An Investor's Timetable for the Coming Credit Collapse
After 1973-1974, it is probably difficult for the investor to believe that 1975 will provide an even sterner test of his analytical acumen. Early in the year, his courage will be tested by the sharpest recession since the 1930's. The real test, however, will come later as inflation slows and government officials claim total victory over inflation. The temptation will be strong to return to old investment techniques.
Yet, it will be more crucial than ever to keep the broader long-term economic picture firmly in mind. The true source of all our problems of recent years is secular in nature and not cyclical, and the underlying secular trends are now dominating the business cycle. That is why the old tools won't work in the years immediately ahead. Once the basic problem is clearly understood, the investor can position himself properly.
THE BASIC PROBLEM OF GOVERNMENT INTERVENTION
For some decades, all Western countries have been experiencing growing demands from individuals and special interest groups for a burgeoning list of government services. Increasingly weak governments, fearing political reprisal, have been giving in to all demands. They are buying re-election through increasing government spending and intervention into the private sector. This intervention has led to the massive economic convulsions of recent years. As the government share of the total GNP grows (The United Kingdom is now over 55 percent and the U.S. is not far behind.), the costs of such interference with free markets become increasingly visible. Eventually, the government can no longer expand at the expense of the silent, tax-paying majority.
Government spending, for instance, has been growing at an annual rate nearing 10 percent over the entire postwar period with the rate accelerating since 1965 to 13 percent. Most of the gains can be attributed to transfer payments for which no services are received in return. Transfer payments are simply government extractions from producing taxpayers which are given to nonproducers. Since 1965, such payments by both Federal and State and local governments have grown from $37 billion to a recent annual rate in early 1975 approaching $160 billion. Of the total increase in the Federal budget from fiscal 1970 through fiscal 1975, transfer payments represented 63 percent. The nation is now reaching the point where nonproducers represent an unworkable proportion of the population, and that proportion is an important explanation of the shortage of savings and capital in the economy.
The damaging economic policies that brought the nation to its current condition must be largely blamed on faulty economics that feature increasing government involvement in economic decisions and abandonment of free market solutions. The New Economists of the postwar years went well beyond the suggestions of their intellectual leader, Keynes. They completely replaced stability as the goal of economic policy with a goal of continuous economic growth at any cost and at rates well beyond the abilities of the country. The country was sold a bill of goods that mathematics could be applied to economics to flawlessly predict and control the economy.
FINE-TUNING THE ECONOMY
The New Economists' ill-fated attempts to fine-tune the economy have not only contributed generously to the growth of government spending but also accelerated the growing loss of personal and economic freedom. The policy has led to an unhealthy orientation to short-term economic effects while the long-term damage to the economy is largely ignored. Monetarists and Keynesians alike tend to concentrate on current income flows rather than on the long-term balance sheet effects of current and past mistakes. Even when the potential long-term damage is acknowledged, the immediate political reaction is considered too dangerous to attempt the lasting cure. The government, the public and the media have been so conditioned that they over-react to every change in the economy which leads to many rapid shifts in policy.
The entire process, moreover, has an inflationary bias. Economists generally feel more comfortable curing recessions (for which they feel more intellectually equipped). It is also more popular with politicians than doing battle with inflation. Therefore, policy-makers are always too quick to fight recession, usually before the war against inflation has been won. But voters are also uncomfortable with uncertain prices and the pressure upon government to intervene leads to repression of inflation rather than a cure. This leads to shortages, malinvestment and other distortions, all of which lead to even more government intervention.
Once the principle is established that the government may intervene in the private sector to transfer wealth from one group to another, the process is limitless. In the early stages of such intervention, the costs are hidden. Each intervention causes more undesirable side effects and usually a completely different result than that intended. Rather than reversing the government policy that caused the problem, the government responds by treating the symptoms with further interferences leading to a new set of distortions. Old programs neither die nor fade away but grow, instead, beyond the wildest dreams of the most enthusiastic social planner. Each program develops a fiscal constituency that demands higher benefits. Politicians dare not stand up to such strong voting blocks.
