An Economy Wrecked By Ivy League Ph.Ds

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The symbol of American industriousness in the days before finance took over was the industrial conglomerate. Power and money were to be had in the creation or evolution of productive behemoths; the Carnegies, the Rockefellers that built vast empires of sprawling commerce. Efficiency was certainly prized, but it was often overcome by the idea of risk and a sort of economic entropy. For the industrialist, there were always riches to be had in another place, never content to sit inside a cocoon of even well-earned and profitable laurels.

Part of that impulse toward expansion without a readily discernable direction was led by the knowledge that nothing was permanent. Even the best-run, most stable company had anexpiration. The world, and the industrial economy, was too dynamic to allow such comfort and stasis. And the American economy turned robustly to such businesses as they performed not just expansion, but raising the living standards of our society and nations all across the globe.

One such outfit was the Gulf and Western Industries conglomerate. Starting out modestly, as these gazelles typically do, in this case as the Michigan Bumper Company in 1934, most people probably have a passing idea of the eventual conglomerate through its purchase of Paramount Pictures in 1966. A few years later, Gulf and Western bought Associates First Capital Corporation.

In July 1989, Gulf and Western, now known as Paramount Communications, sold Associates First to Ford Motor Company for $3.35 billion in cash. That was a huge acquisition in those days, ranking among the giants of the decade. Paramount wanted to focus exclusively on developing its media brands and to target its resources in that direction. Ford Motor wanted to engage in the growing trend of consumer finance.

By the end of the 1990's, Associates First had been developed into a hot commodity. Though it was still a little known portion of the overall financial spectrum, there was interest growing in the retail potential of further developing the consumer lending business. So in September 2000, Citigroup enticed Ford to part with the business for about $31 billion in an all-stock transaction. Stock bubble indeed.

The key to unlocking such fortunes for Ford, at least as it seemed before Citigroup's stock value declined in our first major asset bust, lay in the interpretation of banking law in the 1970's. While the regulatory framework that supported the traditional banking system was largely an outgrowth of Great Depression statutory tinkering, banking itself was evolving with technology and global reach. A bank used to be a bank by sole virtue of its charter - a piece of legal paper from a state or duly appointed federal agency that stated, in no uncertain terms, that you were a bank.

In 1956, Congress passed the Bank Holding Company Act. Bank holding companies were a relatively new invention, with Marine Bancorporation in 1927 as the first independently capitalized holding company in Seattle. The intent of the 1956 Act was to allow the innovation to proceed but to maintain the prohibitions and decentralizations that were judged necessary to prevent the next Great Depression. The best way to remove systemic risk, as it was believed, was to not allow its inception.

The 1956 Act would permit bank holding companies to operate, intending on regulating their expansion by requiring petition to the Federal Reserve by any company wishing to own a bank. There would be a prohibition, akin to Glass-Steagall, that limited the holding company from participating in "non-banking" activities. Further, bank holding companies in one state were prohibited from acquiring banks or branches in other states.

So rather than the "charter test" determining what was a bank and what was not, the Federal Reserve would use Regulation Y to make such determinations. The Bank Holding Company Act defined Regulation Y rules as any institution that accepts deposits that the depositor has a legal right to withdraw and engages in the business of making commercial loans. The key to the entire regulatory framework was the word "and."

There had been numerous challenges to Regulation Y over the years, and some succeeded in narrowing the definition of "commercial loans." However, it was First Associates, then part of Gulf and Western, in 1980 that would unleash the fury of one pillar of financialization. The company proposed, without petition to the Federal Reserve, to buy Fidelity National Bank of Concord, California. The idea was to take advantage of the wording in the Bank Holding Company Act regulations under Regulation Y by using the literal definition of a bank. That meant, under the statute, a bank had to do both, take in deposits and make commercial loans (the word "and"). Associates First reasoned that if they divested the commercial loan part of Fidelity National, it would fall outside the definition of a bank.

However, since Associates First was interested in the bank's retail branch system it was obliged to notify the Comptroller of the Currency, C. Todd Conover, under the Change in Bank Control Act. In August 1980, Conover notified Associates First and Gulf and Western that he would not object to the merger under the same legal interpretation of the word "and." The nonbank bank was born and accepted into legal precedence.

In 1982, Conover was again petitioned for nonbank approval for acquisitions of erstwhile chartered banks by the retailer Sears and mutual fund company Dreyfus. Both were approved.

But the regulatory quagmire did not end; it only intensified. The gauntlet had been thrown down in the race toward interstate banking. Sears, of all companies, was actually in the forefront of that charge. In March 1985, Sears Chairman Edward Telling told an audience at the Economic Club in Detroit that Congress needed to move quickly to harmonize the state of banking evolution and bring regulations, "up to date with the needs of the American consumer by permitting wider competition in the banking field."

