3/5 Potential Larger Implications of Volatile Financial Markets, "Financing Glut" and Real "Investment Restraint"
Mar 5 (Econotech FHPN)--“Overall investment restraint is the real macroeconomic conundrum”--Raghuram Rajan, former IMF Director of Research, now at University of Chicago
To keep this reasonably short, I am not going to recap the highlights of what happened in global financial markets last week, nor try to guess their short-term directions, there is plenty of that of widely varying quality all over the web, so I keep my thoughts on such subjects to my private e-mails (for a very small sample, see my Feb 27 post link).
One and Done Re-Rating of Global Real Estate Assets
Rather, I would like to focus on one simple but critical point. In this 2002-07 business and financial cycle, the U.S. and global economy probably has used up its “one-off” reprieve from the previous recession, namely through a massive “re-rating” of global residential real estate on the basis of a huge shift downward in global long-term interest rates, term premium, and credit risk spreads
Whatever the trajectory of global real estate prices going forward, it would seem likely that this unprecedented “re-rating” is one and done, that asset class can’t get significantly re-re-rated yet again, at least further upwards (although NYC real estate is still going up since it is based on the huge bonuses generated by the hyperspeculative financial, not real, economy).
This real estate asset re-rating was a one-time adjustment, essentially based on compressing decades of suppressed economic development of the majority of the global population into a very tiny 5-10 year window of unprecedented change, and projecting that high-growth, low-inflation historic shift out into the future. Even though this rapid global development trend is likely to continue, with ups and downs, that one-time historic step function is probably now by-and-large over.
The Good News Is That Time For Economic Re-Adjustment Was Bought
The good news is that this bought the U.S. and global economy five more years of prosperity, on the basis of a massive creation of paper asset “wealth,” especially in home equity (and also thus non-income “savings,” as incorrectly redefined from the traditional GDP measures, by some conservative economists), especially for the upper 20% of the population, that “trickled down” into very robust U.S. consumer spending and import demand from, and investment in, the rest of the global economy.
(Briefly, here is aggregate statistical data on household “wealth creation” from the last release—the next quarter will come out March 8—of the Fed’s “Flow of Funds Accounts,” Z.1. From Table B.100 Balance Sheet of Households and Nonprofit Organizations, pg 102. All percent changes are from the end of 2001 to end of third quarter 2006.
Household real estate assets (line 4), home mortgages (line 32), and owners’ equity (line 49) grew 11.0%, 13.1%, and 9.3% CAGR over this time frame. All other assets (lines 1 minus 4), liabilities (lines 30 minus 32), and net worth (lines 41-49) grew 5.6%, 5.5%, and 5.6% CAGR.
I.e., real estate assets, liabilities and net worth grew roughly twice as fast as that of everything else the past five years.)
The Bad News Is That Time Has Probably Now Been Squandered
The bad news is that those five years of breathing room now have been squandered, and it’s probably too late to change that.
By squandered breathing room I am not referring to the failure during the recovery and expansion to address key looming fiscal issues related to the impending “baby boomer” retirement demographic shifts that are frequently focused on by establishment economists, though that is very important.
Rather, I mean the failure to shift global real productive investment away from the inward satisfying of the U.S. domestic consumption boom, outward toward beginning to address the huge development needs of the vast majority of the world’s population.
Unfortunately, the critical opportunity to massively shift global capital investment into more productive uses has been wasted in a veritable orgy of many trillions of dollars of unproductive private equity and other M&A deals that have done virtually nothing except line the pockets of those engaged in their return on leveraged legal looting (ROLLL, see my Dec 19 "World Needs Better "Face of American Capitalism," link).
The U.S. economy continues to be structurally changed to satisfy this booming home-equity “wealth creation” internal domestic demand, not to satisfy the export market for the development of the rest of the world, hence the huge U.S. current account deficits. A good example of this has been the huge shift in focus of Silicon Valley from corporate productivity tools to ad-based media business models, following the huge success of Google.
Businesses and people in literally every other country in the world wake up every working day trying to figure out what to sell the rest of the world in order to earn their keep. It seems very difficult for many Americans to think this way anymore, since "E-Z credit" financing of the U.S. external deficits has been so easy and painless.
What Will End the 35-Year Decline in U.S. Real Wages?
With a long-term trend of stagnating real wages, should the worse come to pass and last week turns out to be the harbinger of a decline into a global slowdown or recession, the U.S. in particular will need to live off its home equity, so to speak, built up over the past five years, provided it doesn’t substantially fall. As a result, muddling through may be the best that one can hope for if the U.S. and global economy were to enter a recession.