The well-intentioned attempts to fine-tune the economy into perpetual prosperity through government intervention must eventually result in a loss of control. Resources are increasingly allocated for political goals through repressive regulation, taxation, price-fixing and spending. This all must lead to inefficient utilization of our national resources, declining investment, falling productivity and a general short-circuiting of the free market system. The demands of each special interest group will be satisfied until finally the revenue system is strained beyond repair. The wealth of producing workers must be progressively confiscated to support the growing numbers of nonproductive citizens in a style that gives little incentive for getting off the government doles.
FINANCING THE GOVERNMENT INTERVENTION
It is through the financing of government intervention that most of the visible damage to the system is done. The problem begins when the government is not honest enough to tell the voter the true cost of its spending programs. Since the public wants more government services but does not want higher taxes, inflation is the only solution. Unnoticed, it pushes up tax bills even faster than prices. Corporations pay higher taxes on fictitious profits that result from inadequate depreciation and distorted inventory costs due to inflation. Under the progressive nature of personal income taxes, individuals move into higher tax brackets as their nominal income rises due to inflation. Finally, tax revenues from capital gains rise as the monetary value of property exchanged rises due to inflation. The government has used this implicit tax generously over the last few decades.
The actual process of inflating used by the government is much more sophisticated than the old printing press. Federal deficits are now monetized by selling securities to the Federal Reserve System which finds its way into new reserves for the banking system. These additional reserves are then multiplied several fold into increased money supply. Eventually, the increase in new credit in the private sector far outpaces the rise in government debt. The increase in total credit far exceeds the ability of the nation to increase the production of real goods and services and this is the only source of general price inflation. By thoroughly understanding this credit-creation process and tracking its progress, the investor can readily see the direct impact of government intervention upon the financial markets, assess its damage, and project the effects which he must protect himself against.
THE CREDIT PROCESS
If one citizen decides to postpone consumption and to loan a portion of his income for interest, there is no problem. The resources claimed by the borrower with the proceeds of the loan have been released by the saver's decision to forego current consumption. The borrower, when he repays the loan in the future, would be engaging in the act of saving that would release resources for the future consumption of the first saver. Moreover, the original saving would probably find its way into investment which would result in a higher level of production of real goods enabling both parties to enjoy a higher standard of living. This is the process of real saving and investment that enables a nation to enjoy real economic growth.
But when the Federal Reserve monetizes the government debt, credit is created out of thin air. There is no real saving to offset the increased buying power and multiple bidders for the same supply of real resources exist causing inflation. We have the situation where credit is growing faster than real GNP. Government must step in to close the gap with even more credit and the growth of debt becomes progressively higher over time. Because of the excessive credit growth, corporations and individuals become overburdened with debt. This becomes a serious deflationary force which can only be put off by the expansion of even more credit. This is exactly what the government has been doing. It has been engaging in a battle to delay the ultimate correction that must be made even while it continues to add to the problem. Additionally, corporate funds are drained off to the government through higher income taxes paid on the phantom inflation profits explained earlier. This leads to a growing demand for external funds putting further pressure upon interest rates and upon the Federal Reserve to supply more credit.
As this trend persists, the number of credit-worthy borrowers diminishes and the number of marginal borrowers unable to obtain funds in the private sector grows. This is the cue for the Federal Reserve to step in once again with the credit. As this process continues, along with the accompanying inflation, distortions of all types are caused in financial markets. Lenders leave the long side of the market and marginal borrowers are thrown upon the banking system which, as we will see, is having its own problems. Spreads between different risk levels rise. Volatility in ail financial markets rises.
As the trends continue, expectations of future inflation gradually rise. Finally, prices rise even faster than credit and if the government attempts to keep up, the danger of hyper-inflation becomes very real.
PAST CREDIT TRENDS
Having explained the nature of the credit process and dangers of a persistent trend of excessive credit growth, the next step is to examine the actual trends. There is little doubt that the nation has endured an extremely long trend of excessive credit growth and judging from the visible side-effects, we are now in a very mature stage of this secular trend.
Over the entire postwar period, the growth in government spending has exceeded the growth of the private sector by over 50 percent. This gap has indeed been financed by both public and private credit growth. During the same timespan, total credit in the economy has grown at an annual rate exceeding nine percent or 2½ times real GNP. Moreover, the pace has been accelerating strongly over the past few years: total debt surpassed the $3 trillion level in June 1974 for a record gain of $898 billion from the end of 1970. The growth in private debt comprised 82 percent of that total demonstrating that public debt stimulates an even faster rate of growth in private debt. Reducing government debt, at this point, is not enough.
