The Catch 22's of the Economic Crisis

A generation of Americans grew up with "Catch 22," but for those older and younger, a brief explanation is due. "Catch 22," was a popular book, written by Joseph Heller, on the contradictions and absurdities of human behavior. Specifically, Heller's book was about a group of the U.S. Army Air force, stationed on an island off the Italian coast during WWII. The overall absurdity is the life they lead on the island and the violent death and destruction they are exposed to on their bombing runs over Nazi occupied Europe. Among the other absurdities are the supply Sergeant who corners the world market in some commodity and becomes a multimillionaire; the squadron commander, whose name is Major Major Major and will grant squadron members interviews in his office only when he's not in his office, etc., etc. The book was written in 1955, but didn't reach the peak of its popularity until the sixties.

So, the term "Catch 22," generally refers to a seemingly reasonable situation wherein it is impossible to get from Point A to Point B, but no one wants to admit it.

There are several very large Catch 22's in today's economic crisis, which I believe have to be resolved before we'll see improvement; this post explains a few of them.

1) Regulation and oversight. Virtually every sane person involved in the crisis, from former Secretary of the Treasury Paulson, to current Federal Reserve Chairman Bernake, agrees that the lack of efficient regulation and oversight has been a major contributing factor to today's crisis. I use the term "efficient regulation and oversight," because a few believe that statutes on the books are adequate and the problem is simply that they weren't enforced. Most, however, believe that there must be a substantial overhaul of the entire regulatory structure. The new Secretary of the Treasury Geithner has explicitly called for a "reshaping of the financial industry." Given the Congressional tendency to "over correct" on problems they've ignored for too long, I believe there is anticipation within the industry and among investors that there will be fundamental changes composed of new regulation, increased transparency, and a re-structuring of oversight functions (eliminating some of the existing ones and replacement by a more centralized, uniform government organization).

Unfortunately, this is a huge task, involving large numbers of special interests and very careful thought. As such, it will require considerable time to accomplish and that "time" is not available due to the urgency of the economic situation.

The Catch 22 here is that until investors understand the new "rules," they will be hesitant to re-enter the markets, and neither tax cuts or stimulus packages can eliminate this reluctance. In other words, any tax cut or government spending plan is likely to fail to jump start markets until the new rules are promulgated. But, the urgency of the situation does not allow for such promulgation prior to government intervention, so tax cuts and government spending will be effected under the old rules, which everyone acknowledges were largely responsible for the crisis in the first place. Catch 22. We can't get from Point A to Point B.

2) Valuation and Mark to Market. Discussion of the current crisis is centered around the valuation of assets. Mark to market is simply the present accounting requirement for all financial institutions to "value" their holdings on daily market prices. This valuation is, in turn, used to establish sound capital-to-debt ratios, which are requirements of the bank industry (or, if you are an individual investor, how much you can borrow "on margin"). Yesterday's testimony of banking CEOs before the House Financial Services Committee may illustrate the problem. Bank of America CEO, Ken Lewis, complained when asked about his bank's ratio of capital-to-debt, because he had already stated that the Bank of America had been a profitable bank for numerous years. He gave the answer (a conservative 10.3%), but implied that as long as he ran a profitable operation, his capital-to-debt ratio was no body's business.

These ratios are established to protect investors (individuals or banks) in exactly the type of situation in which we find ourselves today, falling values. Just as the lack of effective regulation and oversight is generally acknowledged as a major cause of today's crisis, it is also generally acknowledged that "over leveraging" was also a major factor in the crisis. Over leveraging is just another way of saying that the capital-to-debt ratios were far, far overextended. Thus, given today's environment, the question to Lewis was germane.

Here, perhaps, a word or two on "banker mentality" is in order. With rare exception (such as the crisis of the moment), bankers have spent their entire careers in generally favorable investment climates and are, consequently, usually optimistic about the global economic future and assets, which in such a climate, are "bound to rise." From time to time, there may be a temporary retrenchment, but over the long haul - say 10 to 20 years - it is inevitable that global wealth will increase and, as a result, current assets are also "bound to increase in value." [There are limits, of course. Certain things wear out or become obsolete and are replaced, but ultimately that simply generates new assets, with increased value.]

In such an up-market environment, mark-to-market accounting valuation is seen as "conservative," because it is believed that overall assets will only increase in value. It may be that "off balance sheet" investments and commitments, which have become so prevalent today are in many instances used to "correct" what was believed to be "under valued" assets in the mark-to-market valuation requirement. It would be interesting to know if Bank of America's 10.3% ratio includes off-balance sheet items.

The point is that mark-to-market valuation works generally to every one's satisfaction in an "up market," based on the psychological premise that it is better to underestimate your worth than overestimate it and that if you are sure that you are becoming wealthier, it really doesn't matter as much about how much wealthier you are becoming, than it does in a "falling market," when you are becoming poorer.

To some extent, ENRON played this game by carrying "bad assets" off balance sheet, but simultaneously convincing Wall Street that these were, in reality, "good assets" and everybody would make a killing once they were brought back on balance (it worked for awhile).

In a falling market none of the above works and it's much the reverse. To maximize wealth today in a falling market, you would need to substitute mark-to-market valuation with an alternative that "price's in" past valuations, which of course, were higher than present valuations.

