Capital of fancy and the paradox of thrift

By: Procyon Mukherjee

The world is entangled in a myriad of intertwined linkages that start from trade deficits or
current account deficits to saving and long term interest rates into broad money supply
and inflation and finally to endemic risks that plagued the global economy. These
linkages seen from the pure economic theory fail to explain many puzzling questions.
While it is true that a sequence of events happened and ended in a crisis, parts of this
sequence were mismanaged, because the end was never predicted right. Globalization for
the first time confronts with the challenge that could be punishing for some as the odds in
favor of protectionism to return rides high. But this is too large a gamut of subjects to
tread on and I would take one small part of the puzzle in this essay.

Between spending, thrift and saving is there a balance to be found that keeps our future
more safe in these uncertain times of crisis, when Banks have gone bust trying to
deleverage and the money to bail them is never enough for the moment, while large
number of home owners with falling home prices have moved to negative equity and the
holders of stocks and equities have made losses to the extent that the levels of net worth
have virtually gone back by several years? How could the credit environment improve
and what could help to propel this movement?

First let us go through some sequence of events that led to the large trade deficit in U.S.
The seemingly illogical happened that the wealthiest country of the world sat on a
ballooning trade deficit with a number of countries and depended on external sources of
funds to fund the Capital shortfall (Martin Wolf in his article in FT on 9th March says that
70% of the world’s savings moved to U.S.). This is in sharp contrast to the archaic
definition of wealth which would have suggested that the wealthy have surplus Capital to
lend others. The other way to look at it would be that by keeping higher borrowing intact,
U.S. continued to create higher equity and net worth, at least till the crisis struck; now
there is a correction in the making, whether it is going to be sharp needs to be seen. It
seems that the high rate of asset growth, that was unfettered, had much to do with
creating a bubble that had been waiting to burst any time.

Warren Buffet in his famous article to the Fortune magazine (1) in November 2003, on
the subject of trade deficits made a very important observation that the worsening trade
deficit in U.S. was tantamount to exporting of a part of the country’s net worth as he gave
in the brilliant example of two small islands (Sqanderville and Thriftville), one living on
the fruits of labor of the other but facing the consequences of the future claim checks for
the future outputs. Mr. Buffet in this brilliant example proved that the present value of the
future production that the Sqanderville Island had to commit is equivalent to the
production that this same island initially gave up. This is what the economists refer to as
inter-generational inequities, one gets a free ride while the next suffers the burden and
vice versa. He also proved that the current turn of events in US after the 1980s had been
that US holds much less assets abroad than what the other countries hold in US and that
this boils down to selling pieces of land to others while increasing the mortgage on the
balance. This mounting imbalance year on year at the current rate would mean that every
year 1% of net investment income will be flowing out of the country. This is simply not a
favorable denouement for the present or the future generations. His solution to the
problem was however never cared for by anyone, in fact contrary to what he said actually
happened in the following years thus exacerbating the problem.

While Thriftville is actually not China and Squanderville is not U.S., but some of the
behaviors exhibited by these two great nations in the period 2003-2007 is exactly like this
example. But not quite as referred by Warren Buffet, because if we take the example
given by Stephen S. Roach, the Asia Head of Morgan Stanley, when he writes in his
article in China Daily (2) on 31st October 2007, “The multilateral characteristics of the
US trade deficit are the smoking gun to this problem. And it is painfully clear what the
root cause is an extraordinary lack of US domestic saving. America's net national saving
rate - the combined saving of individuals, businesses, and governmental units adjusted for
depreciation - averaged a mere 1.5 percent of national income over the five years ending
in 2006.” But later in the same article he wrote that “First and foremost, the debate is
grounded in very legitimate concerns over the increased economic insecurity of middle-
class American workers. Real wage stagnation is at the top of the list. In the second
quarter of this year, inflation-adjusted median weekly earnings for full-time US workers
were unchanged from levels prevailing seven years ago in the second quarter of 2000.Yet
over that same period productivity in the non-farm business sector recorded a cumulative
18 percent increase. Contrary to one of the basic axioms of economics, American
workers have not been paid their just reward as measured by their productivity
contribution.” The last part is about iniquitous distribution problem, the asymmetry on
the other hand makes perfect sense for the shareholders of the same business entities to
move businesses to low cost countries and bring the products and services to sell in U.S.
at a much lower cost. The lower than commensurate wages (delinked from the
productivity) is an important factor for the glut of savings in U.S. households although
not the most important reason for this glut as we shall see later.

