In recent years, investors and financial markets have been buffeted by a seemingly unending barrage of unprecedented shocks and nearly crippling blows. The demise of an international monetary system, historic levels of inflation and interest rates, soaring food prices and peacetime controls are only a few of the problems. New words are creeping into the financial vocabulary such as credit crunches, floating exchange rates, dirty floats, energy crisis, Phase I, Freeze II and many others. In the land of plenty, shortages abound. In scarcely a decade we have moved from the age of the "New Economists," where the government was confidently expected to fine tune the economy for continuous growth, to one where the credibility of the government has all but disappeared. The world leadership role of the United States has been considerably tarnished. Citizens are even beginning to doubt themselves.
A SINGLE CAUSE
Almost all of these seemingly unrelated problems emanate from a single underlying cause. The source of the disturbances is a secular trend of excessive credit creation that has continued unbroken since the 1940's. While the nation's ability to produce real goods and services can only grow at a rate approaching four percent, the creating of credit in all sectors of the economy has compounded at a rate nearly three times as fast. This unhealthy trend has been fostered and perpetuated by the government, with the aid of the Federal Reserve. It was made possible by an entirely new philosophy of government that took roots in the rubble of the depression years of the 1930's. The philosophy was formalized with the Employment Act of 1946 which made growth at any cost a duty of the government and took wings with the ascendency of the New Economists in the early 1960's.
With the government firmly committed to a program of growth and the growing widespread belief that the business cycle was dead by legislative decree, a new reckless overconfidence took hold among corporations, individuals, and the banking system. With this new confidence, the fears that remained from the depression years were gradually forgotten. A new generation arose with a completely changed credit ethic which allowed corporate and personal balance sheets to be stretched thin in the search for maximum growth of earnings for corporations and the good life for the individuals. Even conservative bankers forgot the pains of the 1930's with its bank holidays. The traditional philosophy of adequate liquidity was exchanged for a new banking philosophy of profit maximization and aggressive liability management.
To make it all come true the government engaged in the most massive spending campaign in the history of the nation, as large and growing budget deficits became the rule. Much of the spending was financed by higher taxes at all levels of government. The cost in terms of the loss of personal and economic freedom has been great. The percentage of each dollar of national income that is spent by the government has increased from 11 percent in 1947 to 48 percent in 1972. When politicians failed to acknowledge their deeds by higher taxes, the Federal Reserve obliged by purchasing the government debt and turned it into high-powered money that the banking system eagerly multiplied manyfold into auto loans, mortgages, and corporate debt.
THE DEMISE OF THE BALANCE SHEET
Most of the growth of the postwar years was made possible only by a massive deterioration of the national balance sheets of corporations, banks, individuals and the government. Like good magicians, the Keynesian economists diverted our attention from the balance sheet to the income statement to see the wonder of their deeds. The cost of their rhetoric, however, has been recorded on the balance sheet but few examine it. To understand how this was done, the growth of Keynesian economics must be traced.
The determination of many in the 1930's that we must never again allow a repeat of the massive unemployment and hardships of that period gave nourishment to a new brand of economic theory. The emphasis was shifted away from the classical quantity of money orientation toward income and expenditure flows. During the Roosevelt years and the Second World War the precedents for big government were set. Throughout the Eisenhower years the philosophy spread and followers of Keynes waited and planned for their big opportunity. In 1946, as mentioned, the government had been charged with the responsibility of maintaining growth. Finally, in 1961 the New Economists got their big chance and they were ready. It lasted for two presidents.
The theory of the "fiscal drag" was spotlighted. Under this theory, as GNP grows and tax revenues rise, a government surplus grows which, if ignored, could choke off further growth. Therefore, a "fiscal dividend" must be declared in the form of a tax cut or higher expenditures. It did not matter whether more spending was "needed"; new programs would simply have to be invented, for continued growth was the goal. The cult of growth was born. The only trouble was that while politicians leaped at the chance to cut taxes to foil the dreaded fiscal drag, raising them when the "inflationary gap" threatened was a vote of a different color.