The massive expansion of actually productive real investment may have been the only thing that could have eventually slowly begun to reverse the -15% decline in U.S. weekly real earnings since 1972.
(For data, see 2007 “Economic Report of the President,” Table B-47, Hours and earnings in private nonagricultural industries on pg 286. In the column “Average weekly earnings, total private,” in 1982 dollars, 1972 was 331.59. Dec 2006, the last date provided, was 282.75, a -14.7% decline. The average in 2002 was 278.83 and in 2006 it was 278.66, i.e. no growth. The only even very modest growth since 1972 occurred from 1996 to 2000, when the data rose 6.2%, a 1.5% CAGR.)
Despite the very minor recent late cycle rise in real earnings, I’m not sure why that long-term trend decline will be reversed. To compensate for stagnant wages, household income was increased through women increasingly entering the labor force, but that gain has long since run its course. So, without some sort of renewed asset inflation paper wealth creation, it is hard to see what will sustain aggregate demand if a sharper slowdown were to occur.
"The mismatch between unabated global desired savings and lower realized investment ... has led to a financing glut"--Raghuram Rajan, former IMF Economic Counselor
To buttress my point about the massive mis-allocation of investment from productive to speculative purposes, let me please try to invoke the authority of no less than the former Economic Counselor of the IMF, Raghuram Rajan, who has just returned to his former home at that bastion of “free market” capitalism, the University of Chicago (its business school, not economics department). Of course he doesn’t exactly say what I just did about ROLLL, no self-respecting eminent economist would put it this way.
But Rajan does make a key point that I have tried to make far less well several times on my web site, i.e. low interest rates are not mainly the result of a so-called “savings glut,” a la Bernanke, but rather also due to under-investment (I would argue massively so) in real productive assets, in my formulation to meet the needs of most of the world’s population, resulting in what Rajan calls a “financing glut,” what I consistently label global hyperspeculation.
(And, btw, the unprecedented amount of philanthropy directed at these needs by Gates, Buffett, etc, which is incredibly worthwhile and extremely admirable, is not enough, what I would argue is that what the philanthropists consider to be a "market failure" itself ultimately must be directly addressed as such and changed).
The following is from the Dec 1, 2006 remarks by Rajan, at the time the Economic Counselor and Director of Research of the IMF, to the G-30 meeting in NYC titled, “Is There a Global Shortage of Fixed Assets?” The full text can be found at this link.
I am reprinting extended excerpts of Rajan's remarks below, relying upon the following usage policy from the IMF web site, “The IMF freely authorizes downloading and/or reprinting files from its website for any non-commercial use,” since my web site is completely non-commercial.
Here is the customary disclaimer made by Rajan in footnote 1: “The following reflect my views only and are not meant to represent the views of the International Monetary Fund, its management, and its board.”
Now, in Rajan’s own words:
"Is There a Global Shortage of Fixed Assets?" by Raghuram Rajan
"…The intent is to provoke discussion rather than to claim I have all the answers …
I will argue that underlying these seeming anomalies [in the pricing of financial assets] may be a global shortage of creditworthy hard real assets relative to desired savings. This has resulted in a financing glut that is particularly pronounced in debt markets. Of course, I cannot prove this is what is going on, but it does fit the facts reasonably well. Moreover the implications are quite important for policy.
Let me draw on three global ingredients to build the case for my hypothesis. The first is a widespread surge in productivity across the world. The second is a desired savings rate that continues to be high, particularly supported by corporations, but also by emerging market governments. The third, and perhaps least well understood, is global nominal investment in physical assets that has yet to return to past levels (as a share of GDP) despite the higher productivity and available savings …
Given strong productivity growth and an unabated desire to save, it is therefore surprising that actual corporate physical investment has not kept pace. After all, if productivity growth is strong as is the desire to save, investment should be both profitable and easily financed. Yet investment is only slowly returning to the levels reached in the last decade, and I would conjecture, probably below the quantities that might be warranted by the tremendous growth experienced over the last few years.
To my mind, overall investment restraint is the real macroeconomic conundrum (Bernanke (2005) offered an early discussion of the phenomenon, though based on work at the Fund, I believe the problem of the excess of desired savings over realized investment is better described as investment restraint rather than a savings glut). [bold emphasis in this paragraph added by econotech] …
To summarize, I have argued the world has experienced strong productivity growth, and desired savings that continue to remain high, but actual investment, after plunging at the turn of the century, despite rapid rates of growth recently, is yet to recover fully. Let me now turn to the consequences.
The mismatch between unabated global desired savings and lower realized investment, between the amounts available for finance and the flow of hard assets to absorb it, has led to a financing glut.
