Surveying the wreckage for signs of life.
12:00 AM, Oct 11, 2008 • By IRWIN M. STELZER
The world's politicians are now running full tilt to get ahead of the markets. So far, the markets are winning, plunging in what to all appearances is a death spiral. Share prices fall, making it nearly impossible for the banks to raise new capital; house prices fall, reducing the value of the mortgage-backed securities on bank balance sheets; governments offer to help by buying preference shares in the banks, but the claims these shares would have on future earnings spook common shareholders, and prices fall further.
Not that the policymakers have not finally gotten it right. Led by British Prime Minister Gordon Brown, they are now about to shore up the capital of the big banks, to increase their ability to lend. Meanwhile, Hank Paulson and his U.S.Treasury team are about to take $700 billion of dicey loans from the banks, and replace them with good hard cash, while Federal Reserve Board Chairman Ben Bernanke invents new ways to throw his balance sheet into the breach. Throw in the fact that the world's central banks finally decided that Bernanke has had it right by keeping interest rates low, and that Bank of England Governor Mervyn King and European Central Bank President Jean-Claude Trichet have been wrong to keep rates high, and you have a policy mix that should break the credit logjam.
Two problems. First, these policy remedies will not take effect immediately. In America, Paulson and his team--headed by an unknown former Goldman Sachs employee, AC/DC fan and aerospace engineer, 35-year- old Neel Kashkari--have to find some way of valuing the bank assets they plan to buy, and hire experts to conduct the eventual sales. In Britain, bankers are not sure that they want to avail themselves of the up-to-£50 billion Brown has on offer in exchange for control over their compensation and some of their operations. They will try to raise at least some of the capital in the markets, a great step forward if they succeed.
Second, and in the end more important, the forward progress made possible by the stimulative measures taken by the several governments is bucking the strong headwinds created by an emerging worldwide recession. The International Monetary Fund says its studies show that financial upheavals following run-ups in house prices generally produce serious recessions. So it sees "a substantial likelihood of a sharp downturn in the United States."
The data suggest that such a downturn is already underway. The travails of the housing industry have been too fully reported to need comment here. Nine consecutive months of job losses have cut the number of jobs in the nonfarm sector by 760,000 so far this year. Jobless claims are at their highest level since 2001, and it is taking longer for the unemployed to find new jobs. Orders for manufactured goods are falling at an accelerating rate, and a leading index of manufacturing activity records the lowest level since the days following the September 11 terrorist attacks on America. Car sales are so low that there are serious doubts about the ability of General Motors to survive the downturn, despite a $25 billion government handout to the industry to help it convert to greener vehicles. Once-mighty GM a few weeks ago drew down the last $3.5 billion from its revolving credit line.
Little wonder that consumer sentiment is dropping, and with it retail sales, a fall that will accelerate when millions of families begin receiving reports, now in the mail, of the third-quarter performance of their 401(k) pension plans. "Discretionary retail sales are cratering," reports Goldman Sachs. Its economists estimate that consumer spending, adjusted for inflation, will decline in the current quarter for the first time since 1991. One wag says retailers should expect a Charles Darwin rather than a Charles Dickens Christmas, a frightening prospect for all save Wal-Mart, which is benefiting from downmarket moves by consumers either hurt by the downturn or fearing they are next in line for layoffs: Its sales seem to be growing at an annual rate of close to 3 percent.
One last note of gloom: Exports, which had shored up the otherwise weak economy, cannot sustain their recent rapid growth. The recession is now global, meaning that export markets are drying up. And overseas sales will be hurt by the continuing strength of the dollar, as investors around the world flee to the safe haven of U.S. Treasury securities. Well, safe relative to just about anything you can think of.
It takes a pair of rose-colored glasses to see any sign of cheer in this dark, dark picture. Fortunately, I am the proud possessor of just such lenses. Start with the fact that the several steps taken by policymakers have not had time to work their way through the system. Just because the immediate reaction of markets was less than enthusiastic does not mean that, given time, the unleashing of a flood of government cash into the banking system will have will fail to thaw credit markets.
Although the number of companies that might be about to default on their debt is at a five-year high, the corporate sector as a whole is awash in cash. Holdings of cash and short-term securities by companies included in Standard & Poor's 500 Index (excluding utilities and financial institutions) stand at $648 billion, a record, and FedEx chairman Fred Smith told the Financial Times, "With the exception of the autos and housing, there's a lot of cash flow in the industrial sector."
Even the housing industry is showing signs of bottoming out. Faint signs, but positive signs nevertheless. The pace of price declines is slowing, from an annual rate of 25 percent to 10 percent. Inventories of unsold homes, although still high, seem to be coming down a bit, as lower prices attract buyers. The August index of pending home sales is at its highest level since June 2007.
The important service sector continues to hold up surprisingly well. The index of non-manufacturing activity remains above the 50 mark, and new orders are up marginally, which means that sector is at least stable and possibly expanding, although jobs are being cut.
More important are longer-term indicators. America's states and localities have become deft at offering incentives to foreign firms to set up shop there. A Financial Times informal poll of leading foreign executives shows that rising labor costs in Asia, plus offers of infrastructure construction to accommodate new manufacturing facilities, makes the United States the world's low-cost manufacturing site. A Fiat executive summed it up, "It [America] is one of the low-cost locations to be in at the moment."
But such incentives are not the fundamental basis of America's competitive advantage. The World Economic Forum, which ranks countries based on the quality of education, labor market flexibility, financial market sophistication and other criteria, ranks the US Number 1 in global competitiveness. That explains America's lead in productivity growth, in creating high-tech companies and keeping structural unemployment at low levels, as well as its history of rapid recovery from periods of recession or below-trend growth.
I am not suggesting that life just now is "one long jubilee" to borrow from a famous song by Ira Gershwin. But we at least know the answer to the question he put in that same work: "Who cares what banks fail in Yonkers?" Policymakers from Washington to Brussels to Beijing care, and enough to throw billions of dollars, pounds, euros and other currencies at banks and businesses to show that they do care. With luck, that will restore confidence to financial markets.
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).