At my former firm, the founder once offered a simple but powerful lesson. He asserted that two basic dimensions sum up everything one needs to know about the prospective health of financial markets: money and confidence.
He explained that for financial markets to function properly, they require a supply of money large enough to process financial transactions in the aggregate, and to support the growth of the underlying real economy. Too much money could precipitate inflation, and this was a potential risk. However, the opposite – too little money – was worse, for it would cause the financial markets and the underlying economy to grind to a halt. Market value and productivity would be lost as a consequence.
Confidence was the other ingredient vital to healthy financial markets. Confidence, underpinned by trust, was the stuff that transformed money into liquidity; and liquidity was what sustained the virtuous cycle of transactions that we know as a “bull market” and a “growing economy.” Without confidence, monetary stimulus (an expansion in the money supply) would likely be futile: liquidity would dissipate, and the new funds would sit idle on the sidelines. In the founder’s view, confidence was the transmission mechanism by which new money entered the economy and circulated through financial markets.
What I understood from that conversation was that money was the lifeblood of markets, and confidence was the heart that pumps it.
I think about that lesson often. I believe it has direct application to what is happening today, whether it is sub-par growth in the U.S., financial crisis in Europe, or jitters in China.
At this moment, the world’s central banks have undertaken what appear to be coordinated efforts at relief, easing liquidity by boosting money supply. This is a welcome move, as liquidity has been strained. My concern is that while this monetary stimulus is necessary, it is not sufficient to achieve financial stability. Unless confidence is restored – specifically, by repairing balance sheet solvency – growth will remain tepid, and markets range-bound.
The Scope of Present Problems
In the U.S., low interest rates and stagnant growth have led some prominent economists to warn that the economy is falling into a “liquidity trap.”1 Such “traps” are problematic because they are characterized by stubborn deflation and low growth; worse, they are difficult to escape because once trapped, conventional monetary policy is rendered ineffective. The economists argue the only way out is to boost nominal prices via unconventional monetary policy, either by using it to target nominal Gross Domestic Product (GDP) growth (known as “NGDP targeting”), or by aggressive quantitative easing in conjunction with fiscal stimulus (think “QE3” plus another spending plan). In short, the idea is for the central bank to print money aggressively as a form of stimulus.
In Europe, different forces are at work. The region has been racked by a sovereign debt crisis, where unsustainable levels of national debt have prompted the risk of default among several European nations. This in turn has undermined confidence in the region’s banking system, which is heavily exposed to those debts. Fear of broad-based financial collapse has meant the sovereign risks in smaller countries have spread to the core of the Eurozone – now even Germany and France appear to be at risk.2 This contagion has led observers to question whether the euro-bloc will persist in its present form, or whether some sort of partial dissolution will occur. Many observers fret that the European Central Bank (ECB) is the only entity that can avert total collapse: they argue that the ECB must offer open-ended liquidity support to Europe’s beleaguered banks by buying their sovereign debt portfolios. Again, the proposed solution involves the central bank printing money to provide liquidity and heal distressed financial markets.
In China, financial markets have been unsettled for the better part of four years. Indices that track domestic stock markets remain about 55% below the high achieved in the fall of 2007. Persistent inflationary pressures and slowing growth have dogged the economy. Worse, solvency fears haunt the country’s banking system. In a bid to offset the global financial crisis, the Chinese government used its influence over domestic banks to prod them to lend aggressively in 2008 and 2009. Those loans are beginning to come due, and there are signs that the underlying credits have soured. Ominously, a credit crunch appears to have hit some of the country’s smaller businesses, even as China ostensibly enjoys some of the most liquid financial markets in the world. Share prices for China’s listed banks have dropped precipitously on fears that widespread credit problems will soon materialize. Many investors hope the Chinese central bank will support markets by relaxing restrictions on money supply – again, the belief is that monetary policy can bail out wobbly financial markets.
Confidence in Disrepair
In each major market, the popular solution to current woes is to lean on monetary policy. The hope is that sufficient monetary stimulus can promote growth, boost spending and investment, generate liquidity and alleviate distress.
I believe that monetary policy is a powerful tool, and under the right circumstances, it can deliver on such hopes. Unfortunately, though, present conditions are far from ideal. Confidence in private markets has been debased, and consequently, central banks’ efforts to boost the supply of money are unlikely to translate to sustained improvements in liquidity. One way this can be observed is by comparing the ratio of “base money” (the supply of money directly under the central bank’s control) to "broader monetary aggregates” (which include additional money that is created by private market activity, such as financial intermediation).