In sum, on this point, to get a "real time" picture of a company's true financial status, we would insist that all assets and liabilities be brought on balance sheet and price them mark-to-market.
There is one problem with this; if we did it, I suspect a dozen or so of the world's largest banks, including several of our own, would be evaluated as "insolvent" and the global financial system would collapse. Catch 22. Returning to economic reality = economic disaster.

The second element to this, but within the same above principle, is the difficulty in establishing ANY valuation in today's market. The economic system is so complex, with so many significant unregulated financial instruments, intertwined with one another, no one is quite sure what any of them are really worth, but also aware of the general proposition that whatever they are worth, they're probably worth a lot less than they were yesterday. This is why Paulson found that he really couldn't use the first phase of the TARP money to buy up bad assets and simply had to pour money into the banks and hope for the best. This is also why banks saw their immediate task as not to make bad assets good, but rather to pay dividends, acquire other financial institutions, and retain employees, who understood the transactions better than the Board, through bonuses. In more vulgar terms, the first and foremost step in creating financial stability was, from the banks perspective, CYA.

In other words, to go back to Catch 22, you may only see the banker when he isn't in.

3) Globalization, the New Economy and Post-Industrial Society. I have written so much on this topic in prior posts, that it is probably unnecessary to go into depth here. Much of the promise of these concepts have failed the average American. Over the last thirty years or so, wealth in the country has been increasingly concentrated in the top few percentiles. Reason? For all of these new "concepts," the global economy still runs pretty much on the production and transfer of goods and, to a far lesser extent, services. For all of their gains in productivity, American workers cannot off-set the differences in labor costs in Mexico, China, India, Indonesia, et al. except in agriculture (via Big Agra Business) and that isn't enough to offset the other.

The annual trade imbalance (now falling due to a lack of consumer spending) approached $1.0 trillion/year. The only way we could sustain this mounting debt was to, basically over value our national assets and sell-off the country. Outside of that giant Ponzi scheme, we hold no particular advantage over our global economic competition in other sectors of the post-industrial global economy.

The Catch 22 is that it is ironic that a country, that for most of its trading history built its industry and positive balance of payments on reasonable tariffs, is now throwing it all away for the theory of "free trade." Federal Reserve Chairman Bernake, hardly a "socialist," recently testified before Congress, that in his opinion, the prime "cause" of the current crisis was not the housing market itself, but rather consistent negative balances in international account balances, which led to a surge of overseas capital flowing back into the United States. The housing bubble was largely an outgrowth of U.S. financial institutions trying to accommodate that flow, through the creation of new and untested financial instruments.

I would add to this the perception of Republican and Democratic politicians who looked at this as a "win-win proposition."

Neither Party has yet suggested a reevaluation of these concepts might be beneficial in resolving the present crisis. In fact, it seems likely that a simple "Buy American" provision in the current stimulus package may be withdrawn before passage due of fear by both parties that such might bring "retaliation."

On the other hand, it seems clear to me that a first step toward resolving the current crisis is to bring national goals in line with national resources and to stop trying to be Masters of the Universe. Immediately, this will require more government spending to assist in the redirection of private investment. It will also require new incentives in policy, including the tax code, to encourage the reconstruction of a sound and self-sustaining national economy.

A few final words on the Stimulus and Geithner Plans. First, the latter. I suspect that when Geithner talks about a fundamental restructuring of the financial industry, he ultimately has in mind specific changes that will not be seen by those still living in a fantasy world as "good" for the economy. Announcing those plans in the present crisis environment would only worsen the present situation and that's the reason for "lack of detail" (aside from the time necessary to work out those plans, noted above).

The stimulus plan is "the least worst temporary solution." It passes on massive debt to future generations. It will create new government bureaucracies, etc., etc. But, I again suspect the alternative is a high risk to social stability. California is virtually in bankruptcy. Other states will follow. This is the major reason Republican Governors are backing the plan. Given the differences that have occurred since 1929 in our overall culture, I do not think we can afford another Great Depression. The social instability, which may today result from 20-25% unemployment rates, will make the Bonus March on Washington look like a walk in the park.

[The bonus march occurred during the Great Depression (1932), when thousands of WWI vets descended on Washington, D.C. insisting the government pay them vet bonuses promised earlier by Congress and not delivered. They were broken up by a call out of the U.S. Army. The March probably helped FDR become elected in the fall of 1932 and led to the creation of FDR's Corps of Conservation Camps. Ultimately, Congress agreed to the bonuses in 1936 and to a subsequent GI Bill, in 1945, for returning WWII vets.]

Additional tax cuts, on the other hand, may be of minimal stimulus value. The poor and middle class are so far in debt that small and relatively insignificant tax cuts will not appreciably change their situation. Nor do these economic classes "create jobs." Further tax cuts to the wealthy will go the same way as the Bush cuts, either into another "bubble" or be withheld entirely pending the fundamental changes to overall financial structure of the country. Worse case is that the debt to Gross Domestic Product will approach or slightly exceed the immediate WWII ration of approximately 120%. I believe that the current ratio is approximately 77% (about 10 trillion in debt, with 13 trillion in annual GDP. The difference is that in the post WWII era, when we ran tremendous balance of payment surpluses and had the world's strongest manufacturing industry, we quickly recovered. If, as a result of an increased indebtedness combined with a falling GDP, we hit 120% again, the imbalance will have a greater impact and require a far longer period of recovery. I do not expect the United States to regain its prior economic significance for at least a generation, if ever, but this does not mean we cannot have a sound, but smaller economy beneficial to all of us.