At the core of the trade deficit and job security concerns and the wage squeeze is the
unhealthy effects of globalization on U.S., or parts of U.S. who suffered because the
benefits were not passed on to them, while the ill effects were, whereas some benefitted
from the low cost of supply of goods and services from those parts of the globe where the
costs were fractional. The argument only a decade back was whether globalization was
good for the developing nations (Stiglitz in his book, ‘Globalization and its discontent’
talked about some of these challenges), while the argument now is whether it made large
parts of the populace in the developed nations any good.

But there is somewhere a connection with the lack of saving, a phenomenon that existed
in U.S. for long but never as severe as it did in the period 2003-2007, when the savings
rate at one time reached negative. It appeared that the money was so freely available and
at such low interest rates or that debt could be collateralized in many creative forms that
risks could be hedged, or so the people thought. At the end we had a conundrum, which
needed constant lowering of nominal interest rates and constant supply of money to
continue unabated.

But there is a connection to saving money, where there is an inherent urge to hedge
against risks for the future. There is a linkage of many other things, as economists
connect this to demographics and related behavior. But perhaps the need to connect this
to the rise of financial market dynamics was never felt so strongly as now. The world of
finance ingeniously developed a plethora of products to create in the minds of the
consumer a surprisingly strong inclination to spend now a part of the future earnings at a
nominal cost, which was at an all time low. The conditions were created by a mix of
factors as we shall see in a moment.

I refer to the famous Bernanke speech (3) of 2005, where he for the first time highlighted
the ‘global savings glut’ as one of the influencers for U.S. current account deficit to rise,
which Krugman has recently pointed out (2nd March New York Times) that for all of that
to end up in United States for the depth of its Financial markets is a fair observation, but
cannot be attributed to its sophistication. But Ricardo Hausmann and Federico
Sturzeneggar proved in their research paper in the same year as Bernanke gave his
speech, in November 2005, that U.S. actually ‘managed’ the imbalances by exporting
‘dark matter’, which is the incremental value that U.S. investments fetched by investing
abroad, some due to higher branding like the Disney Euro, some in the emerging markets
where the returns could be on a higher incremental. It needs some analysis why the
current account surplus of developing nations could not be directly invested in gainful
instruments of change rather than in Treasury Bonds that helped to stymie the long term
interest rates in U.S. Perhaps the answer lies in the calamitous effects of East Asian
Balance of payments crisis that plagued some of these very nations in the nineties that
kept an undeletable impression, not easily to be erased although the proportion of such
U.S. Treasury assets was a reflection of the confidence that the rest of the world posed in
the resilience of the U.S. economy and its currency.

The full implications of these four papers referred above cannot be seen unless we go
back to the root of thrift and savings and the underlying elements that influence these
behaviors on a micro as well as on a macro level. The current influences of the world of
finance cannot be lost sight of.

I would like to take the example of Mr. Warren Buffet’s letter (4) to his shareholders on
27th February 2009, which amongst many things brought in the element of superiority of
financial markets as highest return providers than ordinary business dealings but at the
same time in equal breath it exposed the vulnerability of investment returns to large
shocks and ‘rare’ events (to borrow a term from Dr. Taleb). If we see the table given on
the first page of his letter, Mr. Buffet shows that his company Berkshire Hathway had
given a compounded annual gain of 20.3% in the period of 1965-2008 (his companies
largely deal with financial investments in Blue Chip companies including insurance
companies) against the S&P 500’s 8.9%. The table also showed a few interesting facts
that in this period it was only six times that his company faired badly than the S&P 500.
The point to be noted is that even Berkshire Hathway and Mr. Buffet is in for some deep
introspection, about the follies it had committed (Mr. Buffet mentions a few in this letter,
but actually more are in the offing that would be unwinding this year).

No one, actually no one can continually make a 20% compounded gain over a fairly long
time. Mr. Buffet, when he writes his next letter to his shareholders, would perhaps make
a deeper cut in the net worth (last year’s contraction was 9.6%). Although very
remarkable this unabated (so far) rise of investor wealth through timely ingenious dozes
into and out of capital markets, it remains to be seen, how long this lasts, because when
the underlying elements of the real economies seem to portray a devastating picture there
can be little hope that returns, no matter where they may be bundled into, could be as
stratospheric as possible. I would believe that over time Berkshire Hathway would reach
what many others have reached, the long term average return, because I strongly believe
that unless there is a severe asymmetry of information or misinformation such returns are
never possible over very long periods of time no matter how great the financial genius is
of the managers who manage these funds.

