The proposed fiscal stimulus package of $825 billion is probably (a) too small, and (b) not directed at the right part of our economy (the financial sector). Let me share with you a recent quote that I read from the IMF:
“If there’s not a restructuring of the banking system, then all the money that you can put into [monetary and fiscal] stimulus will just go into a black hole,” Strauss-Kahn, director IMF
On the surface of it all, a massive spending binge of $800bn USD sounds impressive ….but is it? If you think in personal terms, then hundreds of billions sounds like alot of money. And, maybe it is when compared to the budgets of most countries on the planet. But not when its compared to the size of the international finance market, in which there are approximately $140 trillion in financial assets, and hundreds of trillions of dollars traded every year in the currency markets.
Why look at the financial markets size?
When looking at a fix to the financial problem, it is important to compare the size of the proposed fix to the size of the financial system. You need to compare “apples to apples”, if you will. And, since the root of the problem lies in the financial sector, it makes sense to compare the size of the stimulus to the size of the problem. It doesn’t make sense to compare the bailout to the size of a countries GDP (or reserve), when the root of the problem lies not in the real economy (although that is clearly suffering right now), but with the heart of the financial system.
The size of the financial market
Lets look at the numbers…and take a look at how big the fiscal stimulus plan really is in comparison to the estimated size of the global financial system…
see data below…or, here in our GloboTrends wiki
The overall size of the world financial assets (promises outstanding) was approx $140 trillion in 2005. That incredible number was the total quantity of financial assets, or seen another way…there were $140,000 billion promises outstanding for future payments. That unbelievable quantity of promises was only possible because people believed that the underlying assets upon which those promises were made were actually worth what people said they were.
Shrinking the financial market
But when houses started losing value, the mountain of assets stacked on top of them needed to shrink. The underlying assets suddenly couldn’t support this incredible (massive) amount of promises stacked on top of them. And the mountain of finance began to fall…not all the way down, but to a new, lower level of promises. This is what analysts often called “deleveraging“, which meant that we were shifting from an economy with lots of credit…to one with less credit. Less lending, less leveraging, less total financial assets for you and me. Note that this $140 trillion of financial assets was equal to about 3.16 time total world GDP in 2005….up from 2.18 times in 1995, and from 1.09x in 1980. This means that we were living on nearly 3 times as much financial credit in 2005 as we were back in 1980, just 25 years before. This massive boom in finance just happened to correspond to the longest and most prosperous boom in US history…a coincidence? I think not.
Complexity of modern finance…
So, what is happening now is we are moving back to a world with less financial leveraging. It wasnt our choice, but a requirement once investors lost confidence in the underlying value of the property upon which the mountain of promises was heaped.
But because of the complexity of modern finance, once uncertainty entered into the picture, it because extremely difficult to know which assets were worth what. With mountains of derivatives stacked on top of other derivatives, spliced, diced and repackaged every which way…it became extremely difficult for counter-parties to judge the risk of lending to each other.
The result? Banks stopped lending to each other for fear that the assets may not be worth as much as they thought. With bad assets mixed in with good assets, a confusion set in. As a result, all banks sought to shore up their balance sheets and reduced lending. Uncertainty led to a forced deleveraging of the entire financial system…
The pain we feel in the real economy (with job losses, companies losing money, etc) is a direct result of the deleveraging process. We start at one level of activity, and are forced down to a lower one.
The stimulus package is too small
We cant seem to spend enough money. But thats because we are fighting the problems that result from the original problem rather than dealing with the original problem itself. Trying to stop the water from a broken dam is much more difficult than plugging the holes in the dam!
If you add up all the money we have already spend, its clear that throwing money at the problem will not work. Around the globe, country after country is spending money like crazy (cutting interest rates, proposing fiscal stimulus). This latest round of $825 billion is just the latest round. Remember, we previously spent a hundred billion plus in February of 2007,
“After the economy slowed in late 2007, Congress passed a $168 billion stimulus package in February 2008 consisting primarily of tax rebates. The package was later judged by many economists to have been ineffective, since surveys showed that much of the extra money was saved or used to pay debts, neither of which generates direct economic activity.”
And then there was the $700 billion of money in the TARP plan (Paulson Plan) that also wasnt enough to stop this deleveraging monster…
“$700 billion to use to buy up mortgage-backed securities whose value had dropped sharply or had become impossible to sell. While Congress eventually gave him most of the authority he sought, Mr. Paulson ended up switching gears and using the money to make direct investments in troubled financial institutions instead. source NYTimes
I previously wrote an article arguing that the fall in oil prices was a big fiscal stimulus (see link here). But, all of this stimulus has done very little to fix the problem…because none of it went to the root of the financial deleveraging…the trouble is that the financial system is just too MASSIVE in comparison to all of these efforts..
In comparison…the financial Market is MUCH bigger!
- $140 trillion in financial assets…compared to $0.8 trillion in fiscal stimulus.
- On any given day, approximately $1 trillion US dollars worth of currency is traded in just the UK alone….with another $600 bn in the US (each day). Add them up, and you have hundreds and hundreds of trillions of dollars traded each year in the international money markets.
- in the face of such a MASSIVE market…one has to ask….
Will a stimulus of just $0.8 trillion make a difference?
If you accept that the root of the problem is in the financial markets, and not in the real economy…then you need to compare the size of the proposed fiscal stimulus plan not to the size of the real economy, but instead to the size of the financial one. Once you do this, you begin to see why economists such as Martin Wolf are saying that this stimulus package is too small to be effective. (his argument was slightly different than mine, but with the same conclusion that the stimulus package is too small).
