The United States lived in Lever-Lever Land too long. Like Peter Pan, the country has refused to grow up. The object of the stimulus plans offered by the present and the next US administrations is to return to Lever-Lever Land, that is, to debt-financed consumption. It won’t work. Leverage is for the young, who borrow to build homes and start businesses. The financial crisis forces Americans to act their age, that is, to save rather than borrow and spend.
For a world economy geared to servicing the once-insatiable maw of American consumption, that is very bad news for 2009. Recovery cannot begin until Americans have restored their decimated wealth by saving – an effort that will take years – or until the youthful emerging markets start importing from the US, rather than exporting to it.
America’s leaders haven’t yet had the required moment of clarity. Its financial leaders still think the problem is a mere matter of confidence. These were the same people who swallowed their own sales pitch.
The crisis began in June 2007 with the failure of a Bear Stearns hedge fund backed by partners’ money, and peaked in September 2008 with the failure of Lehman Brothers, a shop where managers famously had to drink the Kool-Aid. Wall Street fell on its own sharp elbows and died. Firms that survived the Great Depression have failed or merged into a mockery of their former piratical selves. Why did the kidders succeed in kidding themselves? Don’t blame them: think of a middle-aged Peter Pan unwilling to admit that he shouldn’t be flying.
Like Sauron in The Lord of the Rings, who was not evil at the beginning, the instruments of monetary destruction that caused the present crisis began as the agents of upward mobility and entrepreneurial change. Mortgage-backed securities (MBS), leveraged buyouts (LBOs), collateralized debt obligations (CDOs), asset-backed securities (ABS) and even subprime mortgages unleashed American energy during the 1980s, and made the US economy the wonder of the world.
At the outset, the alphabet soup of finance helped entrepreneurs and households to leap over barriers to market entry and make markets more efficient. Because financial innovation had done so much good, its practitioners refused to believe that it could do so much harm.
America was younger then. The Baby Boomers were in their 20s and 30s when Ronald Reagan took office in 1981, and they needed all the capital they would borrow. All the instruments of monetary destruction that rained ruin on American markets in 2008 came into the world as good things. They arrived at a moment when America need more debt.
Can America return to Lever-Lever Land? Not a chance. America is much an older country than it was during the tech boom of the 1990s. J M Keynes’s “animal spirits” are made mainly of testosterone, and America had loads of that.
Figure 1: Young (25-50) vs older (50-64) American workers
In the mid-1980s, America was young, and was getting younger. Its ratio of younger (25-50) to older (50-65) workers peaked in the mid-1990s, when it had 1.5 citizens aged 25-50 for every one citizen aged 50-64. Those were heady times. The children of the baby boomers were happy to work for stock options, live on pizza, and spent 20 hours a day in a loft launching an Internet startup. Joining a startup was a rite of passage for bright young college graduates, and the exuberant young people of America momentarily persuaded the world that they had discovered a fountain of youth.
Ten years later, the number of aging workers and young workers is about even. The young programmer who worked for stock options during the 1990s still owns them, and all of them are worthless. He or she is pushing 40, with teenaged children who need money for college.
Youth needs leverage. The Reagan Revolution of the 1980s, which launched the quarter-century expansion of 1983-2007, rested on three kinds of leverage: home mortgages, junk bonds and leveraged buyouts. Turning mortgages into mortgage-backed securities made it easy for young families to buy homes and easy for entrepreneurs to draw working capital from the value of their homes. Junk bonds allowed emerging companies without the balance-sheet strength of their big competitors to enter the market and take on entrenched interests. And leveraged buyouts allowed clever upstarts to evict stodgy managers and make capital more efficient. The financiers who created these markets were giants.
The mortgage-backed securities market allowed savers in the aging rustbelt states of America to lend money to young families in the sunbelt. Later, it allowed investors around the world to invest in American homes. Federal agencies that standardized and guaranteed US mortgages made securitization possible, by creating a generic form of mortgage that could be bundled into securities.
The world’s appetite for American mortgage-backed securities, though, grew out of bounds as an entire generation neared retirement in Europe and Japan, and the newly prosperous savers of Asia sought secure investments. America could not produce enough of the standardized, government-backed home mortgages to satisfy demand.
