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| Speaker: | Henry Kaufman, president, Henry Kaufman & Comapny, Inc. |
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June 19, 2003
Council on Foreign Relations
A Keynote Address Delivered Before the 12th Global Borrowers & Investors Forum
Sponsored by Euromoney Institutional Investor PLC
London
I am very pleased to speak to you here in London about the challenges facing the major economic and financial markets. For this is a critical moment in business and financial history. I can recall no other time in my half-century-long career in financial markets when the challenges we confront were more complex and vexing as they are today. A strong cyclical economic recovery continues to elude us; and more than that, there are no official policies in place that will quickly lift the industrialized world out of its doldrums.
In the US, the economy emerged from a relatively mild economic contraction more than a year ago with several months of robust growth. But for the past nine months, the growth rate has sagged to around 2 percent per year. The Euroland economies are even weaker, with real growth rates below 1.5 percent. And Germany —the largest member —may well be entering another contraction. For its part, Japan remains mired in an economic and financial morass that is now more than a decade old. In all major economies, the overriding challenge is no longer to rein in inflation, but rather to re-ignite economic growth in order to halt rising unemployment. Indeed, traditional concern about inflation has been eclipsed by new concern, one not seen in decades —the risk of deflation.
In spite of this rather grim economic picture, many economic and financial forecasters remain confident that a cyclical recovery is just over the horizon. In my own country, many predict an economic revival of nearly cyclical proportions —thanks to continued consumer spending and to a revival in capital investment encouraged by low interest rates, tax reductions, and signs of a profit recovery. In addition, the dollar’s declining value is expected to help the US economy in the year ahead by gradually shrinking America’s huge trade deficit.
Constraints on Economic and Financial Revitalization
But in the current situation, such projections are overly simplistic and grossly inadequate. This kind of analysis ignores a number of structural impediments that stand in the way of significant economic and financial revival, at least in the near term. Although these constraints on markets and on investor behavior cannot be neatly quantified and packaged into quarterly GDP numbers, they are nevertheless very real and important.
From my vantage point, the key relevant issue looking forward in finance and economics is whether the financial excesses of the last few decades can be overcome to the point where lenders and investors will pursue new business opportunities with vigor. Here, the evidence is hardly very encouraging. Consider, for example, the absolute and relative size of US non-financial debt. At the start of this year, it exceeded nominal GDP by $10 trillion —or 95 percent. This was double the $5 trillion or 86 percent of GDP in 1990, and ten times more than in 1980, when it equaled only 42 percent of GDP.
US households have driven much of this debt boom. After borrowing heavily during the recent economic expansion, they have continued to do so ever since. In the five years ending 2002, annual household debt rose 10.3 percent, while nominal GDP rose only 5.1 percent. Household borrowers have been encouraged by lower interest rates and by a virtually automatic process of home financing and refinancing. Household debt now stands at very high historical levels, although household debt burden is below historically high levels because of low interest rates.
It also seems to me that business corporations will not be an important force for economic recovery. Here, I disagree with two commonly held views. According to the first, American corporations have funded a large volume of liabilities by issuing bonds and liquidating commercial paper and some bank indebtedness. To be sure, this transfer of debt has improved corporate liquidity. But at the same time, it has increased corporate debt financing costs. Second, many experts note that corporations have brought their internal cash generation into closer alignment with their external need for funds. This is because profits have come up from their trough and business has constrained spending. Neither of these two developments, however, is sufficient to give corporations adequate financial flexibility.
In the near term, financial constraints on business will remain strong enough to continue restricting business decisions. To begin with, net interest paid in relation to cash flows for nonfinancial corporations has declined less than in the last recovery. While this ratio has fallen by somewhat more than 400 basis points last year —to just below 24 percent —it fell 550 basis points in the first year of the 1991-92 economic expansion. Second, total debt for US non-financial corporations now stands at roughly six times cash flow —which is 100 basis points above the 1991 cyclical peak. Third —and a result of these developments —the universe of bonds rated BBB and below is continuing to grow more rapidly than that of high-grade corporate obligations.