Government spending took on an upward bias. Original Keynesian theory called for deficit spending when the business cycle turned down but surpluses when it was rising. With the fear of fiscal drag and the preoccupation with growth, the disciples of Keynes somehow managed to turn this into a deficit every year. They shifted the emphasis from "correcting" the business cycle to propelling growth continuously. The New Economists were no longer content to moderate the economic declines but instead claimed to be able to fine tune the business cycle out of existence. With an attractive and vibrant new president and a willing media that always has a predilection toward activism, the New Economics got off to a resounding start. The New Frontier and then the Great Society programs, with the publicity of early "apparent" success, enraptured the media.
Not surprisingly, the new government attitudes permeated the entire economy. With guaranteed growth and no serious business corrections to be concerned about, growth became the brass ring. Individuals began to borrow more heavily from the future in their quest for the good life in keeping with the goals of the New Frontier. The cult of continuous earnings-per-share growth for corporations began. Those corporations that did not leverage their balance sheets to maximize or maintain steady growth were considered underachievers and pariahs. Growth at any cost did not apply only to the government. Accounting practices were found to be ready sources of the flexibility needed to keep earnings growing. Nor did investors worry that conglomerates were buying growth by destroying their balance sheets. In fact, they did not even examine the balance sheets. Growth was the end that justified the means. Even banks no longer needed the heavy liquid buffers of earlier years. With little chance of serious needs for cash in an economic slowdown, liquid assets became a burden. Growth maximization was also accepted in the conservative ranks of the banks and a new banking philosophy was born.
All through the period, the income statement became the star while the balance sheet was relegated to the wings. The problem is that such trends are self-enforcing and gradually everyone must run faster and faster just to stand still. The seeds of the accelerating world inflation, rising interest rates and volatility of the late 1960's and 1970's, were already being sown. Increasingly larger doses of credit are needed to keep the house of credit cards from falling. Each dose lays the foundation for the following surge of inflation. In short, underlying the long period of postwar prosperity, much of which is becoming increasingly illusory, is a long trend of steadily accelerating deterioration of balance sheets in all sectors of the economy.
It did not take corporations long to contract the growth fever from the enthusiastic government economists and liberal politicians. By the time the New Economists ascended to full power in 1961, the condition of the average corporate balance sheet had already worsened materially in the period following the war. Since 1960, the trend of deterioration has accelerated substantially as the balance sheet was consistently sacrificed to the income statement and continuity of earnings growth.
Illiquidity is the term generally applied to the firm whose balance sheet has deteriorated too far. The next step is insolvency. With the secular trend of excessive credit creation, increasing numbers of firms are becoming illiquid to the point where their competitiveness is being impaired. As an individual firm becomes illiquid, it becomes less able to withstand external shocks, less able to adapt to changes, less able to compete internationally and becomes increasingly sensitive to business and credit cycles. As more attention must be devoted to managing the firm's debt, the management has less time and inclination to devote to future planning and investment. Consequently, it gradually falls behind competitors. As its debt load grows, it falls increasingly at the mercy of credit markets. Finally, when accounts receivable and outstanding debt are rising even faster than sales, even the novice security analyst would take note. When this situation is multiplied by thousands of firms an alarm should be signaled for the entire economy. This is precisely the state of the corporate sector today.
THE AGGREGATE EFFECTS OF CORPORATE ILLIQUIDITY
The aggregate effects of corporate illiquidity are similar to those of the individual firm. As illiquid firms proliferate, the entire corporate sector becomes more vulnerable to external disturbances. It becomes more prone to a business slowdown and recovers in a more labored fashion. In the aggregate, the growing financial leverage has resulted in more volatility in the entire economy. More importantly, the declining corporate liquidity places an inexorable upward pressure upon interest rates in a number of ways. First, the increasing risk of corporate collapses must be balanced by higher interest returns. The greater volatility resulting from general illiquidity offers another portfolio risk to the investor for which he must receive compensation in the form of a higher interest rate. Secondly, the periodic scrambling for funds among growing numbers of illiquid firms during credit crunches also exerts a strong upward pressure upon interest rates. The postwar pattern has become quite predictable. In each business expansion, corporations incur excessive short term debt. As business begins to slow, they become concerned and rush to fund the short term debt by selling bonds. This only hides the short term excesses in another section of the balance sheet away from the very visible short term section. The excesses have been accumulating, however, and are increasingly manifested in higher debt ratios and lower interest coverage ratios. These, in turn, are reflected in growing number of rating cuts on the corporate securities. Finally, liquidity deterioration is inflationary in the shorter term and this adds a further inflation premium to interest rates.