Since 1970, total government and private debt rose 42.1 percent. Personal debt has increased at an annual rate of 12 percent since 1970 and now represents about 100 percent of disposable income as compared to 39 percent in 1945.
We may look at this growth of debt in many ways. An increasing share of future income must certainly be committed to liquidation of past purchases. It is doubtful whether the nation can grow at the same rate in the future given the huge borrowing from the future which has already occurred. Capital consumption is greater than capital formation which would be another reason to suspect slower economic growth ahead. The credit growth clearly reflects the cost of many years of government intervention but as mentioned above, government debt is not the only problem. Private debt is growing much faster, fed not only by the monetary inputs of the Federal Reserve but also by the false sense of confidence stimulated by the government rhetoric. It has led the private sector to excessive financial leverage in search of greater growth because of a false notion that the risk of financial mistakes was materially reduced due to the government conquest of the business cycle. The costs of the high living will be paid in the years immediately ahead. The financial damage has all been recorded on the aggregate balance sheets of corporations, individuals and banks. A closer examination of these balance sheets will demonstrate this fact.
THE CORPORATE BALANCE SHEET
The corporate sector was partially smitten by the growth cult philosophy fostered by the New Economists. Corporations learned that adding debt to the balance sheet was one grand way to leverage growth. At midyear 1974 corporate debt totaled $1.4 trillion. Relating this to profits, the debt is about 15 times after-tax profits compared to a figure of eight times in 1955. It has been rising at a 12 percent rate since 1970, even faster than the 9 percent annual rate of the entire postwar period.
The cumulative damage of all these years of financial abuse is all recorded on corporate balance sheets and is quite easy to track. The initial impact of the excessive credit growth falls upon corporate liquidity, the ability to meet short-term obligations as they come due. Corporations have suffered a massive and steady decline in liquidity over the entire postwar period. Corporate debt has also become increasingly short-term in nature. Over 70 percent of the gain in corporate debt in 1974 was short-term in nature, for example. This, of course, puts corporations increasingly at the mercy of money markets which, in turn, are becoming more volatile and unpredictable.
The liquidity deterioration is not the entire story, however. Periodically, corporations have become concerned enough by low liquidity levels to move strongly into the long-term bond markets to fund the short-term liabilities. In recent years, the fears have been magnified in credit crunches that have been coming at about four-year intervals with each worse than the previous one. Each, in turn, has been followed by record new issue calendars in the bond market. Between credit crunches, unfortunately, the fears were forgotten and the financial deterioration was allowed to resume. The result of this long process has been a serious deterioration in the entire balance sheet which, when carried to extremes, leads the corporation not merely to illiquidity but to insolvency.
A few statistics* will demonstrate the magnitude of the financial deterioration that has already taken place. Aggregate debt ratios of corporations have grown from around 25 percent in the 1950's to a figure approaching 50 percent currently. The ability of corporations to pay the interest charges on their past debt is also being seriously threatened. Earnings coverage figures (pre-tax income divided by interest costs) have deteriorated from a high over 20 in 1950 to around 2 currently. Another way to look at the same problem is debt service or the total amount of debt relative to total earnings. This ratio has worsened from about 7 percent in 1950 to over 40 percent today. In spite of the huge amount of short-term debt that has been funded, cash & equivalents/current liabilities (the best measure of liquidity) has declined from a peak exceeding $1 to a weak 18¢ at present.
Corporations have generally bought growth at the expense of safety and, while leverage is enjoyable for a while, it eventually begins to work the other way. Now, the entire corporate sector has become much more vulnerable to both the business and the credit cycle. The advanced state of financial leveraging has led to increased volatility in the entire system, higher risk levels and upward pressure upon interest rates. It represents a growing latent deflationary force that must be offset by increasingly larger doses of credit.
THE BANKING INDUSTRY
The banking system has been caught up in the same whirlwind of the performance cult and has suffered the same steady financial deterioration as the corporate sector. In fact, the entire philosophy of banking has shifted from asset management to liability management and the maximization of profits at any cost.