Yet another reason to question the ability of business corporations to finance another strong expansionary cycle is the growth in their book equity —that is, retained earnings plus net new equity issuance —in relation to the increase in corporate debt. Here are the facts. From 1984 through 1990, net book equity fell by nearly $460 billion, while debt rose by $1.3 trillion. A brief respite followed in the next five years, as net equity rose $170 billion but debt jumped by $540 billion. Then, corporate leveraging returned—with a vengeance. In the highly speculative years from 1997 through 2000, equity contracted by $300 billion while debt soared $1.5 trillion. Even during the past two years, equity contracted by $155 billion although debt rose by only $315 billion.
If corporations are to help drive economic recovery in the near term, first, corporate profits must rebound strongly, and second, lending and investing institutions must become more willing to fund corporate investment. Without the first prerequisite for recovery —a strong profit rebound —the second —greater liquidity from financial institutions —is extremely unlikely. This is because corporate balance sheets are cyclically weak right now, and the many leading financial institutions around the world are grappling with their own balance sheet problems and weak earnings.
Japan’s banking and insurance industry travails are now more than a decade old, and far from resolution. The spotlight now has turned to the large German banking and insurance companies, where large losses and write-offs are hampering activity. Universal banking has not turned out to be the panacea it was heralded to be. The view in Europe, particularly in Germany, had been that the irrational financial exuberance was mainly an American phenomenon because of the broad participation of American households and institutions in the stock market boom. German households, in contrast, played a much smaller direct role in the market. What was forgotten, however, was that the German equity markets had little depth, so the lack of strong domestic participation required a larger role for foreign investors, who typically are rather fickle and make a quick exit when uncertainty looms.
In contrast, American financial institutions generally are perceived to be stronger than their international counterparts. I won’t dispute that, but I wish to add two observations. First, even in the US, the credit ratings of major financial institutions have slipped sharply. Second, it is extremely difficult to evaluate the strength of large diversified financial institutions. Their sprawling activities include underwriting, currency trading, stock and bond trading, and a myriad of other functions. With their complicated holding company structures, many contain not only banks, but also mutual funds, insurance companies, securities firms, and real estate affiliates. Unfortunately, neither the accounting profession, nor official supervisors, nor regulators have come up with ways to satisfactorily measure the risk parameters within these complex enterprises.
More than this, these diversified financial giants are honeycombed with conflicts of interest that —as we have learned painfully in recent years —can foster vast financial excesses and shell games that defraud investors and lead to major government investigations. We must wonder whether America’s new financial behemoths will continue to take prudent risks if financial markets remain volatile, especially when monetary conditions become less accommodating than they are today.
Another obstacle to a full cyclical economic and financial recovery is the new corporate governance provisions promulgated by the American government and by a number of supervisory agencies. These are perhaps the inevitable consequence of the many financial excesses of the past decade. As you know, standards of behavior were compromised by varying degrees across the entire spectrum of business and finance. Those who failed in their responsibilities include accountants, corporate boards of directors, senior managers of business and financial institutions, analysts, investors, and official supervisory authorities who should have responded quickly to the unfolding market mania.
Now the pendulum is swinging to the other side. The Sarbanes-Oxley legislation has profound implications for corporate governance. It will inspire corporate heads and chief financial officers to think hard before they attest to the accuracy of their corporate financial statements. It will compel them to promulgate and familiarize their employees with codes of proper business conduct. It requires firms to establish procedures for reporting inappropriate business activity. At the same time, corporate boards of directors are tightening their oversight over corporations. Outside auditors have become stricter in what they will certify. Insiders are prohibited from serving on board auditing committees, and outside and inside auditors must report directly to the Auditing Committee of the Board.
Other key players are heightening the atmosphere of vigilance as well. It is quite obvious that credit rating agencies are lowering ratings more quickly than in the past. The US Securities and Exchange Commission has done a turnaround by toughening its supervisory posture in a variety of ways. As numerous scandals have come to light, the financial press has intensified its reporting of financial and corporate malpractices.