Mortgages with risky credit comprised a tiny portion of total issuance during the 1990s, but grew to $800 billion a year of issuance by 2006 before the market crashed to zero during 2008. Wall Street appropriate Milken’s old idea of pooling credit risk and selling different grades of risk to different investors and applied it with a vengeance to risky mortgages, creating the sub prime disaster of 2008.
Figure 2: Annual issuance of non-agency (lower credit quality) mortgage-backed securities
Michael Milken, the creator of the modern high-yield bond market, might have been history’s best judge of credit. By the time Milken went to jail on largely technical securities infractions in 1989, an army of imitators had turned the high-yield market into a manufacturing machine for soon-to-default credits, which helped trigger the recession of 1990. Milken invented the collateralized bond obligation – a pool of securities whose credit risk could be assigned to different investors willing to assume different degrees of risk in return for more or less income.
During the 1980s, junk bonds gave entrepreneurs access to clubby capital markets that had favored the stodgy Fortune 500. Sadly, this market financed a wave of telecom startups during the technology bubble of the late 1990s. At the peak of the bubble in 1999, telecom comprised a third of high-yield issuance, and the vast majority of the sector defaulted with little recovery for investors. The technology debacle discredited the market’s original mission, namely to promote entrepreneurship; it had done far too good a job with the wrong sort of risks.
By the mid-2000s, Wall Street had stood the junk bond market on its head: if investors were once burned and twice shy of new market entrants with low credit ratings, they would buy junk bonds long-established companies that used to have investment grade ratings. Wall Street proceeded to issue vast amounts of low-quality debt to fund leveraged buyouts of industry-leading giants: US$33 billion for Health Care Associates in 2006, $36 billion for Equity Office Properties Trust, nearly $40 billion for the utility TXU, for a total of $350 billion of leveraged buyouts in 2006, compared with just $50 billion in 2003.
Wall Street sold junk bonds to finance the LBOs, and the junk bonds in turn were sold into alphabet-soup trusts such as collateralized debt obligations. Michael Milken’s old vehicle for dealing out risks to different classes of investors became an assembly-line for levering up corporate balance sheets.
To accommodate the leverage boom in American and overseas corporate finance, issuance of collateralized debt obligations rose almost 10-fold between 2002 and 2006, before falling to zero this year.
Figure 3: Global issuance of collateralized debt obligations (quarterly)
Nearly $1 trillion of these structured instruments have been written off in the past year. The US Federal Reserve has added more than $1 trillion to its balance sheet, buying hundreds of billions of dollars worth of structured instruments from banks, not to mention roughly $300 billion of commercial paper issued by US corporations who otherwise could not raise money. The Treasury has injected over $300 billion of capital into the banking system and insurance companies, with full-dress bailouts for two of the largest players in the structured finance market, American International Group and Citigroup.
Some analysts worry that inflation is lurking behind the Fed’s exploding balance sheet. I am less concerned. Aging people buy future goods (securities) for their retirement rather than current goods. Demographic decline is deflationary, as Japan should have taught the world by now.
Aging workers, who soon will predominate in the American workforce, missed their chance to accumulate savings for retirement and education during the boom years of 2002-2008. Instead, they borrowed cheap money from foreigners and gambled on real estate. Many analysts have drawn attention to the link between America’s zero-percent personal savings rate and the current account deficit (Figure 4). Americans’ home equity probably is worth half of what it was three years ago, and fall a great deal further. If they had a retirement savings plan, it is probably down by 40% or so. If they still have a job, they need to save as much as they can and make up for lost time. All the stimulus in the world won’t persuade them to spend now that they know that they can’t retire on the price of their houses.
Figure 4: US current account deficit vs savings rate
America’s aging Peter Pans have discovered that happy thoughts and fairy dust no longer entitle them to fly. The young people of America led the world economy during the 1980s and 1990s, but now they are older, struggling to pay down mortgages that might be worth more than their homes, and to put something aside for a retirement that they never may be able to afford.
The world needs more young people to restore “animal spirits” to the market place, and America no longer has enough of them. That is why emerging markets must become more than an outsourcing shop for cheap manufactures, or an oilwell-cum-ethanol plantation. Harnessing the potential productivity of the world’s young people is the challenge for next year and the next decade. Without them, America will endure a lost decade more depressing than Japan’s during the 1990s.