Here again there is another observation to be made. Spreading risk has always been the
catchword. Every careful investor would like to hedge the risk and the cumulative effect
of all the hedge instruments employed by all the companies in the S&P 500 yielded a less
than 9% return over a very long period. 9% as a relative metric is quite significant when
long term interest rates have come down significantly in the period 2003-2008, but when
seen against the highs of 6% or 7% in the nineties (refer to History of Inflation vs.
Long-Term Interest Rates: A Comparison of Inflation and Long-Term Interest Rates
from 1940 – 1999 by Essex Corporation (5)), is this a great performance? I am not very
sure. Also to be noted is the fact that in the period 1970-1990, the rates went close to 8%
or 9%.

So actually it is a myth that the best of the equity markets and the S&P 500 index which
is the best of the best have yielded stellar returns. Yes, they have outperformed the others
in the same market, but their yield over a long period is hardly that spectacular. The point
however is that some (could be an infinitesimally small percentage) has gained
disproportionately at the cost of the others. This point has been proved in the book,
Fooled by Randomness by Taleb (6) very succinctly.

A word on the low long term interest rates, because that is regarded by many as the
starting point of the housing bubble. In the phenomenal book, ‘The Ascent of money’ (7)
by Niall Ferguson, one would see the effects of bond prices sparking off many upturns
and downturns in history. Before every war the bond prices soared as the governments
borrowed heavily and the very news of the victory or defeat changed the expectations and
therefore the value in the bond markets; many wars, who knows where orchestrated by
these markets. Similar is the case with the U.S. bond market, with the deluge of foreign
funds entering this market and as an after effect it drove down the interest rates and the
long term interest rates very dramatically. The increase of M0, M1, M2 and later M3,
where all linked to this surge of funds in the bond market in a low interest rate regime.
The Chinese central bank or the Japanese or the Indian, when they invested in the
Treasury Bonds of U.S. hardly could have imagined that they were embarking on a
crusade that would make sweeping changes in the way credit was going to be doled out to
many.

Let me move to the subject of growth of assets, because lying within the very depths of
the savings attitude is the craving for assets. But let me take a very extreme example. For
those who are at the very bottom of the pile, the people who cannot make ends meet, do
not own any asset. Assuming that they do not carry debts and owe money to others, they
would not have any liability either. So their net worth is zero. As they start moving up the
value chain, they start creating a surplus of their own, the excess of expenses and
earnings. They save that and reinvest that for creating further surpluses. This simple
equity that they create is the fundamental source of all value creation, which translates
into assets. But this process got expedited by the world of finance, which brought in the
concept of debt beyond the conceived means, which was found to be cheaper than equity
and when equity could be leveraged for this debt it created a plethora of options to
expand one’s assets and wealth thereby and equity thereby. I think these two elements
were two fundamental innovations of the financial markets which created higher growth
trajectory in the manner consumers started consuming and thus creating the foundations
of the economic engine of the world to traverse faster.

Unfortunately various parts of the globe did not do it the same way. I never heard the
term interest to EBIDTA ratio before; I did hear debt to EBIDTA. This departure in the
new world of finance meant that a company or an individual simply had to focus on the
interest component and forget about the total debt. This is the core of the current crisis.
The world of finance believed and also preached that as long as the individual had the
ability to pay off the current component of the interest there was no need to get worried
about the ability to pay the principal, because when the time came to pay back the
principal part, it could always be rolled over. This created the debt spiral, because by this
concept only it meant more debt was needed to consume even more as no one worried
about the principal. It almost meant that the principal could be passed on to the next
generation!

There is a problem to this kind of debt creation if part of the debt is used to create assets
that could contract in value as well! Through the contraction of asset value, the net worth
of a large number of ordinary households actually shrunk. I have been quite amazed at
the fact that large net worth individuals actually carry so much of debt on their ‘Balance
Sheet’. There are other examples also as with Corporations, where we do not find an
aorta of debt as much of the growth in measured dozes is funded from internal equity.
But when we look at the data of all the households in America, we would see that both
these behaviors led to the creation of a regime that created and destroyed net worth.

What is the contraction of net worth of the entire US households? Very simple, as net
worth is defined, Assets minus Liability and that to my mind would be a scorching
number as assets have shrunk in size while liabilities have grown. This aspect is my
principal investigation in this current essay. While all the euphoria was riding in the last
stock market boom, between 2003 to the second quarter of 2007 when the net worth of
U.S. households plummeted from $46.7 Trillion to $63.6 Trillion, the decline started after
that, when the median house prices came under intense downward pressure and the stock
markets felt the dizziness. The final turn of events of 2008 is well known.