At the same time, sell-side research is in a state of disarray. It can no longer play a direct promotional role for new underwritings. But commission fees from transactions with institutions and private clients alone are not enough to justify the cost of sell-side research. I anticipate that more and more underwritings will be put out for competitive bidding, and that investment bankers will garner the bulk of their income from trading and positioning securities.
A third development that will impede a dynamic economic expansion is the growing risk of friction in globalization. It is not that the developing countries will be endangered by globalization, but rather that the competitive consequences of globalization will continue to bear down on industrial nations. As emerging economies around the world become more and more willing and able to produce goods and services at lower costs than their First World competitors, the latter will see more of its key industries hollowed out. In the face of rapidly diffusing technology and political freedom, the developed countries face the choice of shaping up or continuing to dissipate their wealth to comfort their own citizens.
Many of the restraining forces I have described have been with us for months or even years. But it would be wrong to conclude that their influence is largely behind us. Far from it. Their restraining influence is only now reverberating through corporations and financial institutions. In the long run these new disciplines will improve economic and financial performance. They will help to limit extreme behavior. In the near term, however, they will undoubtedly slow the speed of the economic recovery.
Prospects for Europe, Japan, and the Developing World
In the past decade or so, the benefits of globalization to the industrial countries were quite apparent. Inexpensive foreign labor coming into the United States and Europe eased inflationary pressures, as did a massive volume of imports from abroad. In the early 1990s, the US tried to resist the Japanese encroachment on its automobile industry by exhorting Japan to increase its domestic economic activity, by setting acceptable auto import targets and by the appreciation of the yen. That political pressure subsided as Japan built production facilities in the US.
But now the US faces an even more powerful trade challenge. Today, US annual imports from China total about $120 billion, while our exports to China are about $20 billion. The US accepts this trade imbalance, partly because of the growing political ties between the two countries and partly because many Chinese exports to the US are produced by direct American investment in China itself.
Compounding this deflationary pressure from globalization is the huge excess capacity to produce that was put in place through speculative financing practices in the industrial countries during the 1990s. It may well be impossible to make effective use of all of this capacity because technological obsolescence will render it non-competitive. Already, the industrialized world outsources a large and growing volume of accounting, billing, and other transactions to Asian and Latin American companies. And so it should, in a competitive economic world. Over a longer time frame, standards of living will rise in the rest of the world and move eventually into an equilibrium level with that of the industrial world.
But what about the medium term? The major countries on the European continent are most vulnerable during this interim period for at least three key reasons. First, they have been slow to adjust to the new competitive environment. Most developed European nations have continued to support the politics of social democracy. They remain uncomfortable with many aspects of free market economies, especially the sometimes-cruel logic that markets impose. At the same time, they continue to cultivate close relations among governments, business, and finance because they see corporations as a natural adjunct to the welfare state. This is not to say that the United States is a pure economic democracy—far from it. Nevertheless, the US has a much more flexible society that allows it to pursue less rigid business and labor practices and to adapt more quickly to the rapidly changing domestic and global business conditions.
Second, Europe lacks political cohesion. Around whom do Europeans rally? The answer, of course, is that national identity retains its ineluctable pull, in spite of long-term European ambitions for continental unification. In the meantime, the individual countries have agreed to restrict the use of one of the most important powers of a government —fiscal policy —to the 3 percent deficit ceiling imposed by the Growth and Stability Pact. But conditions in Europe today —high unemployment and excess business capacity —call for more aggressive fiscal expansion. Nevertheless, key European nationals are struggling to stay within the fiscal policy guidelines. And they continue to protect the social safety net at the cost of retarding future growth of living standards.
