As of October, the United States had written off $800 billion of bad debt, representing some 55 percent of the losses accrued to American banks, and 45 percent to foreign banks–mostly German, Swiss, and British, with smaller losses in Canada and Japan. Global economist David Hale says this represents a real challenge for the American financial system because the equity capital of U.S. banks is only $1.35 trillion: “If we were to write off $300 billion or $400 billion more just in this country, that could wipe out 30 or 40 percent of U.S. bank capital. Needless to say, that is major risk for the U.S. financial system—and for the U.S. economy.” Hale spoke about the effect of the regulatory response and the prognosis for recovery at the Directorship Boardroom and Economic Leaders Forum in New York in December. What follow are edited highlights of Hale’s remarks.
The Federal Reserve Board in Washington has cut America’s core lending rate from 5.25 percent in September of last year to nearly zero. That’s where Japanese interest rates were in the years 2001 to 2006, a level of interest rates we have never experienced before in this country. This is a record low.
In addition, [Federal Reserve Chairman] Ben Bernanke has been injecting hundreds of billions of dollars of liquidity into our financial system. Since August, the Federal Reserve balance sheet has grown from $800 billion to $2.3 trillion, and the best guess is that it could soon be at $3 trillion. This is unprecedented monetary expansion. We have never seen it before in our history.
Bernanke does not believe this huge monetary expansion poses an inflation risk because we are in the midst of a credit crunch. We are in the process of something called de-leveraging. And when you have de-leveraging combined with risk-aversion, and financial institutions that will not extend credit, then this kind of central-bank policy will not have, at least in the short term, any inflationary risks. Indeed, some could argue we now have a liquidity trap. We have liquidity piling up, but it’s not going anywhere.
Recently, the Fed has become even more active in what it’s doing with its money. The Fed has indicated it now may use its balance sheet to buy uninsured assets, like commercial paper or mortgage-backed securities. If the Fed or U.S. Treasury is aggressive in these areas, it might have an impact on the credit crunch by providing new sources of liquidity directly to the intermediaries that provide credit for real estate and consumer lending. The U.S. government is thought to be laying the groundwork for a second phase of its rescue attempt, with officials at the Treasury, Federal Reserve, and Federal Deposit Insurance Corp., in consultation with the incoming Obama administration, discussing a plan to create a government bank that would buy up the investment and loan losses that U.S. banks continue to report.
Tax Incentives to Buy a Bank
The Internal Revenue Service changed U.S. tax policy in mid-September that altered the terms under which a good bank can buy a bad bank. Under the new IRS rules, when a good bank buys a bad bank and writes off the troubled assets, [the acquirer] can immediately claim a huge tax credit. This explains the Wells Fargo takeover of Wachovia.
Back in mid-September, the government told Wachovia it was in trouble and would have to find a buyer over the weekend or be seized by the FDIC, wiping out the shareholders completely. Under government pressure, Wachovia agreed to sell itself to Citibank for a dollar a share—a miniscule price, given the size and the scope of that bank just a few months ago. But when the IRS tax change occurred, Wells Fargo came in to compete and offered $8 a share.
Under the deal Wells Fargo struck, it spent $15 billion to buy Wachovia and get a huge tax refund. The IRS, in effect, subsidized the transaction. And a few days after that deal, PNC took over City National Bank in Cleveland, again for a few billion dollars, and will get a $7 or $8 billion tax refund. There will be far more bank-merger activity because of these tax allowances.
Global Power Shift
What we are seeing overall is a change in the global balance of power. For the last 10 years, the world economy’s dominant growth engine has been the American consumer. The American consumer spends $10 trillion a year. Nobody can come close to rivaling that. But now we’re looking at several quarters in which American consumption will decline. We have to find alternatives. And the good news is some countries are rising to the challenge of providing an alternative.
The Chinese government recently announced a $600 billion infrastructure program, a sum equal to 15 percent of its GDP, to occur over the next two years, to prevent China’s growth rate from going below 8 percent. China is very, very sensitive to its rate of economic growth, in order to maintain a high level of employment correction. The legitimacy of the Communist Party in China, over the last generation, has come to depend on a high rate of economic growth. And China can maintain political and social stability only if it can guarantee a high rate of economic growth for its citizens. This is all part of a much larger long-term shift in the global balance of power. And it will not be a one-year phenomenon; it will be a multi-year phenomenon. Right now, it centers on China compensating for the loss of the American consumer with a lot more infrastructure spending.
Economic Mystery Tour
So, we’re on a kind of economic mystery tour. The recession will run for at least six or maybe nine more months. There will be a massive policy stimulus from the Obama administration. The Federal Reserve Board will keep injecting liquidity. These actions should, at some point, set the stage for a recovery next summer or autumn. We have had very dramatic action all over in the world to try and contain this crisis. And the result is, it would be fair to say, in the year ahead there will be no more Lehman Brothers, no more major bank failures.
Investors right now are focused solely on the recession and the possibility of deflation that could worsen, intensifying the financial crisis. At some point this year, the psychology could change. Right now, we can’t predict that scenario because of credit shocks, the credit crunch, and this whole process we call deleveraging. Deflation does lurk in the background as a possible danger.
So, we are very much in an exciting time—a very interesting time. And all we can do is watch and see what happens with the new administration. If they can move effectively to address the U.S. residential real estate market, if they can provide, through Fannie Mae and Freddie Mac, effective liquidity to try and limit that decline in home prices, and at some point, if they can set the stage for a recovery in housing prices, that would then help to end this financial crisis and the trauma we’ve experienced in the markets over the last six or seven months.