I refer to the Federal Reserve Government Release of 11th December 2008 (8), which
gives the following picture when I plot the Assets Versus the Liabilities and it clearly
shows the Net Worth sliding in the last four quarters, the real slide is yet to come in the
following quarters, which unfortunately we would have to wait to see.

U.S. HOUSEHOLD NET WORTH

90

80

70

60

50 ASSETS ($ Trillion)
LIABILITIES ($ Trillion)
40 NET WORTH ($ Trillion)

30

20

10

0
Q42007 Q12008 Q2 2008 Q3 2008

But I see a much deeper endemicity to this problem. What is true for a small household is
true for a large corporation; each in its own mirror saw a fate not easily discernible, that it
relied on debt to expand on assets, which meant leveraging it beyond its means to finance
in the long term. The capital of fancy as I call it, like a fractal, X=f(X), created the asset
bubble, as more need of capital was endemically embedded in the surge and the absence
of capital meant a disaster for this scheme to fall flat.

Let me take this example to how it works for the common man. I am a median member
with a household income of $65,000 per year. For me to be able to afford a house of my
own and two cars and also have enough money left in the future for my kid’s education
and pay for the current and future healthcare, would mean that I need to balance
investment (savings) which is primarily my current mortgage payments on house and my
spends on car, and other purchases(the list could go on as I become more attracted to the
endless list of things that the modern world offers, but have to be paid for either now or
later) for which I need to carry a debt and would need an essential credit to take me
through at a cost etc. There are two distinct approaches, one like the more Eastern
approach of caution and prudence and a deep concern about the future which leads to
savings and measured dozes of spending. The other is the more Americanized approach
of investing in Housing for the long term security and spending through a consumer
credit environment. Housing is the biggest component of saving for an American
Household, this is on the other hand an investment for the future. The American tax
system also ensures that one gets maximum mileage out of this saving/investment.
The second approach means that the total savings potential is actually restricted to a very
small part of the income (no wonder the savings rate of U.S. has come down from the
highs of 16% to a very low number).

But first let us look at the way the housing mortgage works and how the consumer credit
works. The mortgage rates are much lower than the rate at which consumer credit is
doled out to consumers by commercial banks. This is because there is no question of any
collateralization. For housing mortgages when individuals make a choice, the most
fundamental is the capacity to pay off a mortgage and not the rising price of the asset,
which counter-intuitively acts as a reckoner that given the probability that I want to sell
my asset, I would not lose due to the slide of the asset value discounted for inflation. The
seller of the mortgages however jumped on the bandwagon that the rising prices of
houses gave an added insurance and part of that insurance was passed on to the owner of
the house in the following way, ‘Don’t worry about the principal now, just pay the
interest.’ By this method the owner did not realize that his payments were liable to be
going up against a potential risk of prices coming down, thus forcing him to move to a
negative equity territory. While investment on the house is the major source of savings, it
cannot be the only one though, how it matches with the liabilities for the short and long
term is the crucial question. Not many seemed to be aware that while the assets increased
and were a source of great happiness, the rise of liabilities stemming from either a large
mortgage which the owner is not capable of continuing or a rise in interest rate, or a
mixture of many other one timers came in the way.

Now let us move to the rise of consumer credit. “Pay later” is a catch word perhaps
coined by commercial banks to influence such buying behavior of consumers and to
attract buyers to assets, where any expense could be amortized over a longer period. At a
given interest rate, which is not more than the discounting rate at which the buyer finds it
comfortable to make the investment, it makes sense or otherwise seen from the finance
sense, the NPV should be zero, in which the buyer compares the price of the commodity
or asset that he wants to buy. This equilibrium would depend on the buyer’s ability to pay
stemming from his economic capability to live out of present and future earnings and his
capacity to grow. This raises the question is that with 2% to 3% GDP growth how could
the consumer credit growth increase by more than 5%?

On the other hand we need to look at the consumer credit environment or the household
indebtedness which is related to consumerism or the spending side of the problem. U.S.
consumer credit today stands at 2.5 Trillion and has risen steadily year on year. Only in
the end of December 2008, the consumer credit actually declined by 3% as per the
February 6th release of the Federal Government (9)
(http://www.FederalReserve.govtrelease).
The world of finance discovered more sophisticated instruments that could deal with
parts of this puzzle. There was the invention of an instrument called the CDS, or the
Credit Default Swap. In Ascent of Money, there are numerous examples of how various
loans could be bought and sold in various markets from time immemorial that spread
risks at times. But this instrument originally discovered in the nineties was a relatively
new instrument for risk management. But instead of hedging risks it actually extended to
speculative trading. But before that a word of caution; this instrument was introduced in
an unregulated environment by the U.S. lawmakers and passed without any debate in the
house. This is the biggest remiss of our times that such a financial instrument to be kept
out of the regulatory environment and oversight created a chain reaction of events that
virtually made two banks, Lehman, Bank of America and the Insurance Giant AiG
virtually stranded with holding stratospheric levels of counter party risks and in the event
of default the assets of these banks just fell like kingpins.

