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Legal Commentary

: Adam Smith, Esq.

The Balance Sheet Recession

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More than ample is the ink that's been spilled over trying to explain just exactly what we're going through economically: Is it a bad recession? A near depression? Is it analogous to 1929? Is it analogous to....? Does our salvation lie in monetary policy? In fiscal policy? Are trillion-dollar budget deficits as far as the eye can see a monumental threat to the economy, or not nearly enough to deal with the crisis? Is capitalism fundamentally challenged? Was this all the fault of the hubristic financiers and bankers of Wall Street, whose greed for outsized bonuses is unsated even to this day, or was it in fact the decade of irresponsible self-indulgence engaged in by middle America as they serially re-financed their McMansions to buy Hummers and over-sized flat screen LCD TV's?

We're not going to solve this right now--and the reality is we'll only begin to create informed judgments when we have some perspective, years from now.

But I'd like to pull together a few perspectives at this juncture.

First of all, what can we learn from the past? Unfortunately, less than we think. As The American put it in "Our Epistemological Depression:"

History rarely repeats itself. There are some standard patterns in economic recessions, but major recessions are characterized by something novel. If only this were not the case: economists have devoted a great deal of attention to learning the lessons of the Great Depression that began in 1929, not least Ben Bernanke. As a result, we are unlikely to make the errors of monetary policy made by the Fed in that era (of tightening money when it should have been loosened); or the errors of fiscal policy made by the Treasury (such as raising taxes when they should have been lowered); or the errors of ideological tone made during the 1930s, when anticapitalist rhetoric frightened many potential investors from making new investments. In all of these respects, we have learned from the past.

Unfortunately, initial conditions are too different from case to case to simply apply some historical template that would permit us to fully understand what is currently happening, let alone how to deal with it. Instead of explaining why this recession (or depression) is just like the others, we should attend to what is new and especially problematic about the current downturn and why it may not respond to policies modeled on avoiding the errors of the past.

This is not a counsel of confidence. It suggests there's not so much we can learn from the past and that, by implication, we're flying relatively blind. That's not to say deny that by and large, this piece defends--as do I!--capitalism. Only consider its opening lines (emphasis original):

The history of socialism is the history of failure--and so is the history of capitalism, but in a different sense. For the history of socialism is one of fundamental failure, a failure to provide incentives and an inability to coordinate information about supply and effective demand. The history of capitalism, by contrast, is the history of dialectical failure: it is a history of the creation of new institutions and practices that may be successful, even transformative for a while, but which eventually prove dysfunctional, either because their intrinsic weaknesses become more evident over time or because of a change in external circumstances.

Opposing this counsel of faith in the long-run wisdom of capitalism is a piece written by a former chief economist of the International Monetary Fund, The Quiet Coup, from The Atlantic, which posits essentially that the US is "becoming a banana republic:"

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn't be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn't roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there's a deeper and more disturbing similarity: elite business interests--financiers, in the case of the U.S.--played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

This piece reaches its rhetorical apogee in "The great wealth that the financial sector created and concentrated gave bankers enormous political weight--a weight not seen in the U.S. since the era of J.P. Morgan (the man)." There are other counts to the indictment:

  • Under "The Wall Street/Washington Corridor:" "Just as we have the world's most advanced economy, military, and technology, we also have its most advanced oligarchy. [...]
  • The American financial industry gained political power by amassing a kind of cultural capital--a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors. [...]
  • Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round. A civil servant from Washington invited into their conference rooms, even if just for a meeting, could be forgiven for falling under their sway. [...]
  • A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan's pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone.

You get the gist: The "oligarchs" of the financial services industry have thoroughly captured the mewling and subservient regulators, Cabinet officials, and Congressmen and Senators. If this is an accurate diagnosis, the solution follows inevitably:

Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.

Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical--since we'll want to sell the banks quickly--they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.

Fundamentally, this posits the economic meltdown as just desserts for the over-reaching of the priviliged few, who now need to be put brusquely in their place by force majeure.

Warrant you, I do not subscribe to this ideology or this explanatory device for a moment, but I have dwelt on it herein to bring attention to what a substantial stream of thought it is. The Atlantic, after all, is not exactly a fringe publication.

Having presented these two dueling explanations--the first that capitalism, the best of all possible worlds, is still subject to episodic paroxysms of dysfunction in the face of endogenous excesses or exogenous shocks, and the second that (democratic) capitalism, not necessarily the best of all worlds, is subject to capture by oligarchies to the supreme detriment of the commonweal--I'd like to present a third and, I believe, more informative, perspective: What if this recession is not the usual "income statement" recession but instead a "balance sheet" recession.

For suggesting this train of thought I'm indebted to Roger Altman, Chairman and CEO of Evercore Partners but perhaps better known as deputy Treasury secretary under President Clinton, who recently wrote in the FT that:

The rare nature of this recession precludes a cyclically normal US recovery. Instead, we are consigned to a slow, painful climb-out [...]

What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. [...]

For households, net worth peaked in mid-2007 at $64,400bn but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big - especially when household debt reached 130 per cent of income in 2008..... Now that wealth effect has reversed with a vengeance. The crisis and unemployment have frightened households into raising savings rates for the first time in years. They had been stagnant at 1-2 per cent of income but have surged to nearly 5 per cent.

Why do I emphasize this?

Recessions as described or dissected by Econ 101 are income-shock driven, not balance-sheet shock driven. Typically, rising inflation compels the Fed to tighten money and raise interest rates and the predictable slowdown follows as (a) business investment contracts because of higher funding costs (b) causing all the industries and suppliers associated with that investment to contract (c) laying off their workers and cutting their orders to their own suppliers (d) leading to further employment contraction (e) decreased consumer spending (f) decreased demand for business products and services, and so on until inflation is tamed and the Fed can ease off the brake and back onto the gas.

Alternatively, of course, a single sector can become a bubble unto itself (the dot-com boom or the S&L crash of the 1980's) or an exogenous shock (the OPEC price spike of the early 1970's) can prompt a recession, but the single-sector bubbles are typically self-contained and parochial in scope and the exogenous shock bring forth a plethora of innovation and plain old readjustments (turn down the thermostat and stock up on sweaters?) that hasten recovery.

This time is different.

This time everyone--households, small businesses, big busineses, banks, investment banks, and yes, law firms--has seen their net worth hosed. The problem with recovering wealth is that it takes so much longer than it does to recover income.

The famous arithmetic tautologies still hold, alas: If your portfolio drops by 20%, it takes a 25% gain to recover; if by 33%, a 50% gain; and if by 50%, a doubling.

By contrast, replacing "lost" income isn't all that simple, especially if, blessings upon you, you're unemployed in this environment. But once you are re-hired, the bleeding instantly stops. Not so easy and not so fast in terms of regaining lost wealth.

Aside from having had a tour d'horizon of how we might have gotten here, where does this leave us?

Actually, with some perspective.

Law firms are not, permit me to suggest, the worst industry to be in right now. Would you rather work for a large retail chain? A resort or hotel or entertainment complex? A bank? An investment bank? A hedge fund or private equity house? A magazine or newspaper publisher? An auto company?

If this is a "balance sheet recession," be grateful at least that, while no firm you work for and no industry you work in can bulletproof your 401(k) or the "mark to market" value of your home, the long-term prospects for your income are, I maintain, as bright or brighter than ever.

Chin up.

Full post as published by Adam Smith, Esq. on April 08, 2009 (boomark / email).

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