Let me now argue that the glut is likely to be particularly pronounced in debt like instruments, and this is partly responsible for low long term real interest rates the world over lower. [bold emphasis added by econotech in the above two paragraphs] …
There are a number of implications. First, given financial markets are integrated, the glut has spilt over into markets for existing real and financial assets—real estate, high-risk credit, private equity, art, commodities, etc—pushing prices higher. [unless where otherwise noted, this and the bold highlights that follow were made in the original by Rajan] …
Second, while uncertainty may hamper cross-border corporate investment, no such uncertainty hampers domestic investment in non-traded goods such as real estate …
Third, different financial systems have different abilities to take advantage of the global hunger for savings instruments. The United States financial system is particularly adept at creating instruments the market wants. For instance, the recent phenomenon of large leveraged buyouts may simply be the financial system catering to a market that is desperate for debt. [bold emphasis added to the second sentence by econotech]
Finally, given this discussion, I would suggest that the easy financing conditions the world over are not primarily because of the accommodative policy followed by the G-3 central banks in recent years, though clearly monetary policy can add or subtract at the margin by affecting liquidity conditions and carry trades.
Indeed, monetary authorities face a particular dilemma. If they raise policy rates they could reduce investment in sectors sensitive to short rates or liquidity, increasing the financing glut, pushing long term interest rates even lower, and increasing the possible mis-pricing in other asset markets. … If on the other hand, monetary authorities allow the environment to be excessively accommodative, they allow inflationary pressures to build, even while the liquidity glut adds to the financing glut. [bold emphasis added in this paragraph by econotech]
Let me conclude. Current conditions are unlikely to be permanent. Indeed, investment does seem to be picking up steadily. My hope is that as a better balance between desired savings and realized investment is achieved over time—long term interest rates will move up steadily, certain pumped up asset markets will deflate slowly, exchange rates will adjust, and global imbalances will narrow, without major blow-ups … We also know adjustments, either on the real or financial side, rarely take place as smoothly as hoped for. Appropriate caution is warranted. Thank you."
Paulson’s Latest China Trip, Japan’s “Mr. Yen” on U.S.-China Deal
“On his trip next week, Paulson will meet with Vice Premier Wu Yi. The secretary will hold meetings in Shanghai, China's financial capital, with financial sector leaders and give a speech on Chinese financial market reforms. The administration is trying to convince the Chinese to open their financial markets to greater participation by U.S. companies.” (UK Guardian, Mar 2)
Americans should be aware of Paulson’s agenda with China (I'm sure China is, e.g. see my section on "Whither China" in my Oct 27 "Global Strategic Bargain," link).
Eisuke Sakakibara is Japan’s former Vice Minister of Finance for International Affairs, where he gained visibility as “Mr. Yen” during the Asian financial crisis of 1997-98. He is a strong proponent of Japan’s system and interests, e.g. Japan floated the idea of an Asian Fund during that crisis which was immediately snuffed out by the Rubin-Summers U.S. Treasury Department. An economics Ph.D., he is now at Waseda University.
In his remarks to Tokyo’s Foreign Correspondents’ Club of Japan on Mar 2 (link to the Bloomberg audio), Sakakibara says, “We really do not know the magnitude of the carry trade” (my transciption, at 8:26 mark). Then, deep in the Q&A period, he drops one of his outspoken comments (often delivered with a hearty laugh):
“Well I think Mr. Paulsen [U.S. Treasury Secretary] and Governor Zhou [head of China’s central bank] seem to have a struck a deal that China would stick to a gradual appreciation of the renminbi. Wen Jiabao [Premier of China’s State Council, like his predecessor in that position, Zhu Rongii, CPC Politiburo Standing Committee member most responsible for economic policy] has said that, in June of I think 2006, that China would stick to the gradualism, and China would not lose control of forex market either. And I think the deal is that China would gradually appreciate the currency but at the same time China would open the financial markets, particularly for U.S. investment bankers. So I think as long as that deal is there, I would not expect the renminbi to have a very rapid appreciation in the coming year or so.” (my transcipition at 1:00:31 mark)
Needless to say, China would not be pleased with this characterization, rightfully so, especially when coming from a former high Japanese official. My point in posting it is simply that Americans should better understand what the real U.S. agenda is for China and for American jobs.
Paulson is mainly concerned about the extraordinarily lucrative jobs of his former colleagues at Goldman Sachs and other U.S. hyper-speculative giants, not primarily with American manufacturing jobs. That war was lost long ago, in the first Reagan administration.