In earlier years, banks would take their deposits as given and structure their portfolio for optimum return commensurate with adequate liquidity and safety. When a loan was granted, a liquid asset would be sold to meet the demand. When the loan was repaid, the money would again be placed in liquid assets. Now, banks aggressively seek loans regardless of whether the funds are available. If loans are made, the funds are purchased in the form of Eurodollars, Federal funds or DC's. These funds are all very volatile and highly interest-sensitive. The ratio of purchased funds to invested assets has risen from a little over 20 percent in 1969 to around 35 percent in 1974.
Banking philosophy has also changed with regard to the nature of bank loans. Instead of concentrating on short-term, self-liquidating business loans, an increasing percentage of bank loans have longer maturities. Such innovations as term loans with variable interest rates have enabled corporations to borrow long-term funds without regard to the level of interest rates knowing that their interest costs will be "marked to the market." This, of course, dulls the natural corrective force of higher interest rates in a boom and also frustrates Federal Reserve monetary policy.
Thus, the new banking philosophy has brought a dangerous combination to the banking system. The sources of funds are short-term and highly volatile while loans have increasingly longer maturities and are substantially riskier. This combination of "borrowing short and lending long" goes against usual banking advice to clients.
Like corporations, banks must also stand ready to meet short-term obligations or sudden surprises such as large deposit withdrawals and surprising loan demand. With the increased risk described above, one would conclude that more liquidity is required. Yet, the reduction in banking liquidity over the postwar years is even more dramatic than corporate liquidity. The very liquid government securities portion of total assets, for example, has declined from over 50 percent over the postwar years to around 8 percent currently. All other traditional measures of banking liquidity have suffered similar deterioration. Banking liquidity is the first line of defense against sudden reversals of a normal business nature. As we have seen, in spite of increased risk and volatility in the system, this line of defense has been seriously weakened.
The long-term capital of the banking system is meant to be the strong second line of defense, the reserve against abnormal losses such as might occur in a depression. This too has been seriously weakened. Equity in the banking system has declined by 50 percent since 1960. This, too, is part of the new banking philosophy which aims to please shareholders instead of protecting the safety of depositors. Like corporations, banks have made generous use of financial leverage to maximize earnings per share. Liabilities were about 11 times capital in 1960 but by 1974 had exceeded 30 for the very largest banks. Indeed, liquidity and solvency are constraints under today's banking priorities rather than objectives. Bankers excuse their low capital levels by saying that government programs such as the FDIC were established to protect against abnormal losses and that the lower levels of banking capital are therefore adequate. The problem is that the FDIC can only diversify against selected bank failures not against failure of the whole system. Its reserves are only a tiny fraction of total insured deposits.
In summary, we have a banking system which has tied up an uncomfortable portion of very short-term, volatile deposits in long risky loans to a corporate sector that is highly leveraged. In recent years banks have also expanded into many new areas through the bank holding company structure and moved heavily into overseas markets where financial conditions are even worse. While all this would call for higher levels of both liquidity and longterm capital, both are at historic and dangerously low levels.
A CURRENT APPRAISAL
Despite the chaotic conditions in recent financial markets, there is a certain orderly succession of events that has been taking place for many years and is easily predictable from the underlying trends of government intervention and credit creation.
The nation may now be finishing its third major credit crunch which was predictably worse than the previous two. New records were established for interest rates, volatility and other side effects of the underlying trends. Corporate and banking liquidity reached new lows in this cycle as in previous ones. The Federal Reserve, once again, has pulled up short in its fight against inflation and has begun the credit reflation that may prevent an uncontrollable credit liquidation but will set the stage for the next record inflation and credit crunch. Banking liquidity is beginning to improve on schedule but will not improve much, remaining close enough to record lows to set new records early in any expansion.
Meanwhile, corporations are scrambling to fund the record amounts of short-term debt they incurred. Liquidity indicators are reaching new record lows but may improve as the funding progresses. Financial indicators in the long-term section of the balance sheet will set new records in the months ahead, however.
CURRENT CORPORATE FINANCIAL CONDITION
There are many signs that corporations will have a much more difficult task in funding their short-term liabilities this time around. Long-term corporate debt sales were already a record in 1974 and will reach new record levels in 1975 if the market is willing. Internal generation of funds by corporations has declined from 75 percent in the early 1960's to less than 50 percent recently. With the sharp decline in cash flows in 1975, the internal source of funds will be even lower. The high rate of inflation in recent years has also seriously drained corporate assets through higher tax payments. With interest coverage slipping even further, the market is becoming very discriminating. Rating services, which have been very active in reducing ratings recently, are very concerned about the excessive use of short-term funds by corporations. The growing gap between high and low quality bond yields demonstrates the growing awareness of the marginal financial condition of many corporations.
