At the annual monetary policy gathering in Jackson Hole, Wyoming last month the issue on the table was the responsiveness of the economy to government stimulus. The question took heightened significance when it was reported that the second quarter GDP annualized growth rate was revised downward to 1.6%. This less than stellar GDP performance caused Fed Chairman Bernanke to review the remaining monetary policy tools left after which he lamented that “the benefits of each tool outweigh the associated costs and risks of using the tool”.
Following this candid admission that monetary policy had reached an effective dead end, it was reported that the President’s economic team spent the next two weeks formulating yet new fiscal stimulus packages. While the administration is persuaded to add stimulus despite no multiplier effect from previous stimuli, there are now many who would prefer a European style austerity of less spending and higher taxes to slow down the growth rate of government debt. In either case, the economy crawls along at a growth rate that doesn’t allow it to catch up to supply side Potential GDP and the country’s debt to income ratio rises.
While the economic weakness and the less than reassuring policy response is in plain sight, the financial markets in its usual rosy myopic way somehow still frames the question in term of will there be a double dip recession as the worst case scenario. However the larger question being raised by many is why three years after the onset of the sub-prime meltdown and the resulting recession and trillions in deficit generating stimulus spending and a doubling of the monetary base is the level of GDP nearly what it was at the outset of the recession with much higher levels of unemployment and a deterioration of many other significant measures of economic activity. Almost as importantly there is clear loss of confidence in not only the policies but the policymakers which in turn translates into reduced investment spending.
For a perspective on what is being generally attributed to a recession, let us look at the progress of this business downturn as compared to all previous Post WW II business cycles. The Figure below indicates the level of employment relative to the number of months from the prerecession business cycle peak. We see that cyclical employment declines typically ended about 14 months into the recession with recovery of employment levels to previous highs occurring approximately 28 months for the great majority of the previous post WW II cyclical events. The lengthiest recovery was the “tech” recession that took nearly four years to regain its previous employment high level mark.
In contrast, the current cyclical episode, if one wishes to characterize it that way, shows the depth of the decline in employment in percentage terms relative to the previous peak and whatever little recovery is wavering. This would appear to cast the current episode not in cyclical terms as no progress has been made in recovery momentum, but rather in secular terms of an economy that resists the jump start of economic policymaking calling into question the efficacy of both expansionary fiscal and monetary policy. This is tantamount to the economy coming up with a new strain of bacteria that is resistant to all previous successful antidotes. This has become the question of the day: why is fiscal and monetary policy shooting blanks at great expense in terms of the accumulation of US government debt and rising government debt levels relative to income.
This raises the question of the missing link to both fiscal and monetary policy. They are related. This is a debt satiation economy (see: The Debt Satiation Economy) in which the accumulation of consumer debt relative to disposable income changed consumer behavior with priority number one being frugality and reduce debt at the sacrifice of current consumption. For example the first Federal effort to offset the recession over two years ago was a tax refund which was about 80% utilized to retire debt and if the consumer will not spend green Treasury checks they will not line up at banks to further indebt themselves. The resistance to further borrowing and spending renders monetary and fiscal policy ineffective. This is a condition which goes under the academic title of the Liquidity Trap first identified in the Depression by Keynes and once again exists.
The Liquidity Trap is actually two sided. Borrowers will not borrow and lenders will not lend. The result is that no matter how much liquidity the Fed provides the banking system, loans and spending are not forthcoming so there is no bank credit expansion multiplier from the Fed’s Quantitative Easing. The question then becomes is the absence of borrowing and spending more due to a reluctance to borrow or a reluctant to lend. Banks being profit motivated have an incentive to lend to the private sector rather than the government and the Fed at rates well below 1% which has been the expanding portion of their contracting portfolio. Indeed, bank lending to especially the important Commercial and Industrial loan category to small business has been declining over the last 18 months and total private bank lending contracted for only the second time since the Depression.
The Missing Link to bank lending to the private sector is insufficient bank capital that would allow banks to lend to private parties as banks do not need capital (to meet minimum capital requirements) to finance the government and the Fed but does need free capital to finance private parties which regulators considers “risky”. Certainly there is a demand by small businesses to at least refinance but while credit is cheap it is also unavailable. Just as cash is king in a liquidity scarce market as in 2008, currently capital is king in the banking industry as an insufficient ratio of bank capital to bank assets causes the FDIC to demand the keys to the bank to set in motion the bank’s liquidation. To date nearly 300 banks have been liquidated and over 800 banks or 10% of US commercial banks are on the FDIC’s endangered species list awaiting the Grim Reaper (the FDIC swat team) with many more holding on for dear life as their commercial real estate loan portfolio is melting down and 2.5 million homes are currently in the process of being foreclosed both of which would further erode bank capital. To make the system more capital deficient, the Basel III agreements call for yet higher ratios of bank capital to assets to be phased in over the next few years so required bank capital is chasing a moving target.
The problem of insufficient bank capital to meet minimum regulatory capital requirements has been addressed many times since the financial meltdown but most banks are still among the walking wounded. That is the bank still “operates” but is only going through the motions as far as lending is concerned and the bank hopes for a stay of execution by the FDIC. The attack on the problem of the scarcity of bank capital has had four prongs.
The first and most overt was the TARP Bill that infused $700 billion of government funding into bank capital via the purchase of bank preferred stock much of which has been repaid as large banks were able to raise capital in the markets though many smaller banks have not been able to do the same. In addition to the fiscal subsidy for bank capital, monetary policy has added to bank capital indirectly by inflating bank asset values through its wholesale purchases of residential mortgage backed securities hence elevating bank asset prices and bank capital. The third prong has been current net income spread from the bank’s portfolio which is then committed to the provision for loan losses. Virtually all current bank earnings are being accumulated as a loan loss reserve in order to allow banks a charge-off ratio that is running at that highest rate since the Great Depression (3.4% of assets) with more to come next year.
The fourth prong of the attack does less to provide capital than to cover up the capital deficiency by changes in the accounting standards for bank assets. This has taken the form of twisting the arm of the Financial Accounting Standards Board to eliminate market based accounting of bank assets and other legerdemain known as “extend and pretend” which overvalues the collateral behind bank commercial real estate loans.
Despite all this assistance from either the government, the Fed, current earnings or the accountants, bank capital continues to be depleted when charge-offs for prospective future losses inhibit the ability of the bank to accumulate capital via retained earnings or the sale of common or preferred stock. Furthermore it has been anecdotally reported that bank regulators are requiring outsized charge-offs for new loans at the margin at considerably higher ratios hence inhibiting the willingness of banks to lend even if they do have capital to spare.
Another solution to the problem of insufficient bank capital is for existing banks to have successful offerings of common or preferred stock. While private capital is eager to invest in a depleted banking industry, it is reluctant to do so when the estimated losses of the existing bank assets are so uncertain. To bring certainty into the investor model a clean start-up bank charter is more appealing. However, the FDIC reports that the number of new banks chartered in the most recent quarter was ZERO hence the bank regulators block the eagerness of private capital to provide eager fresh capital to the industry.
Rather the FDIC’s wish is that the private sector infuses capital into the existing walking wounded in order to reduce the government’s exposure to FDIC guarantees from bank insolvency. The same policy of protecting the walking wounded (and the FDIC) was adopted in the middle of the depression to protect the bank survivors after the first bank tsunami that took down 30% of the banks. It took more than 25 years until the existing walking wounded from the Depression were stabilized and new bank charters were issued. We can’t wait 25 years to repair the Missing Link to an economic recovery. The body politic doesn’t have that kind of patience these days.