To a firm that is top heavy in debt, rising interest rates can be fatal. Thus, we can see the first of many self-enforcing aspects of the liquidity deterioration. Illiquid firms are heavily penalized by the very interest rates that they are instrumental in raising. This is one of the many reasons why the trend of excessive credit creation and its effects are rapidly accelerating. The growing corporate illiquidity represents a latent deflationary force in the economy that can only be offset by ever larger doses of credit which, of course, enforces the trend. The economy is now in need of a massive rebuilding of capacity to atone for many years of underinvestment that may also be traced to the inflation that resulted from excessive credit. The enormous financing requirements of such an undertaking will be the final straw.
Banks were both willing and able to supply the credit necessary to support the long deterioration in corporate liquidity. Following the lead of the government, the banking system has gone full circle. From the 1930's, when the government could not force banks to grant loans, the balance sheet of the banking system has reached a condition where it is far worse than the 1920's by any traditional measure of safety and liquidity. The steady deterioration since World War II has been interrupted only by short and partial cyclical restorations of liquidity. Since the liquidity scare of 1969-1970, there has been no recovery at all.
The climate fostered by the government has created a new banking philosophy. Banks no longer wait passively for deposits and then structure for balance between safety and earnings. Such high safety buffers, they say, are no longer needed. They can compete in the market place to determine their own deposit levels. The amount of loans is limited only by their ability to raise deposits, not by antiquated standards of safety. Thus, the percentage of assets in loans as well as the length of such loans has increased dangerously. One flaw in their reasoning, of course, is that what is possible for one bank is not possible for the entire system. Hence, the struggle for deposits among banks only succeeds in introducing a greater note of volatility into the financial system. The deposits, due to the competition, are becoming more sensitive in the short term and more volatile. At the same time, the traditional self-liquidating loan has become a smaller proportion of the average loan portfolio. In their place are increasing proportions of less liquid term loans as corporations have gradually gone into debt to the banking system. So we have a situation where deposits are becoming shorter and more volatile while loans are becoming longer, riskier and less liquid. This goes exactly counter to advice usually given by the banker to his customer to avoid borrowing short to invest long.
As loan demand rises sharply during cyclical upswings, the banks must aggressively compete for deposits at any cost and by any means since they have no unused capacity. This activity pushes interest rates higher, forcing banks to push for higher returns to cover the higher cost of funds. This search leads the banks to higher risk loans and investments. The gradually lengthening maturity of their loan portfolio also tends to lock in the higher costs and thus the level of interest rates in the system. Thus, banks have also added to the upward pressure on interest rates, increased volatility and risk in the economy. Through their money-creating function they have also added to inflationary pressures.
The deterioration of the banking balance sheet is so severe that only a huge liquidation of credit would restore normal liquidity relationships. Given the unwieldy debt load of corporations and individuals and the precarious financial condition of both sectors, such a credit liquidation would become cumulative. Banks have no choice but to continue to help their clients become more deeply mired in debt in order to keep the system from collapsing.
THE ROLE OF THE GOVERNMENT AND THE FEDERAL RESERVE
If banks did not create the necessary money and credit, the liquidity trends could not continue. Banks, in turn, could not supply the credit if the Federal Reserve did not supply the reserves. Therefore, the Federal Reserve does have a major supporting role in the problem. We must look first, however, to the government to find the prime mover.
The philosophy of small government, as mentioned, began to disappear in the 1930's. It was the huge buildup of liquidity during the Second World War and the pent-up demand, however, that provided the springboard for the postwar boom. Until 1951, the Federal Reserve was engaged in pegging the rate on government securities at artificially low levels creating even more excessive money in the process. From this condition of excessive liquidity, pent-up demand and the incipient belief in a large benevolent government, the long postwar boom and liquidity rundown began.
Although liquidity levels began to reach more normal levels in the 1950's, the growing government spending programs helped to perpetuate the deterioration. Programs, once begun, assumed a bureaucratic life of their own and consumed increasingly more funds even beyond the dreams of the original planners. Politicians, getting into the mood, vied with each other to bring their constituents more programs. The budget became gradually less controllable.
