Bernstein’s Wisdom

By on March 30, 2008

87 year-old Peter Bernstein recently wrote the following which I found to be a good synopsis of the mess the economy is now in:

Credit is always and everywhere a matter of trust. Where there is trust,
anything goes, as the recent proliferation of so many structured financial
instruments vividly demonstrates. When trust vanishes, the revival of the
buoyant credit creation of the past becomes extraordinarily difficult. But
without credit creation, economic growth and risk-taking are stifled.

Liquidity is also a matter of trust to some degree. But liquidity has
another feature that few people notice. Liquidity is a function of
laziness.
By this I mean that liquidity is an inverse function of the
amount of research required to understand the character of a financial
instrument. A dollar bill requires no research. A bank draft requires less
research than my personal check. Commercial paper issued by JP Morgan requires
less research than paper issued by a bank in the boondocks. Buying shares of GE
requires less research than buying shares of a start-up high-tech company. A
bond without an MBIA (once-upon-a-time anyway) guarantee or a high
S&P/Moody’s rating requires less research than a bond without a guarantee or
lacking a set of letters beginning with “A” from the rating agencies. The less
research we are required to perform, the more liquid the instrument – the more
rapidly that instrument can change hands and the lower the risk premium in its
expected returns.

This emphasis on trust and liquidity in a
well-functioning credit market provides useful insights into what is happening.
Trust has vanished in many areas where it was taken for granted just a few
months back. And when the ratings of S&P and its competitors lost
credibility, paper that had traded on sight lost the liquidity it once enjoyed
because now it involved far more research than in the past. These words are just
an elaborate way of explaining why credit spreads were so narrow just nine
months ago and so wide in today’s markets.

This abrupt shift in viewpoints has caused snarls in many areas of the credit markets. Over the
longer-run, the most serious of these blockages is the disruption in the process
of securitization. Securitization works only in an atmosphere of trust and where
the paper involves a minimum of research. Without securitization, and
without the lively derivatives markets that developed around the securitization
process, the entire credit system loses an immense source of capacity, hindering
deserving borrowers in search of financing and, as a result, the pace of
economic growth.

Until the system can restore trust and the related willingness to buy instruments on the basis of limited research (or even no research), the credit markets are going function below optimal levels. But
restoring trust and liquidity is no simple matter. Securitization broke the old personal relationship between lender and borrower, greatly expanding the market for credit in the process. The old-fashioned way – when lender and borrower were essentially on a face-to-face relationship – was slower, more cumbersome, and, most important, far more limited in terms of capacity.

In my days as a commercial banker, back in the late 1940s, the president of my bank said to me,
“Remember this. I much prefer the customer to be angry at you because you denied him credit than for you to be angry at him because he failed to repay when due.”  That attitude sounds quaint today, but it was very much in the spirit of a time where jokes about bankers’ glass eyes were legion. As the market for glass eyes revives – and it is reviving as we speak -new credit creation will inevitably slow down. As Woody Brock recently emphasized, “the combination of diminished bank capital and tighter lending standards could prove fatal to credit creation.”

Now, it would be naïve to project this set of conditions into
the indefinite future. Trust will regenerate over time, and the burdens of
research will lighten. The pace of change in that direction, however, will be
slow, a matter of years rather than months. An entire structure has crumbled and
has to be rebuilt, brick-by-brick. Nor will that process necessarily be smooth.
The impact of unforeseen but inevitable credit problems will loom large,
detouring and delaying the pace and patterns of recovery on each occasion.

There could be bright spots as well. Our whole argument rests on the
proposition that the demand for credit is going to exceed the supply, which is
blocked by lack of trust and an increased burden of research. But a case where
supply fails to respond to an excess of demand is rare in our system. People in
finance have extraordinary energy for innovation in new products, new concepts,
new paths to ultimate objectives. For example, hedge funds and sovereign wealth
funds are already functioning as sources of credit, although a bump along the
way might turn them off as well.

These widespread and complex problems
originated from an unanticipated sequence of shocks involving banking
institutions believed to be impervious to losses in the billions and major
impairments of equity capital. As we emphasized above, new régimes are colored
by the unhappy memories of the preceding régime, and those memories linger on
for extended periods of time. The plight of Citicorp and Merrill Lynch reaching
for massive help from foreign government investment funds was an event nobody
could have foreseen – but few will forget. How the mighty had fallen!

The critical ingredient in the state of
distress

The sequence of events that caused the economy to
lose its forward momentum over the course of 2007 was unique. This fact is
central to our entire argument here. The cause was not too much inventory, not
overexpansion in industrial capacity, not a sustained burst of inflation
requiring a determined move to tight money and higher rates at the Fed.

The root of today’s problems in the financial markets and in the
economy as a whole is the household sector.
The point needs no elaboration,
but its significance cannot be minimized. As we have argued on more than one
occasion, the shrinkage in the personal savings rate is not the result of
consumer profligacy, as other commentators persist in describing it. Rather, the
savings rate has been suppressed by a slowdown in the growth of household
incomes. The shortfall between income and outlay has been met by borrowing, and
in particular by borrowing against the family real estate. Now the opportunity
to borrow has shrunk dramatically, an outcome that will profoundly change the
household’s spending power and spending patterns. But the impact is not just on
the household. A slowdown in the growth of consumer spending has ominous
implications for the entire global economy – and, along the way, the U. S.
federal deficit, soon to be overburdened by spiraling benefit obligations. This
predicament is not a short-run matter, unless home prices abruptly reverse
themselves and head back into the stratosphere – which is hardly likely.

The bottom line

The central
message of our analysis is not that the origin of today’s difficulties is
uniquely in the household sector or that the residue of these difficulties has
scrambled the whole credit structure in the financial markets. Everybody knows
about these troubles.

On the other hand, too few observes have noted how
the consequences of these developments are going to require an extended period
of time before the blockages they impose have been eliminated. But that is not
all they have missed. This extended period of difficulty is going to bring
about a new economic régime, different in many aspects from the experience of
most people alive today.
Along the way, we will have to pass through a
transition period that harks back to an unfamiliar past in both the financial
system and in the household sector.

But this, too, shall pass. Yes,
glassy-eyed bankers, prudent consumers, and a reformulated globalization can
keep a lid on economic activity around the world for quite a while. What
develops from that transition, however, should resemble what took place over the
course of the 1980s. Without anyone realizing it, the errors of the past, drip
by drip by drip, were buried and a new and better system took their place.

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