There is also more attention being paid to off-balance sheet debt or "hidden debt." It has been estimated, for example, that corporations held close to $90 billion of leased equipment at the end of 1974. The accounting profession will eventually make capitalization of these leases mandatory for statements. The recent pension legislation has also called attention to the unfunded pension liabilities of many corporations. Over half of all corporations are underfunded to some extent and there are some NYSE companies whose pension liability is greater than the market value of the stock. If cost-of-living clauses for pension funds proliferate, it will be difficult for many corporations to catch up. Needless to say, the accountants will not overlook this problem for long. Lenders are probably already considering the problem in their rating of the securities.
Finally, with many stocks selling far below book value, it will be difficult to use equity sales to fund the short-term debt obligations. It is safe to say that it will be some time before many corporations will be able to get out of the banks. It is difficult to see banking liquidity improving much with this in mind.
THE CURRENT INTERNATIONAL BANKING SITUATION
The Arab oil problem with its accompanying financing problems has demonstrated the international nature of our current credit problems. Europe is suffering the same decline in corporate liquidity, corporations are having trouble selling equity, the Eurobond market has dried up as investors avoided long-term bonds and bankruptcies are higher.
The investor is now more aware of the Eurodollar market and its problems. The market has grown so rapidly that many safeguards were ignored. When Eurobonds dried up, Eurodollar banks filled the gap with medium-term bank credits in large volume. Consequently, the "borrow-short-lend-long" problem is even more pronounced among Eurodollar banks and it has been further aggravated by the flow of Arab oil funds. Developing countries borrowed heavily from Euro-dollar banks with many now approaching borrowing limits. These countries have been hurt terribly by oil prices and, more recently, by declining revenues from their raw material sales. Others are dependent on remittances from workers in Northern Europe who are the first to be laid off in the recession. It would not be difficult to imagine large scale loan defaults from these countries which would reverberate through the Eurodollar markets and affect our own domestic banking system. Small and medium-sized banks are coming under more pressure in Europe where there is no such thing as a FDIC. Underlying everything is tremendous volatility in currencies raising the risk of further bank failures.
The biggest problem caused by the high oil prices is that they obscure the real problem of government-oriented inflation. An oil price hike is not inflationary. Only government can raise the general level of prices. The higher oil price has lowered the real standard of living of oil-importing countries and the sooner this is realized, the better. Instead, countries are attempting to borrow from abroad to support the old consumption levels. They are, in effect, eating into their capital. This is no different from the credit process that was described earlier, i.e., consumers are attempting to live beyond their means through the use of credit. In this regard, to the extent that recycling of Arab funds is successful, the real adjustment to higher oil prices is delayed leading to a much greater cumulative adjustment that must eventually be made. If the Arab oil cartel is inflationary it is only because it leads governments to excessive credit creation to avoid difficult real adjustments. This is no different from the government inflating of past years to avoid serious recession because of the huge debt overhang. The Arabs only accelerated a problem that was already there.
In spite of all the obvious confusion in all financial markets and the economy in recent years, the easiest prediction of all is that it will all happen again and it will be worse the next time. Knowing that monetization of government deficits lies at the root of the problems, it requires little courage to make such a prediction. In the 10 fiscal years ending 1974, the cumulative government deficit totaled $105 billion. In fiscal 1975 and 1976, according to many estimates, we have a good chance of beating that record with eight years to spare. Given the low levels of both corporate and banking liquidity, there is little choice for the Federal Reserve but to strongly reflate the economy setting the stage for record levels of inflation later. It was estimated that the government would take 80 percent of the total funds raised in 1975. Not only must the huge Federal deficits be financed but off-budget agency debt financing will remain at fairly high levels. They took 15 percent of all new capital raised in the second half of 1974, for example. The NYSE has estimated that agency debt will climb by $103 billion over the next 10 years from roughly $90 billion in 1974 which is up from only $16 billion in 1964. Sale of municipal bonds will also set a new record in 1975 following a near record in 1974.