On top of this, the New Economists finally came to full power. They came with theories and aspirations developed over the Eisenhower years and before in universities across the country. The original Keynesian theories were expanded. Under their guidance, the deterioration in the national balance sheet was accelerated. Even the Vietnam War did not deter them in their goals. Money was spent on both guns and butter as huge nondefense spending was added to the expenses of the longest war. Fiscal discipline was finally lost completely and deficits grew to astronomical heights as the government sector rapidly encroached upon the private sector. This spending, of course, had to be financed and this is the cue for Federal Reserve to enter the picture.
Taxes have certainly risen substantially in the postwar years financing a large part of the government debt. If this method of finance had been followed exclusively, the long deterioration in private balance sheets would have been greatly reduced. The government, however, would have been spending an even larger part of each dollar. But raising taxes has always been much less popular with politicians than the invention of new spending programs. Hence, an ever greater proportion of the debt was financed by government securities. The Federal Reserve, in its role of faithful handmaiden to the Treasury, purchased all the securities that were not taken up by the private sector, issuing high-powered money in payment. These reserves, multiplied manyfold by the eager banking system, supplied the means for the liqudity deterioration among corporations and individuals. Banks today generally loan or invest almost all of any increment to deposits.
In addition to aiding the Treasury financings, the Federal Reserve has also stimulated excess credit growth because of conflicting goals it has taken upon itself over the years in the spirit of the New Economics. While pursuing conflicting goals of full employment and stable prices, it has always erred on the side of inflation. Finally, the Federal Reserve has for years also pursued conflicting targets. It has fought valiantly to hold down interest rates but has lost control of the money supply time and again in the process. In the long run, the inflationary result of such excessive money growth has served to place further upward pressure upon interest rates in one more example of the self-enforcing nature of the postwar credit trends.
Thus, we see that the government and the Federal Reserve have teamed up to create not only a climate favoring excess credit growth but have also created excessive monetary growth over the postwar period to make it possible. The correlation between excessive money growth and price inflation has been well-documented just as the relationship between inflation and interest rates has been established.
Now that the actors have all been introduced we can see the full explanation of our current financial problems. Banks, corporations and individuals have all run down their balance sheets over an extended period of years aided and abetted by the government and the Federal Reserve. The primary results have been inflation, rising interest rates, increasing volatility and a growing risk of total collapse. Although the primary blame rests upon the government, as the effects become persistent they interact to form a self-enforcing upward spiral that becomes more difficult to break as time passes. Many nostrums have been applied but to date, no one has attempted to break the chain at the root of the problem.
CAUSES AND EFFECTS
One reason the chain has not been broken lies in the fact that the credit deterioration has been allowed to persist for such a long time that the primary effects mentioned above have become deeply engrained in every sector of the economy. They have so permeated the system that many secondary effects such as lower capital formation, declining productivity, declining profitability, increased labor militancy and shortened investment horizons have also taken hold. Labor unions have learned to protect their real wage with proliferating cost-of-living clauses, for example. Along the way, all the restraints on the ability of the Federal Reserve to increase the money supply, such as the gold cover, have been removed by necessity. Through the fixed exchange rate system, our increased money supply and the resulting inflation have been exported throughout the world. International crises and the scrapping of the old international monetary system have resulted. The Keynesian system is a "closed system" and did not anticipate this development. All these effects have been intertwined and work to enforce each other into an independent self-enforcing trend of liquidity deterioration. In many cases, the effects are confused with the cause: business blames labor, labor blames big business, scapegoats like multinational companies, the gnomes of Zurich and others are singled out. Yet, the underlying government spending and money creation continue unabated.
As further evidence of people's ignorance of the basic causes, controls on prices and wages have spread throughout the world. The result has been loss of economic and personal freedom but little reduction in inflation. Controls, in turn, lead to shortages and declining incentives to invest by the private sector. This results in lower capital formation, lower productivity and further shortages. Inflationary pressures are thus worsened and the United States is now importing the inflation in the form of higher commodity prices which it exported earlier. The self-enforcing upward spiral continues as long as the underlying causes are neglected.
An obvious solution would be a reduction in government spending and enlargement of the private sector. The growth of credit must also be reduced to a rate not exceeding the rate of potential growth of real goods and services. Nothing less than a complete reversal of government philosophy will solve the problem. The entire credit ethic that has mushroomed in the postwar years must be changed. Finally, a long period of slower growth and higher saving and investment to offset the long stimulation of consumption at the expense of investment is needed.