My thought is that spending $0.8 trillion in the face of $140 trillion in assets … is like spending half of one percent of the total assets in the hopes of propping up the market. Not only is it way too small, but it goes after the real economy, and not the financial one.
So, what is the solution?
Do we all just need to accept financial system deleveraging? Do we just need to learn to live with less (credit, goods, finance)? No. But we need to accept that this problem is not going to be solved by throwing $825 billion at the real economy. Instead, what we need to do is to find a way to get all of the bad assets out of the larger pool of assets in the financial system. Separate them, write them down, and isolate them from the majority of good -quality assets still in the financial system.
Here are my thoughts for a practical solution.
- Create a “bad bank” which would purchase assets from financial institutions in exchange for cash and equity.
- Look to Sweden, not to Japan (for the answers). My recommendation is to spend some time studying the Swedish model for recovery
- Give the TARP another go. Although Paulson later switched course and tried the European model of direct bank recapitalizations, I think he was originally on to a good idea…buy up bad assets, and find a way to strip them out of the financial system
If those steps fail…then the only other alternative may be to reluctantly nationalize the banks. But, this WILL NOT SOLVE the root problem of forced deleveraging due uncertainty of what assets are worth. It will only lead to forced lending and bad debts, and a potentially huge bill for tax payers.
Final recommendation…go ahead with the stimulus package
Yes, thats right. After arguing that it wont work, Im still arguing that it should be done. The point of my article is that this particular plan will not solve the underlying problem that is causing the financial crisis, but that doesnt mean that the fiscal stimulus shouldn’t be done.
There is a feedback-loop that exists between the “real economy” and the financial markets. While the trouble may have started in finance (and ultimately needs to be solved there), the real economy plays a vital role. Anything that can be done to get people working, and the economy moving ….will give our policy makers time to fix the real problem in the financial sector.
But the risk is that politicians will pat themselves on the back for “solving the problem”, when they should be realizing that the stimulus package is just a (much needed) bandaid. It will cover up the trouble for a little while, but hopefully we dont all forget that this is just a temporary fix, and that further action is needed.
Hopefully, whatever fix comes next will be directed at the financial markets themselves….hopefully we wont open the newspapers 6 month from now to read news reports like this:
” USA faces extended downturn Despite Stimulus“
The data: our financial mountain of promises:
* here is a sample of the data we are collecting in our GloboTrends Wiki…
Size of the Financial sector:
What is amazing is that the financial sector ballooned to the size that it has…with a worldwide total of $140 trillion in promises outstanding in 2005 (surely more in 2008/9). Of that total, the US was the prime holder of promises (assets). The US household sector held about $39 trillion (28% of world total), and with the US as a whole holding nearly $52 trillion (37% of all world financial assets, or promises).
- household & non profit:
- total assets = $64.4 trillion assets owned (5x USA GDP)
- total debts = $11.9 trillion
- total balance: $52.5 trillion
- of this $52.5 trillion…the breakdown was as follows:
- $25.6 trillion = tangible, mostly property
- $38.7 trillion = financial assets
- $6.1 trillion in deposits
- $3.1 trillion in credit market instruments
- $5.7 trillion in direct corporate equity
- $8.9 trillion in indirect corporate equity, of which…
- $1.1 trillion in life insurance
- $3.0 trillion claims on pension funds
- $1.9 trillion claims on gov’t retirement funds
- $2.9 trillion mutual funds
So, total US financial assets in 2005 was as follows…
- Household & non profit sector (data from above):
- financial assets: $38.7 trillion
- Business sector - Non-farm, non-financial corporate sector
- financial assets: $10.9 trillion
- Business sector - Non-farm, non-corporate sector
- financial assets: $2.3 trillion
- TOTAL US private sector Financial Assets:
- $52 trillion USD (approx. in 2005)….obviously it grew more till 2008 (especially housing bubble), before falling…
Financial assets globally…
Compare this with world (in 2005): source : McKinsey report 2005, “Mapping the global capital market”
- USA (private sector only): $52 trillion = 37% (rounded)
- Eurozone (all): $30 trillion = 21%
- Japan (all): $19.5 trillion = 14%
- UK (all): $8 trillion = 5.7%
- Top 4 total $109.5 trillion / 140 = almost 80% world total !!
- World total (all, including private + govt + business): $140 trillion….owned of financial assets
How this $140 trillion breaks down…
- $44 trillion was equities = 31.4%
- $35 trillion was private debt securities = 25%
- $23 trillion was government debt securities = 16.4%
- $38 trillion was bank deposits = 27.2%…….down from 42% in 1980 (shift away from simple deposits to more indirect banking)
- $140 total
How has it grown? As a % of GDP…
- $140 trillion was = 3.16 x total world GDP in 2005….up from 2.18 times in 1995, and from 1.09x in 1980
- Regional trends from 1995 to 2005
- UK: rose from 2.78x to 3.59x GDP
- USA from 3.03x to 4.05x GDP
- Eurozone: from 1.80x to 3.03x GDP
* data from McKinsey report 2005, “Mapping the global capital market“ and http://www.federalreserve.gov/releases/
Should we More money for banks?
“Politically difficult”…but worth it…
Strauss-Kahn recognized that putting more public money into the banking sector to restructure it can be unpopular politically. “But the reality is that one dollar spent in restructuring the banking sector today is much more useful to achieve recovery than the same dollar spent on bridges, hospitals etc.”