With the mammoth Federal deficits in store, economic conditions will continue to worsen in the years immediately ahead without a doubt. Though the period may be punctuated by periods of economic recovery, seeming improvements in the inflation picture and even market rallies, the problems of recent years will reappear but each time will be worse. Real economic growth will become increasingly labored.
The steady retreat from capitalism will accelerate. The government will continue to loom most important in all economic decisions. The government's decisions will continue to be based more upon political realities rather than upon economic sense. The country is now at a very critical stage which will determine its course for many years to come. Unfortunately, it is quite obvious that we have already taken the wrong turn. The credit inflation that is implied in the announced government deficits guarantees the continuance and worsening of all the problems discussed here.
The most important point for the investor to keep in mind is that our underlying problem is progressive in nature. Increasing inputs of credit are needed to keep the huge debt overhang from being liquidated but each new input sets the stage for an even greater surge of inflation and progressive financial deterioration. As long as the rate of credit growth exceeds real production, the gap must be filled by even more credit.
We have already explained earlier how government intervention itself is progressive. There is also an inflationary bias to government stabilization policy. Whenever the government uses stimulation, it leans most heavily upon policies to increase consumption. When restraint is the objective, government policies usually serve to curb investment. The net effect is an inflationary bias. Constraints upon governments to avoid inflation are also quite small. Under floating exchange rates there is little incentive to hold spending down and with fiat currencies there is little incentive to avoid cheapening currencies. Monetary policy will also become progressively impotent. As the number of credit worthy borrowers declines and lenders become even less willing to lend longterm, any restraint attempted by the Federal Reserve will have to be abandoned quickly to avoid wholesale bankruptcies.
A SELF-ENFORCING CYCLE
At this late stage of financial deterioration, inflation will no longer provide a long period of euphoria before the costs begin to emerge. As inflation persists, the citizen becomes increasingly aware of the consequences of government credit intervention and learns how to protect himself. His growing inflation expectations add to the progressive nature of inflation. A demonstration of this problem can be seen by examining the various periods of expansion of consumer prices and intervening contractions since 1960. During each period of expansion, the rate of growth in prices was successively higher. The rate of growth was also successively higher during each intervening respite from inflation. It is even more interesting when the rate of money growth relevant to each price move (the average rate of money growth for the two years prior) is compared to the expansion in prices. In the early years, prices did not rise nearly the amount indicated by money growth demonstrating that people were fooled into holding larger cash balances than warranted. But in the last three periods, rising prices were much more closely correlated to underlying money growth indicating that people are catching on to what is happening and the lag time is shortening. The next stage will show prices rising even faster than one would have predicted from the preceding monetary growth. This is the early stage of hyperinflation.
Finally, the progressive government intervention, the growing expectations and the myriad side effects of the credit trends all interact to form a strong self-enforcing spiral that eventually gets out of control. Inflation begets credit and financial deterioration which requires government credit intervention which accelerates inflation and expectations.
We hope that investors can now see why the problem of recent years should not be treated as simply an especially bad business cycle. They should now realize that our problems are the result of an underlying secular trend of government intervention paid for by steady financial deterioration. They know that the basic problem is not only continuing but worsening. They know that the side effects will continue to worsen progressively and that financial conditions now are at the point where they dominate the business cycle. Although it is difficult to time the ending of the secular trend or the form, an investor can quite accurately project the conditions that will be present until then and take steps to protect oneself. We have listed below some of the conditions that one may project by assuming a continuation of the underlying causal trends. Although the list is not all-inclusive, it is broad enough to describe the total investment environment over the next five years or more.
REAL ECONOMIC GROWTH
Future economic growth will continue sluggish at best for the balance of the decade. The recovery from the present recession will provide a model of future recoveries. All sectors will show labored improvement due primarily to credit problems.
The consumer is already over-extended. The installment debt relative to disposable personal income is also at record levels. Delinquency rates on installment debt are the highest of the entire postwar period with the worst for this cycle still ahead. Personal bankruptcies rose as much as 50 percent over the previous year in 1974 and will set new records in 1975. Even though delinquency rates are extremely high on home mortgages, savings and loans are instituting many novel schemes to make borrowing even easier with flexible payment mortgages and other techniques reminiscent of the 1920's. The ultimate impact will be that consumers will simply be allowed to dig their credit hole a little deeper. Although consumer financial indicators may improve cyclically, they will continue to deteriorate under the twin problems of sluggish growth and high rates of inflation.