There is a very important question as to whether any politician in the free world has the will to order or vote for the changes that would be necessary to solve the problem. In the United States, the budget is already out of control. Over 70 percent of the government's expenditures are now uncontrollable without major changes in legislation. It is difficult to imagine many Congressmen willing to vote out Social Security, veterans' benefits, welfare and other deeply engrained government programs. Controlled inflation has always been a favorite government tool but now control is being lost.
Like the large dollar overhang in the world, the level of debt already outstanding may be so large and the credit ethic so deeply engrained that token changes in government policy will not be enough to stop the trend. On the other hand, if a sufficiently large decline in credit growth is attempted, it would set off a cumulative liquidation of credit that will also get out of control. Just as the creation of credit takes on a self-perpetuating nature, the liquidation will do the same. We simply cannot reduce the credit base too rapidly. To avoid a crisis, the debt can only be eliminated slowly, over a long period of time. This will require close cooperation between all branches of government over several administrations, which seems too much to expect. Each time the government has attempted to slow credit in recent years (e.g. 1969-1970) it finds it cannot without the situation getting out of hand. It then quickly reverses itself and must feed out even more credit to turn the economy around which sets the stage for further credit growth and the next credit crunch. The government has a tiger by the tail. It is afraid to let credit grow too much but at the same time it must supply increasingly larger doses of credit to offset the deflationary pressures that are growing from increasing numbers of illiquid firms.
HOW WILL IT END?
The chances of a financial panic at any time are great. Contrary to much current thinking, the collapse can be worse than the 1930's, for credit has permeated the entire economy. Not only the speculator will be hurt but most private citizens as well. All panics in the past have been caused by credit liquidation but the credit binges preceding the past panics had been relatively short and speculative in nature. We have now engaged in a much more respectable 30 year credit binge where the average citizen and corporation has participated fully with the blessing of the government. This time, the binge has taken the form of mortgages, auto loans and other consumer debt. Corporations have become much more highly leveraged than at any time in the past and banks have become more illiquid. Anything could trigger the liquidation of this huge credit base whether the near-miss of the Penn Central or an Arab oil embargo. Once started, the trend will gain momentum in spite of government efforts to halt it.
Can the government continue to put off the inevitable? We should never underestimate the power of the politician and his skill in crisis economics. The hour is late, however, and to the extent that the government is successful, the side effects will continue to worsen. The price to be paid is more credit extension, inflation, volatility, rising interest rates and a continued loss in personal and economic freedom. Balance sheets are now so weak that they constitute a separate force that must be reckoned with by the government. Increasing doses of credit will be needed, crisis economics will continue, and shortages will periodically emerge as the government attempts to supplant the law of supply and demand. Worsening credit crunches and international disruptions will also be the rule. Eventually, control will be lost completely and either inflation will spiral as in Germany after World War I followed by a crash or a crash will be triggered before then by some yet unknown event.
WHAT TO DO
The task of protecting one's investments will be difficult in the years ahead. The investor must keep the possibility of a crash in mind while at the same time he must reckon with the government's ability to patch things up and put off the eventual end. The side effects could continue and investments that one may choose for a crash can suffer substantially in the interim if inflation accelerates. It is simply difficult to hedge against both inflation and deflation at the same time. If one were sure the crash was imminent, cash, gold and high quality bonds would be excellent.
Until the crunch, however, inflation will continue to be the primary evil. Cash could become worthless before the crash finally comes. In the meantime, choppy business cycles and frequent credit crunches will be the rule. Rising interest rates would make long term bonds a poor investment. The only solution is to structure portfolios judiciously between short-term fixed investments, gold investments and high-quality equities with strong finances and the ability to offset inflation.
Alexander P. Paris holds a B.A. in economics and an M.B.A. in finance from Michigan State University, and an M.A. in economics from Wayne State University. He is presently an officer of a major institutional investment firm, where he specializes in institutional research. Paris is the author of A COMPLETE GUIDE TO TRADING PROFITS (Whitmore 1970) and THE COMING CREDIT COLLAPSE, to be released later this year by Arlington House.