Tuesday, July 21, 2009

America is for now still blowing bubbles

By Richard Bernstein
Published: July 20 2009 19:30 (Financial Times)

Although many market and economic observers quarrel over whether the Obama administration’s involvement in the private sector upholds the American principals of contract law, private investment and capitalism, this discussion misses the most important point for investors. The question is not whether there is a battle between socialism and capitalism, but whether the US economy is on a path to mimic Japan’s.

Financial history shows that bubbles create capacity, which is no longer needed once they deflate. An inevitable and intense period of consolidation follows. For example, the internet bubble gave rise to hundreds of publicly traded dot-com companies, many of which either merged with other technology companies or went out of business once the bubble deflated. Similarly, the gold rush of the 1800s led to construction of outposts that subsequently became ghost towns after that bubble subsided.

The global economy has experienced during this decade the biggest credit bubble in our lifetimes, and virtually every industry in every country benefited. In fact, all the growth stories of the past decade (such as China, emerging market infrastructure, residential housing, hedge funds, private equity and commodities) are capital intensive investments that benefited from easy access to cheap capital. The global credit bubble seems to have created a global economic bubble.

History would suggest, therefore, that there should now be massive overcapacity in the global economy. That is indeed the case. Global capacity utilisation was recently at generational lows.

Ignoring this history, the goal of Washington’s policies has been to stymie the inevitable consolidation, keeping companies operating – and employing voters – rather than managing the consolidation to maximise the economic benefit. History says that Washington’s is an unwise and ultimately fruitless strategy. Certainly, there may be short-term gains in an economy by keeping a bubble’s unnecessary capacity alive (this may explain the recent improvement in economic statistics), but the continued misallocation of capital significantly hinders longer-term growth.

Washington’s tact has not been unusual. Politicians everywhere are naturally fearful of post-bubble consolidation because it always means higher unemployment and voter distress. As a result, policies in post-bubble environments tend to sustain an economy’s unneeded capacity, with the hope that economic growth will rebound so the economy can eventually grow into and soak up those excesses.

Japan’s post-bubble strategy during the 1990s supported excess capacity and stymied the post-bubble consolidation forces. Companies were deemed “too big to fail”, and excess capacity (particularly in the financial sector) was kept alive. Basic economics states that significant overcapacity leads to lower product prices, and Japan’s policies accordingly resulted in an extended period of deflation. Japan did have some inflation during its “lost decade”, courtesy of China’s boom, which soaked up Japan’s excesses. However, deflation returned to Japan and overcapacity grew once the Chinese economy cooled.

US policymakers made a clear choice to follow a Japanese-like route when they declared that a select group of financial institutions were too big to fail, and devised the troubled asset relief programme (Tarp), term asset-backed securities loan facility, and public-private investment programme. The bankruptcies of General Motors and Chrysler may seem to run counter to this contention, because the government took swift action to reduce unnecessary productive capacity, but it will be interesting to see how the government deals with the resulting consolidation within the industries that supply carmakers.

Recent private sector support for CIT Group – which saved the lender from failure – may be a good deal for investors who bought CIT’s debt at a discount, but it is clear that lending capacity will not be reduced as much as it would under a full CIT bankruptcy. If CIT had failed, some rightly feared that lending to smaller companies might have been constrained. However, the government could have encouraged other Tarp-funded institutions to lend to small businesses rather than continuing to allow bailed-out institutions to make outsized trading profits. If public policies insist on maintaining excess financial sector capacity, then at least utilise that excess capacity productively for the economy.

Many observers claim that comparisons between the US and Japanese economies are inaccurate because the US economy is more “dynamic” and less “rigid”. There are, of course, differences between the two economies, but it seems increasingly clear that both the US public sector and, with CIT, now the private sector too are working against post-bubble consolidation, slowing the economy’s dynamism and increasing rigidity.

A California roll is an American version of a maki, a type of sushi. It is based on Japanese tradition, but has a decided American flavour. Similarly, the actions of the US’s public and private sectors seem to mimic Japan’s. Although the markets’ short-term reactions might correctly be positive, investors should be wary that the US will be an American version of Japan’s moribund economy.

The writer is CEO of Richard Bernstein Capital Management and a former chief investment strategist at Merrill Lynch


Nomad said...

Perhaps because Japan's overall economy was manufacturing based, with little to offer in the service industry, the U.S's huge service sector will minimize the deflation impact that Japan suffered.

Any thoughts on that?

Cesar Garcia said...

Nomad, thanks for your comment and my apologies for the late response. I have argued that price deflation cannot occur in a fiat monetary system. Upward or downward moves of 2% can at best be described as statistical noise. Sustained price declines, in the absence of productivity boost, are nonexistent in post-WWII US.