The farm sector may also be in for trouble in the years ahead. Farm debt is now at record proportions. With farm prices probably on the decline for the next several years, farmers will be in for one of their recurring cost squeezes. A reinstatement of farm support programs is inevitable.
The construction industry is a particularly ripe example of the massive distortions possible from government intervention. Through unsustainable subsidies and artificially low mortgage rates, the nation underwent a period of tremendous overbuilding relative to the financial wherewithal. Financial intermediaries have also been placed in vulnerable positions and participants in the industry have become overextended due to government rhetoric of huge building programs in the future. As a result, the very important building industry will not be able to supply support to the economy in the years immediately ahead. Total construction will remain sluggish for some years as this sector will lose out in the scramble for capital. The next swing up in the economy will be accompanied by a sharp advance in interest rates which will abort the building recovery. Moreover, the industry will suffer from a capital shortage for a number of years.
Although estimates abound for substantial capital spending through 1985, both the inclination and the capital will be insufficient to fulfill the projections. Though rhetoric is high, there seems to be little political will to reduce consumption in order to make additional capital available for investment spending.
Thus, it is difficult to see which major economic sector will lead the nation back to sustained real economic growth for some time. Among the additional projections below, will be seen more evidence supporting the thesis of lower economic growth.
The safest projections can be made regarding future government policies. The government will continue to inflate for it is inconceivable that it could find the political courage to finance the massive deficits ahead by taxation. The pressure will be great to repress the resulting price inflation, however. This means a proliferation of government controls.
Government controls will be much more repressive and extensive than in the past. The new set of controls will include capital allocation, foreign exchange controls, and wage/price controls. Because the controls will necessarily lead to substantial shortages in many areas, spot rationing and allocations will also be necessary.
Government bailouts of many corporations and banks will become common. This could stretch out the transition period but only at the expense of progressively higher rates of inflation.
State and local governments will have increasing financing problems as their tax base is impacted and investors will avoid long-term municipal bonds in greater numbers. The declining fortune of New York will cast a pall over all municipal issues. The only solution will be higher revenue-sharing payments from the Federal Government which will add to inflationary pressures.
The financial markets, of course, will continue to absorb the initial impact of continuing government intervention. The problems of recent years may simply be projected into the future with greater intensity. Private borrowers in the credit markets will be increasingly choked off by direct government financing and rising agency financing.
High interest rates will be a direct obstacle to economic growth. Interest rates will remain high for a number of reasons. Demand for credit will remain high despite high interest rates because external financing requirements of corporations will continue to grow. Government financing will continue to preempt the private borrowers. The rate of savings will remain low both by individuals and corporations as inflation expectations grow. The government will then be forced to create more money to satisfy private borrowing needs. The high inflation rates that result will keep interest rates moving even higher.
The number of uncreditworthy borrowers will accelerate and lenders will gradually learn to avoid them. Banks will be forced to bail out many corporate borrowers to keep previous loans safe. Lenders will continue to move to the short end and toward higher quality borrowers. Marginal borrowers, on the other hand, will find it increasingly difficult to fund short-term liabilities and to improve their balance sheets. The problem will be compounded by lower cash flows. With continuing low stock valuations making equity sales difficult, the only reasonable conclusion is lower planned growth for many corporations and hence for the economy as a whole. Meanwhile, the banking system cannot come to the rescue alone for they have already used up most of their leveraging power and the quality of their loans is already quite low. Banks must strengthen their own capital positions. The Federal Reserve is the only answer but any addition to bank reserves will quickly show up 'in higher price inflation. It would also lead to serious trouble among thrift institutions and other intermediaries.
Two-tiered markets will continue to be the rule in bank CD's, commercial paper and long-term bonds. Volatility in all financial markets will continue to grow. Bank loan losses will reach new records in 1975.
