and
see" business model. Thanks to speculative hype, coupled with
intentionally suppressed returns on less speculative but better
understood investment choices, we continue to allocate the nation's
scarce savings in ways that are ultimately unproductive, and that error
will return to bite us over time.
How do we change course? To restore the economy to
the path of long-term growth, we need to allocate capital better. This
requires the willingness to allow bad investments to work out badly,
without being bailed out or otherwise rescued. It would also help to
detach the global economy from the burden of bad loans that can't be
serviced. The first order of business is to restructure debt burdens.
This requires lenders and bondholders to take partial losses (rather
than transferring those losses to the public through bailouts) and
requires debt repayments to be restructured - ideally swapping part of
the principal for some form of equity claim. A return to growth will
require regulatory structures that protect depositors but fully remove
government protection from investment banking and trading activities. A
return to growth will require monetary policy that stops distorting
financial markets by simultaneously suppressing the incentive to save
and encouraging speculative investment.
Over the long run, economic growth really means
the introduction of new products and services, new methods and
technologies, and indeed whole new industries. These aren't the result
of stimulus programs, but are instead the result of productive
investment, education, creativity, and frankly time. Of course,
stimulus programs can have important short-term effects, but even here,
we can't talk meaningfully about "stimulating aggregate demand" unless
we also restructure the debt burdens on individuals, primarily on the
mortgage side. Next to nothing has been done in on this front in recent
years. A sharp "fiscal cliff" would be very disruptive here, but we
shouldn't overestimate the ability of deficit spending to produce
meaningful or sustained economic progress, however "enlightened" a
given stimulus package seems to be.
Meanwhile, we can't imagine that the European
crisis can be addressed by piling up excessive government debt to bail
out troubled banks, and then relying on troubled banks to buy the
excessive government debt. Unless we want a world where public services
are cut to the bone in order to make bank bondholders whole, and where
recession (or in some countries depression) is forced onto citizens in
order to make government bondholders whole, the world's leaders will
eventually have to wake up and recognize that bad debt requires
bondholders who willingly took the risk to also take the loss.
The latest item in the ongoing European crisis is
the news that Spain has been promised loans from the EU in order to
bail out its banking system. The promise to bail out Spain may provide
a burst of positive market sentiment, though I suspect there are some
wrinkles ahead before any of that funding will actually be forthcoming.
It's a little depressing to reflect on the fact that Spain is one of
the four largest European nations, so it's effectively being
called on to lend to itself. Somehow, this is seen as Europe "doing the
right thing." But what is really happening is that a continent that is
already excessively in debt is promising funds so that Spain can
increase its government debt, and then needlessly protect the
bondholders of Spanish banks, who should be subject to orderly
restructuring instead. This is interesting because the new debt will be
senior to existing Spanish bonds, much to the chagrin of existing
Spanish bondholders, and the bailouts will put the claims of Spanish bank
bondholders ahead of the claims of the Spanish citizens who are
funding the "recapitalizations." The only way Spain could make a more
explicit gift to bank bondholders would be to include wrapping paper
and a bow.
If it seems as if the global economy has learned
nothing, it is because evidently the global economy has learned
nothing. The right thing to do, again, is to take receivership of
insolvent banks and wipe out the stock and subordinated debt, using the
borrowed funds to protect depositors in the event that the losses run
deep enough to eat through the intervening layers of liabilities (which
is doubtful), and otherwise using the borrowed funds to stimulate the
economy after the restructuring occurs. We're going to keep
having crises until global leaders recognize that short of creating
hyperinflation (which also subordinates the public, in this case by
destroying the value of currency), there is no substitute for debt
restructuring.
Finally, on the subject of a Greek exit, bank runs, and general Euro-area stress, the always observant guys at ZeroHedge noted the following news item last week:
VANCOUVER, BRITISH COLUMBIA--(Marketwire -
June 7, 2012) - Fortress Paper Ltd. ("Fortress Paper" or the
"Corporation") (TSX:FTP), announces that its wholly-owned subsidiary,
Landqart AG, a leading manufacturer of banknote and security papers,
has had a material banknote order reinstated. This order was
unexpectedly suspended in the fourth quarter of 2011 which negatively
impacted the financial results of Landqart's operations in the first
half of 2012. The Company operates its security paper products business
at the Landqart Mill located in Switzerland, where it produces
banknote, passport, visa and other brand protection and security papers, and at its Fortress Optical Facility located in Canada, where it manufacturers optically variable thin film material.
We'll add that De La Rue PLC, a British company
involved in the design and production of over 150 national currencies,
registered a new 52-week high last week, despite steep recent losses
elsewhere in foreign stock markets.