I’m sensing a general perception that the economy is broken. Yes, unemployment is high and markets are volatile; but, to categorize this as economic malaise is not correct. My friends, the real economy is not broken. It yearns to grow as this is its nature and right. Sitting dormant only fuels its fire.
Our modern capitalist system is made up of 3 entities; the real economy, the banks and the government. The role of 2 players is definitely slowing our pace. Banks and government are merely an arrangement, created to increase the efficiency of our whole. When one peels back the layers we can more readily see the problems in the system.
The real economy produces goods for the market place. In its infancy these goods are based upon the needs of the market. For humans, these needs are fairly simple; food, water and shelter. As an economy matures, strengthens and grows, it garners efficiencies from specialization and innovation. The economy continues to leverage its inventiveness and the variety of goods in the marketplace evolves and multiplies. The primary factor that fuels this real economic demand is the growth of participants in the economy, population. All the economy needs to grow is human nature, brain power and mouths to feed.
Government was formed in order to make rules to protect this economy and allow it to flourish. These rules ensure that no one cheats, as this would disrupt the economy and prevent it from performing efficiently. Government is also a third party contractor. The economy entrusts government to perform some duties that benefit the whole and no one individual. The economy will pay a percent of its earnings for such items as defense against foreign invaders, law enforcement, a social safety net and roads connecting individual market places.
The banking system was formed, initially, as a safe house for the combined financial profits of the economy. Banks also perform two additional functions which increase the efficiency of an economy. First, the central bank has authority over our common unit of exchange, money. They control how much is floating in the system at any given moment. Our currency increases the efficiency of a transaction. Instead of trading chickens for shirts or computers for tires we all transact in dollars. Efficient transactions free up time for more innovation. Second, banks control the creation and cost of credit to fund our innovation. If an innovation will benefit the economy, it will extract a margin. Credit creation enables us to fund projects and the cost of this credit ensures such projects provide marginal value. The central bank controls the amount of currency, the amount of credit and the cost of this credit. The rest of the banking system is best described as a middle man.
It is important to realize that the economy doesn’t need the banking system or the government. We have created them to serve a purpose and they should help us to better ourselves at a faster pace. It is when banks and governments begin to define an unproductive mandate for themselves that the economy will begin to suffer on relative terms. This is where we find ourselves today.
Banks have been overextending credit, to the economy, governments and themselves. This has been especially true over the past 14 years. Governments have borrowed money on the people’s behalf in order to fund overdevelopment and deployment of military strength, spurious pet projects, and overly gracious charitable endeavors. Also realize that governments funnel capital resources to themselves as well as their friends and family. The financial sector has leveraged itself in order to monopolize and manipulate capital markets, speculate in hard assets and market its extortion to unwary customers.
Over time these marginally unprofitable endeavors erode the capital of an economy. Many of us have moral and ethical objections to such affairs. Outside of morality, we can attribute the destruction of capital, and the subsequent lack of economic pace, to 1 particular item. The cost of credit has been too low for too long.
Until 1971 there was a buffer to the economy preventing central banks from erring in this regard, a gold standard. The gold standard protected the economy by sounding an alarm. If credit formation was funding unprofitable endeavors then the store of gold would begin to leave. In 1971, President Nixon removed the alarm thus enabling the destruction of economic resources with seemingly no repercussions.
Banks and the governments have very little equity. What they have is the ability to form credit, a promise to pay future private sector equity. Without a finite definition of value we allow the banks to essentially create credit or gamble on innovation to the tune of our entire future net worth. From 2007-2008 the equity of US households plunged by about $12.8 tln, an amount, at that time, equal to about 300-350% of the value of all the gold ever mined in the history of the world. I’m not saying a gold standard is the answer; but, some definition of prudent needs to be put in place for these banks.
One curb on banks that exists today is the amount of equity we supply them in order to create credit. They have not proven to be good custodians of our investment, so, now, no one wants to give capital to banks. The extent of undercapitalization in the banking system is open for debate but its current state definitely leaves us in a pickle for growth.
A recent conversation brings to light the effect on our economy. A college friend has a company which needs a loan for $1.6 mln to purchase and renovate a rental property in Chicago. On the bank’s request, they liquidated less profitable company assets in order to deposit $1 mln in an account with a bank to secure the loan. This was over 2 years ago and neither this bank nor any others have lent them the money. One bank has changed hands 3 times in 2 years; turnover of lending officers has exacerbated the problem. The banks have formally cited such items as undercapitalization and lack of certainty on future banking regulation. The reality is $1 mln of company equity has been sitting idle for 2 years because this company cannot secure a total sum of $1.6 mln via a 32.5% loan to value credit extension.
Meanwhile our central bank is issuing 90% loan to value extensions to these same banks at .25% or less. These banks are then lending that money to our government for fractionally more. Capital and labor sit idle while our banking and government sectors perform their circular ritual of incompetence.
The default solution for the private sector is for the seller of this property to lower his price to $1 mln. Despite all Ben’s string tricks, this is deflation anyway, but it doesn’t need to be so.
Put in place a system for banks that restores confidence. This requires a unit of exchange linked to a tangible and finite value to serve as an alarm for poor economic allocation of resources. Second, we need a non-arbitrary, market determined cost of credit capital. This will help ensure that investments have economic margin to justify their existence. Combined, this will give the private non-financial sector the necessary assurances and enough confidence to provide capital to the banks.
Then recapitalize the banks through voluntary or involuntary means.
It is the banking sector and the governments that are broken. They yearn to grow as well; but this is not their institutional right. They are the poorly performing partners of our real economy. They need their roles redefined and their incentive clauses rewritten.
No, the real economy is not broken. It yearns to grow as this is its nature and right. Sitting dormant only fuels its fire. We have the capacity to fix the capital and confidence in banks and government. Once accomplished, our American Eagle will once again soar.
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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Douglas R. Terry, CFA is reachable at email@example.com