THE STOCK MARKET
Future stock market rallies will be aborted quickly for a number of reasons. Any improvement in stock prices will be met with huge new equity offerings by liquidity-starved corporations and secondaries from frightened insiders. Short-term interest rates will rise sharply from the trough in the early stages of any economic recovery offering a safer haven for equity money. Growing government controls will continue to worry investors. The dollar will continue weak. Corporate failures will continue to be a problem. Dividends will not expand due to lower profits. Investors will continue their growing interest in current return in contrast to the pie-in-the-sky earnings projections previously bought by investors. There can be no major stock market move without a substantial rebuilding of liquidity. But government policies and competition for funds will make this impossible. The growing fears of foreign earnings for many of our corporations will be increasingly justified. Pressure upon price-earnings multiples will continue. The institutional investor, spurred by recent pension fund rulings, will continue to shift away from equities.
As we have indicated elsewhere, corporate liquidity will continue to decline, and profits will be difficult. Hindered by government controls, growth will be restricted and bankruptcies will rise. The financial squeeze on most corporations will continue with money for high risk venture situations simply not available. Industry concentration will rise as the strong will continue to get stronger under the conditions outlined here. This, of course, is one more example of the perverse results of government planning. External financing needs required for operating needs have remained very high in the current recession relative to recessions of the past. This condition can be expected to continue and worsen. It would take years to restructure the unhealthy balance sheets existing today even under the best of conditions.
Since financial conditions are quite similar all around the world, it is easy to make many projections here as well. The huge transfer of wealth required by the oil situation makes the situation worse. The massive debt creation to finance balance-of-payment deficits will heap huge new debt upon an already overloaded system.
International crises will continue to worsen as all Western governments continue to practice patchwork economics though they be temporarily moderated by cooperative financing schemes. Developing nations will be a great potential source of financial disorder as their financial condition becomes unbearable. The ultimate result of the worldwide financial problems will be growing nationalism and protectionism as all countries work to stimulate their exports at the expense of other countries. Inflationism will continue to be the chief government tool for avoiding the ultimate correction and the retreat from all currencies will continue.
We have attempted here to provide a broad long-term framework which investors may use to understand our recent problems and to predict the likely investment environment ahead. With the recent economic convulsions still fresh in mind, the obvious negative overtones presented here probably seem quite reasonable or even obvious to many. But stock market rallies have a way of dimming the memory. We have suffered increasingly serious credit dislocations three times in recent years, each being forgotten by most investors shortly afterward. As long as the basic problem remains, we are doomed to a repeat.
After all that has been written above one might ask is there any chance of an economic recovery and stock market rally? The answer is yes. The stock market has always reacted well to credit expansion in the early stages. Given the respite from inflation in 1975 due to previous monetary constraint and the lag relationship between the credit reflation and the resulting price inflation, the climate could be quite conducive to a rally. The very sharp inventory liquidation that was underway in early 1975 will also leave room for an inventory-rebuilding bounce later in the year. But each rally in recent years was more short-lived with fewer stocks participating and risk increasing. Given this risk, very stringent selection criteria should be used for any stocks purchased keeping in mind the steadily worsening side effects of the basic underlying trend.
The more important question is what follows the rally? The economic recovery will be disappointingly sluggish except for the inventory-rebuilding bounce. The Federal Reserve will consistently underestimate the greater transfusion of new credit that will be needed to start the economy moving again. As election year approaches, the pressure to increase money growth will accelerate. The rapid money growth of 1975 will begin to show up in a rekindling of price inflation about early summer in 1976. It is then that the pressure will grow for the reimposition of wage and price controls. This could put a temporary lid on prices but it would surely blow off by 1977 when prices will begin moving up sharply to set new records before an even worse credit-crunch and recession will follow probably in 1978.
Finally, investment planning should still consider at least the outside possibility that government control of the debt structure could be lost much sooner. The huge accumulated debt can only continue if it is serviced regularly and confidence remains reasonably high. There is little ahead to inspire a quantum leap in consumer confidence and default levels are already at record levels with the worst still ahead. Since the whole world is in the same condition, the trigger to a cumulative and self-enforcing credit liquidation can come from anywhere. In early 1975, we have already had a taste of what "pushing on the string" is like with the Federal Reserve's inability to raise money growth in the face of falling loan demand.
All panics in the past have been caused by credit expansion and the subsequent liquidation. The postwar credit expansion was the longest and most extensive in history with weak balance sheets now beginning to dominate the business cycle. Eventually, inflationism will not work.
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 (Arlington House 1974).