The Crucial Role of Monetary Policy
Where, then, does the power reside on the European Continent? I believe that the most powerful institution on the Continent today is the European Central Bank. It has become the de facto political and economic leader. This is unfortunate, especially because the bank has not acted like a leader. Ever since it came into existence, the EBC has been trying to show that its anti-inflation stance is equal to that of the former powerful and independent German Bundesbank. This well-orchestrated posturing allowed the EBC to pursue a timid monetary policy and, because other policies were inoperative, to gain political strength.
However, conditions today are quite different from the years when the German Bundesbank was the great anti-inflation hawk. Where, in Europe and elsewhere, is the great inflation threat? Even with the weakening of the US dollar, the EBC’s 50-basis-point interest rate reduction two weeks ago lags too far behind events and again displayed the Bank’s unwillingness to lead or assume some risk. An increase in the value of the Euro will only make conditions more difficult in Europe, especially if the Chinese and some other Asian currencies maintain their fixed currency relationships with the US dollar. The synergy among all of these factors —timidity about structural reforms, the straitjacketing of fiscal policy, and the central bank’s rear-view policy approach —will act to hinder economic growth and financial revitalization on European Continent.
I should add that other major central banks haven’t really demonstrated greater wisdom in the last decade or so. Japan’s central bank remained idle for too long after stagnation set in, and actually nurtured an equity and real estate bubble that capsized the Japanese economy into a decade of virtually no growth, and now deflation. While Japan did increase the fiscal deficit to about 7 percent of GDP, the fiscal expansionary measures were poorly designed and did little, if anything, to increase economic incentives. Nor did the central bank institute other measures to encourage corporate and financial restructuring. Even so, Japan probably is not as vulnerable as Europe. A huge creditor nation with a homogeneous population, Japan places great emphasis on education and should benefit from its close association with other Asian countries.
In the US, monetary policymakers are now trying to make amends for their unwillingness to curb the runaway financial speculation and for pursuing policies that contributed to the financial and corporate abuses of the 1990s. The Federal Reserve never actually admitted any responsibility. Professing “the market knows best,” the Fed claimed it should not pit “its own judgment of fundamentals against the combined judgment of millions of investors.” Yet how could highly trained Federal Reserve economists consider reasonable the financial hallmarks of the dot com stock bubble: corporate P/E ratios —in multiples many times above average; the explosion in junk bond financing; IPOs of companies with weak underpinnings that nevertheless multiplied quickly in price; massive deterioration in the quality of debt —not to mention the overall disregard for capital? The Federal Reserve also observed that trying to puncture the bubble in 1996 or 1997 might have required an abrupt shift to a very firm policy, which in turn might have ushered in a business recession. Of course, we’ll never know. But the observation itself suggests that the basic underpinnings of the economy were weak and thus rested on speculative fervor. Among other things, the Fed never used moral suasion or even a few selective measures to dampen speculation.
Suppose a business recession had occurred. Many gross abuses in corporate governance would have been avoided. A lot of capital spending that is now superfluous would not have been put in place. Corporate debt load would not be so high today. And the image of Wall Street and of corporate leadership would not be as tarnished. All of this would have kept the economy and markets on a sounder path to recovery and sustained expansion.
After the market crash, the Federal Reserve has eased monetary policy dramatically. The recent drop in the funds rate to 1 ¼ percent has helped buoy the markets. Stocks have rallied from their lows; and credit quality bond spreads have narrowed (although they are still wide by historical standards). All of these moves have helped, as will fiscal stimulus just legislated by the Congress.
But a tricky monetary path still lies ahead. The consumer must continue to be the main force driving economic growth. With further increases in unemployment likely, the key stimulus to spending seems to be even lower housing finance costs. This is because consumers already have taken out all of the housing refinancing benefits from the latest round of interest rates cuts —so the Fed must initiate yet another round of reductions. The key rates to watch are those on 10-year US Governments, on which mortgages are usually priced.