When a central bank wants to boost the supply of money, its primary tool is to increase “base money.” This action injects a fixed amount of liquidity into the private financial system. However, the total supply of money in the economy – known as “broader money aggregates,” and represented by either “M2” or “M3” – is normally a multiple of base money. The intermediation of the financial system – lending base money to customers, customers depositing their funds, which are lent out again – multiplies many times over the original liquidity created by the central bank. This multiplier effect is what provides sustained liquidity to markets. However, the multiplier is largely out of the control of the central bank, and depends in large part on a healthy and confident financial sector for its realization. The absolute value of the multiplier matters: a high multiplier means that the central bank can readily transmit supplemental liquidity to the market. Arguably, a marginal change in the multiplier is even more important. A rising multiplier means the efficiency of the central bank’s effort is improving, and a declining multiplier implies the opposite.
Unfortunately, the evidence in the U.S. and Europe suggests that the multiplier is softening. Central banks are boosting the supply of money; but confidence is lacking, and it is failing to translate to sustained, broad-based liquidity. I have charted below the M2 / base money ratio for the U.S. and Europe – each has fallen since the financial crisis of 2008.
I have also included Japan’s experience in the 1990s; its experience with weak financial intermediation is instructive. The banking system in that country failed to repair solvency following the bursting of a financial bubble in 1989; confidence ebbed, the ratio of M2 to base money fell from 13 to 6 over the next decade, and financial markets deteriorated. The ratio remained relatively depressed despite the central bank’s attempt to pursue massive quantitative easing in the mid-2000s.
The lesson is clear. Without confidence, the private sector will not translate new money from the central bank into sustained liquidity, as some advocates of quantitative easing hope. Restoring confidence should be of the utmost priority for policymakers in the U.S., Europe and China.
But how does one restore confidence? We all know confidence when we see it, but it is obviously an amorphous term. What is its application in the context of a modern economy?
My own training and experience are that of a “bottom-up” investor, meaning that I generally look at the world one company at a time. This perspective has pros and cons. However, it affords me a view of what “confidence” means, in practical, financial terms: balance sheet solvency, or having sufficient assets to cover liabilities. Solvency is the raw stuff that financial confidence is made of; it is the tangible means that markets have to assess their confidence in specific counterparties and proposed transactions. That’s what makes the present situation so caustic: solvency is in doubt across the U.S., Europe and China, all at the same time.
Here is why solvency is so important: when you have basic confidence in the solvency of your counterparty to a transaction, the questions you ask yourself are relatively straightforward. You ask: is the price fair? Is the quantity sufficient? Is the quality acceptable? Do I want to complete this transaction? Some of the questions may be tough to answer, and there is risk associated with every transaction; still, we are on familiar ground, because we think this way every day, in transactions both large and small.
However, if you doubt your counterparty’s solvency, your confidence in the transaction mechanism itself begins to deteriorate. You ask unfamiliar questions: will I receive what I paid for? Can this counterparty complete the transaction? Will the money that I commit wind up in limbo (MF Global), or go down the tubes (Bernie Madoff)? These questions can go on ad nauseum, because there are no definitive answers. Transactions freeze up, volumes decline, and liquidity dissipates. It is this sort of raw doubt that impedes “base money” from being multiplied into broader money aggregates, such as “M2.”
Much of the commentary I read assumes that monetary policy is the best cure for the ills facing the U.S. and Europe (and even China); the arguments either subordinate or exclude solvency as a contributing factor. To be absolutely clear: while there is an immediate need to improve liquidity conditions via monetary policy, this alone will not cure the current solvency crisis. Unless solvency is repaired, monetary policy will have limited and temporary effect, and financial markets will remain fragile.
How can solvency be repaired? The table below provides some answers, for most major solutions short of bankruptcy or outright default.
|Mode of Repair||Household Insolvency||Corporate Insolvency||Sovereign Insolvency|
|Improve capacity to service liabilities||A. Raise revenue (taxes)|
|a. Cut expenditures||1. Cut expenditures||B. Cut current fiscal deficits and / or future liabilities ("austerity”)|
|b. Debt restructuring (e.g., consolidation, forbearance, lengthening of maturities)||2. Debt restructuring (e.g., consolidation or lengthening of maturities)||C. Debt restructuring (e.g., consolidation, or issuing pooled-sovereign bonds)|
|Enhance balance sheet quality||3. Enhance transparency and fairness of valuations (e.g., writing down bad assets, and properly accounting for liabilities)|
|4. Carve outs (e.g., separate viable assets from unviable ones)||D. Carve outs (e.g., separate good sovereign credits from bad ones)|
|Increase capitalization||5. Inject new capital||E. Privatization of public assets|
|c. Principal reductions and debt forgiveness||6. Principal reductions||F. Partial default|
|7. Transfer liabilities to external party (e.g., guarantees or nationalization)||G. Transfer liabilities to external parties (e.g., cross-sovereign guarantees or “enhancements”)|
|8. Swap debt for equity||H. Financial support from multinational institutions (e.g., IMF)|
In my view, the first step is to locate the focal point of the insolvency – does the problem arise from the household sector, corporate sector, or from the government? This can be tricky to do, because insolvency in one sector can bleed into the others. However, this step is critical because a cure for one sector does not necessarily translate well to another. It may be imperative that an insolvent household cut costs; however, applying the same approach to an insolvent government (i.e., austerity) may worsen an already weak economy.