The Commodity Futures Modernization Act of 2000 or CFMA (H.R. 5660 and
S.3283) is United States federal legislation which repealed the Shad-Johnson
jurisdictional accord, which had banned single-stock futures in 1982. The legislation also
provided certainty that products offered by banking institutions would not be regulated as
futures contracts. The CDS was included in this.

The act contributed to Enron's bankruptcy in 2001 (through the keeping out of the over
the counter energy trading) and the much broader liquidity crisis of September 2008 that
led to the bankruptcy filing of Lehman Brothers. The "Commodity Futures
Modernization Act of 2000" (H.R. 5660) was introduced in the House on December 14,
2000 and was never debated in the House (10) (taken from Govtrack.com). The day was
the last working day before the Christmas Holidays.

This was a modernization program that moderated the entire global financial system to a
grinding halt. But this was not uncommon because the world’s most deliberative house
that is supposed to debate and argue before any enactment is framed, does not even have
any listeners (Obama writes in the Audacity of Hope -11).

So where do we go from here. The Keynes argument seems to be the savior and almost
every economy is trying to work on the paradox of thrift, by looking at the demand side
of the problem, that is do anything that creates jobs, that gives money to the people to
spend that would make the economy start functioning as normal again. The increase in
the marginal propensity to save in a recession does a world of negative things although it
could do a world of good to the man who increases his savings for bad days to come.

Robert Shiller and George Akerlof in their recently published book, Animal Spirits
proves this point that the failure of Capitalism lay in failing to reverse the attitude of
spending when actually savings was needed and saving when actually spending was
needed (12). This follows some of the successful ventures of Mitshubishi Global, who
knew when to buy assets (when the prices were low) and when to save (when the prices
were high but the company made money to save) for the next cycle.
But perhaps the time has come for the behavioral economists to take over and therefore I
would take the example of the bounded rationality theorem by Herbert Simon. The
current times have put too much pressure on the utility function particularly in the area of
higher discounting. The whole generation has been given to believe that the current value
of money is much higher, in fact too much higher. Thus we have all used a much higher
discounting factor. If we normalize these discounting factors, if we assume the
discounting factor to be close to the inflation which has remained quite low in the period
of the crisis, we would end up with a new model of business thinking. This model would
mean that we have all the time in the world to spend in the future what we are in the
craving to spend now. We would keep many things for the future to enjoy that we end up
enjoying now.

We just need to enjoy what we earn by the fruits of our value creation, not more not less.
If we want to enjoy more we need to keep in mind that there is a moderation waiting to
be done in the future.

Why do we need to get into a looming moderation when we can avoid it?

Procyon Mukherjee

Completed on 9th March, ‘09

Zurich

References:

1. Warren Buffet: Article in the Fortune Magazine on November 10th 2003,

‘America’s Growing Trade deficit is selling the Nation out from under us.’
2. Tephen S.Roach: Article in China Daily by Morgan Stanley Asia Chief on
October 31st 2007.
3. Governor Ben S. Bernanke: At the Sandridge Lecture, Virginia Association of
Economics, Richmond, Virginia on March 10th 2005: The Global Saving Glut
and the U.S. Current Account Deficit
4. Warren Buffet: 27th February Letter to the Shareholders on the Annual report for
FY’08.
5. History of Inflation vs. Long-Term Interest Rates : A Comparison of Inflation and
Long-Term Interest Rates from 1940 – 1999 by Essex Corporation taken from “A
History of Interest Rates” by Sidney Homer. Copyright 1977 by Rutgers
6. Nicholes Taleb: Book-Fooled by Randomness
7. Niall Fergusson: Book-Ascent of Money
8. U.S. Assets, Liabilities and Net Worth Data: Taken from December 11th 2008
release Balance Sheet of Households (Federal Government Release)
9. Consumer Credit in U.S. : taken from the http: www.federalreserve.govtrelease
10. Commodity Futures Modernization Act of 2000: taken from Govttrack.com
11. Barack Obama: Book- The audacity of Hope
12. Robert Shiller and George Akerlof: Book- Animal Spirits