There are several complications now confronting the Fed as it attempts to manage the yield curve. First, a huge volume of US Treasury financing is coming to market. The combined budget deficit for this fiscal year and the next is likely to exceed $800 billion. Undoubtedly, the US Treasury will get its funds. The issues, however, have to be taken down readily and with the expectation that they will be a profitable investment to investors. This poses a couple of problems. To begin with, foreign official institutions may not be deterred from buying US Governments by expectations that the dollar will weaken in the foreign exchange markets; but they may prefer to buy shorter rather than intermediate and longer issues.
This, in turn, would require American investors to pick up a larger proportion of the longer obligations. This will not be a problem as long as American investors deem these investments to be profitable—that is, as long as their prices remain steady or go up. But major financial US institutions already are holding huge “carry trades” (as they are called) on their books. These are fragile investments that cannot tolerate adverse interest rate movements. At the end of April, US commercial banks held nearly $1.8 trillion in securities, an increase of $400 billion from the end of 2001. US Government securities dealers had net holdings of securities, including US Government, agencies, mortgage securities and corporates totaling $159 billion at the end of April this year; up $56 billion since year-end. To these fair-weather market positions should be added the holdings of hedge funds, for which no reliable data is available. For all of these carry trade participants, the use of derivatives to enhance leverage is probably much greater than in any earlier comparable period.
Consequently, it seems to me that whenever any correction appears in the US Government market, the Federal Reserve must be prepared to sweep up the excess supplies with zeal. The highly leveraged market participants simply cannot afford to sit by. They will unwind their own holdings, causing sharp upward gaps in the yield curve, which in turn will redound negatively on mortgage financing and foster uncertainty in the stock market and in the larger economy. The unwinding of positions in mortgage securities held by private institutions will in itself unleash a large supply of intermediate US Governments into the market because they have been held to reduce some of the duration risks in their mortgage portfolios.
For the Federal Reserve to help move the economy from weak performance to more robust growth, two prerequisites are essential. First, as noted, the Fed quickly must clear the market of any excess US Government securities in the market. And it should do this in a highly visible manner in order to buttress market confidence. Second, in its open-market pronouncements, the Fed should shift its stance from projecting a soon-to-arrive economic acceleration to projecting a moderate and competitive path ahead. Otherwise, the bond market will nullify the underpinnings in the economic recovery.
The Fed may well have to take the risk of overstaying on the path of monetary accommodation. The turn in policy should come when corporate profits are rebounding sharply and corporate capital expansion plans will not be deterred by the early stages of tightening monetary policy. In other words, the certainty of the profit potential to the corporation must outweigh the cost of any increase in interest rates. This will be a very difficult judgmental call for the Federal Reserve.
As difficult as the Fed’s task may be in the period ahead, the Bank of Japan faces a far greater challenge. The carry trade is now nurturing the Japanese banks. In the virtual absence of loan demand, banks borrow at virtually no cost and buy Japanese Government securities in the intermediate and even longer maturity range. Buying a 10-year Japanese Government at a yield of .45 percent with virtually no cost is very profitable to the banks and insurance companies. It provides them at least some income to offset loan losses. In a way, the Bank of Japan is subsidizing these institutions. But what will happen when the Bank of Japan raises interest rates in the future? Japanese banks may endure huge losses unless the Government finds a way to exchange the longer-dated bank holdings at par for short maturities.
The challenges confronting us today, as I have outlined them in this talk, all relate to the fact that business and finance now stand in a transitional period between abuses and excesses of the past decade and —we hope —a more flexible, rational, and responsible economic and financial order in the future. This means that we must unavoidably deal with key imbalances ranging from inadequate financial capacity to structural changes in economic markets. In the meantime, it is vital that the monetary policymakers of the industrialized world remain highly accommodating, even to the point of overextending an easing posture. In the US, at least, I believe that a combination of recent developments will encourage moderate growth and avoid deflation: a new financial sobriety, the fiscal stimulus coming on stream next month, and a less doctrinaire and more responsive monetary policy. If so, US economic performance is likely to outpace that of most other developed nations. For financial markets, volatility will remain high as the elimination of structural imbalances and imperfections in policies continue to extract their toll.
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