America and China should also realize the risks of a Goldman-led U.S. economy (e.g., almost the entire increase in S&P 500 earnings is now coming from the financial sector). “Goldman Sachs Group Inc., Merrill Lynch & Co. and Morgan Stanley, which earned a record $24.5 billion in 2006, suddenly have become so speculative that their own traders are valuing the three biggest securities firms as barely more creditworthy than junk bonds.” (Bloomberg, Mar 2)
Glenn Hubbard, a Harvard Ph.D. economist, was chairman of the Council Economic Advisors in the Bush administration and was reportedly interested in replacing Greenspan as Fed Chairman, the post Bernanke got (a hilarious, light-hearted video spoof link of this by the Columbia b-school follies, where Hubbard is dean, was widely circulated on Wall Street last year).
Hubbard recently addressed the Stanford Institute for Economic Policy Research. He tells a little story:
“I once showed a picture to President Bush of declining work in a sector. And he said yeah, I’m sick of the manufacturing jobs we’re losing. I said Mr. President, I just showed you agriculture, 1900 to 1940, and do you want to put all those people back on the farm?” (my transcription, 32:30 mark)
Left unsaid was that earlier era was one of rapidly rising real wages and productivity. This historically anomalous era is one of rapidly rising productivity, but as I mentioned earlier, declining real wages since 1972 (I won’t get into the distinction between compensation and wages here, it doesn’t really change the unprecedented in American history negative trend in real wages).
Book recommendations: Corporate America has responded to the distorted “market signals” I think inherent in Rajan’s above analysis by meeting U.S. domestic demand from the home equity “wealth creation.”
There are several very well-meaning books, usually by professors at leading b-schools and consultants, that attempt to re-orient this corporate focus outward toward more sustainable global economic development.
All are excellent, but I think all suffer from the same limitation of not realizing that the necessary re-ordering of corporate investment, especially away from the wasteful paper-shuffling of assets by private equity and other M&A deals, depends on the need to re-prioritize the incentives coming from global capital markets, which have been captured by the global hyper-speculator hedge and private equity funds and investment banks (the same thing).
Perhaps the two most well-known books of this genre are “The Fortune at the Bottom of the Pyramid,” (2004) by C.K. Prahalad and “Capitalism at the Crossroads,” (2005) by Stuart L Hart, and also “The 86 Percent Solution,” (2005) by Vijay Mahajan and Kamini Banga; “Green to Gold,” (2006) by Daniel C. Esty and Andrew S. Winston.
A related genre looks at the lessons from increasingly world-class firms from the emerging markets themselves, see “The Emerging Markets Century,” (2007) by Antoine W. van Agtmael and “Made in China,” (2005) by Donald N. Sull.
A larger but also important genre is on the impact of China and India (now called Chindia by Wall Street), e.g. two very enjoyable reads by two former and current FT journalists, “China Shakes the World,” (2006) by James Kynge, and “In Spite of the Gods,” (2007), by Edward Luce.
While not related to these genres, yet another b-school academic, Phil Rosenzweig, who acknowledges Sull, has just published a very healthy and skeptical antidote to the most standard of all business genres, what makes a company great, “The Halo Effect” (2007). Also see “Hard Facts, Dangerous Half-Truths” (2006) by Jeffrey Pfeffer and Robert I. Sutton.
And speaking of b-school academics, about twenty-five years ago marketing profs, including Theodore Levitt and Philip Kotler, began their campaign to shift the mind of America’s business leaders outward to markets and customers.
Unfortunately, that shift has now focused so heavily on the home equity-based demands of the U.S. consumer, rather than those of the global economy. A sympathetic description of the consumer's never-ending obsession with “trading up” and “trading down” is “Treasure Hunt” (2006) by Michael J. Silverstein.
For my book recommendations on the Middle East and oil, see the last section my Feb 28 article link, to which I would add to that list “The J Curve” (2006) by Ian Bremmer (his curve is more like a swoosh). The J curve, from international economics, was also adapted by yet another management author in “Managing the Dynamics of Change,” (2006) by Jerald M. Jellison, one of the better books on corporte change management; on the same subject, also see "Built to Change," (2006) by Edward Lawler, Chris Worley, Jerry Porras.
The basic idea in all these applications is that with change, often things get worse (the bottom of the J, think Iraq) before they get better (coming up the right side of J), so if you don't want backsliding (in your company, for example), you better figure out strategy, tactics and concrete ways to deal with the inevitable resistance (again, think of Iraq).
Bremmer applies the idea to changing nations. This is also a good idea to keep in mind when dealing with the inevitable adjustments of global economic imbalances, financial markets, etc.