In my own view, the center of U.S. insolvency overlaps between the household sector (still reeling from the residential housing bust) and the corporate sector (many commercial and investment banks’ balance sheets are still a mess).3 Yes, many are rightfully worried about the U.S. fiscal position; but I don’t think this is the acute source of insolvency, at least not yet – not least because all debt is issued in dollars (thus the sovereign can print more), and the bulk of the debt is still held onshore by U.S. entities. Europe, by contrast, is clearly facing a sovereign debt problem that is cascading into the banking sector. China’s problems are firmly located within its semi-private / semi-public banking sector.
The second step is to recognize that there is more than one way to cure a solvency crisis, as the table suggests. Fiscal austerity is being promoted as the primary cure for perceived solvency problems in the U.S., and also for Europe’s sovereign ills. Austerity is no panacea, and if pursued blindly, it may derail already weak economies. China has pursued austerity within its banking system, and in my view this has done very little to cure its core solvency problems.
In my view, the U.S. needs to 1) recognize its immediate solvency problem lies in the private sector, 2) move to improve households’ solvency (possibly via reductions in principal), and 3) conduct a major “clean up” of the financial system (via a combination of capital injections, debt-for-equity swaps, write downs and bad asset carve-outs). The latter exercise will undoubtedly be a painful process, suggesting further shocks to banks’ equity prices, at least in the short run. In the process, we must embrace flexibility on asset prices, and allow markets to fall far enough to clear. The silver lining is that once begun, the balance sheet adjustment process may not need to be carried out to its bitter end. Markets may re-discover their confidence if they observe an improving solvency trend, allowing the U.S. to grow itself out of the rest of its debt burdens.
Meanwhile, Europe must consider means beyond austerity (solution “B” in the table above) and partial default (F) to cure its solvency problems. As I write, there appear to be efforts to secure financial support for Italy from the IMF (H). This is a good start, at last. However, I strongly believe that the Eurozone, as it exists today, is not a solvent construct, not least because it lacks fiscal integration. So far, Germany has rejected the possibility of pooling debts (C) via the issuance of a regional “Eurobond;” but in the end this may be a necessary to increase debt-servicing capacity. Ultimately, the membership of the Eurozone may be at risk – good sovereign credits may need to cleave away from bad, hopefully in orderly fashion (D). Given that the sovereign crisis has spilled over into Europe’s banking sector, a clean-up and recapitalization (possibly via debt-for-equity swaps) will be necessary.
China’s insolvency is located almost exclusively in its banking system. Its solutions therefore must draw from a tested, private-sector playbook: the banks must enhance the transparency of their balance sheets, and recognize non-performing assets; those assets must be restructured, or carved-out; and the banks must be re-capitalized, again. If not, it will be difficult for the financial markets in that country to recover, regardless of economic performance.
Paul Krugman, a noted economist, has suggested that pursuing austerity to escape a recession is to believe in the “confidence fairy” – in other words, fiscal rectitude itself will not invoke confidence, nor lead to growth.4 I concur: when large numbers are unemployed and growth is shaky, it makes little sense to me to further cut government expenditures. There is no “crowding out” effect, there is too much slack. However, the solution that has been offered is to undertake QE3 or its equivalent, along with another round of fiscal stimulus, so as to avoid a liquidity trap. I think that policy prescription invokes a confidence fairy of a different sort – it presumes that the central bank can induce confidence simply by engaging the printing press hard enough.
Plentiful money, in my view, cannot itself invoke confidence, nor can it act as a surrogate for it. Instead, balance sheet solvency must be addressed in tandem with monetary policy in order to achieve financial and economic stability. My fear is that, unless policymakers act to restore solvency soon, much of the world may follow Japan in its two decades of sub-par growth, or stagnation. Let’s hope for a changed debate, and a different future.Andrew Foster
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- Paul Krugman, “Ah Yes, LM (Wonkish),” 8 October 2011; Brad DeLong, “The Sorrow and the Pity of the Liquidity Trap,” 5 November 2011.
- Bloomberg News, “German Bonds Fall Prey to Contagion; Italian, Spanish Debt Drops,” 25 November 2011.
- For more on recent and ongoing solvency problems in the U.S. financial sector, please see: Bloomberg News, “Secret Fed Loans Gave Banks Undisclosed $13B,” 27 November 2011; Wall Street Journal, “BofA Warned to Get Stronger,” 22 November 2011; Bloomberg News, “BofA Clash With Fannie Mae Escalates Over Loan Buyback Stance,” 20 November 2011; FDIC, "FDIC-Insured Institutions Earned $35.3 Billion in The Third Quarter of 2011,” 22 November 2011.
- Paul Krugman, “Death by Accounting Identity,” 25 November 2011.