Telling admonished Congress as, "wasting time calling each other names, trying to define what is and isn't a loophole." His advocacy at that time was meant to push nonbank acceptance under federal jurisdiction, thereby creating and clearing a path toward truly national and interstate banking. And it was Telling's intention to make Sears the leader in consumer financialism, as the company had not only purchased a Delaware bank (the nonbank bank), but also a brokerage firm and real estate service company. In doing so, the retailer had opened 300 financial service centers in its stores to sell financial "products", including insurance through its Allstate subsidiary.

For some reason, there was suddenly "gold" in financial services. When Paramount sold Associates First to Ford, it was at the time responsible for about half of the conglomerate's profits. Paramount was more of a financial firm than industrial or media conglomerate, just as Sears grew into the same role rather than just a retailer.

In December 1980, there were 14,391 banks operating in the US. Of those, 4,942 were controlled by 2,860 bank holding companies - an ownership rate of about 34%. Just five years later, the number of banks had declined very slightly to 14,216 banks; of which 9,182 were now owned by 5,913 bank holding companies - an ownership rate of just under 65%. So both the ownership rate and the number of bank holding companies doubled as the "and" loophole allowed evolution in banking to progress.

By the time Citigroup was incorporating its Associates First purchase in 2000, there were only 8,166 banks left in the US, 80% owned by bank holding companies. Just before the housing bubble burst, the number of banks fell further to 7,161; 84% of those controlled by bank holding companies.

In light of those statistics, Telling's admonishments over competition seem somewhat disingenuous. The advent of interstate banking had not increased competition, but opened the door for systemic creations. Banks got bigger and moved further into the evolutionary processes that were migrating out of depository institutioning. It could not have come at a "better" time, merging fully with the monetary system's basis transformation toward wholesale money and the eurodollar standard. It was the perfect storm of financial confluences.

But in revisiting that maelstrom and confusion of transitions, there is little thought given to anything beyond the re-emergence of systemic risk. The now-inevitable road to Gramm-Leach-Bliley gained significant traction in those nonbank creations of the early 1980's, and that is undoubtedly an important discussion, but lacking here is any appreciation for why so many erstwhile non-financial firms were seeking, desperately, to gain a foothold (or even overhaul their own business plans) in financial services.

There is a macro-economic angle to this development that is only being explored now in the interest of orthodox economists groping for an explanation for the current failure of orthodox prescriptions. Larry Summers gave this testament full endorsement just recently with his suggestion that the natural rate of interest may in fact be negative at this juncture. The implications of that are asset bubbles - meaning, in Summers' summation, that asset bubbles are not the intent of monetary policy but the inevitable ends to it given the economic landscape.

Paul Krugman found his way to the same kind of conclusion, or at least a tacit acceptance of the premise, writing that,

"So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers's answer is that we may be an economy that needs bubbles just to achieve something near full employment - that in the absence of bubbles the economy has a negative natural rate of interest. And this hasn't just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s."

But it wasn't just the recognition of bubbles since the 1980's; it was the advent of the debt-based economy. Krugman further asserts,

"There was a sharp increase in the ratio [debt] after World War II, but from a low base, as families moved to the suburbs and all that. Then there were about 25 years of rough stability, from 1960 to around 1985. After that, however, household debt rose rapidly and inexorably, until the crisis struck."

The year 1985 appears over and over again, in both recounting the evolution of banking and in the data that accompanies it. It was the year that banking took an evolutionary step, that monetary policy aimed to destroy Japanese competition, that eurodollars stopped being a mechanism for trade and became fuel for global dollar-denominated debt saturation.

At the heart of the argument Summers and Krugman are making is that there is something wrong with the US economy in that period, and that policy can only do what the textbooks say. Following that to its inevitable end, we get this idea that we might have to accept a bubble-based economy or suffer multitudes of disaster and malaise. There is no forward momentum or surge without the monetary intrusion.

This conclusion simply rearranges causes and effects. Again, going back to the early 1980's, is it not more likely that the malfunctioning, bubble economy of negative real interest rates was due to this trend of every kind of industry and business suddenly gaining intense desire to enter finance? From Gulf and Western to Sears, and all manner of businesses in between, there was a discernable and even obvious trend to give up on the age-old concept of business dynamism through productive enterprise, succumbing instead to the sudden appearance and lure of easy debt.

In terms of the macro-economy again, any negative real interest rate is simply the recognition of decades of wasted resources pouring into erstwhile nonproductive uses. Such a negative rate would signal that the orientation of the margins of the economy is not profitable - as if that is a revelation given recent history. That seems to be the lesson in the construction industry, as it was in the IT and telecom industries of the late 1990's.

Knut Wicksell, the Swedish economist that first suggested the natural rate of interest, wrote in 1898 in his seminal book Interest and Prices that, "Easier credit sets up a tendency for production (and trade in general) to expand; but this does not in any way imply that production will in fact increase." In other words, the allure of new money is not always sated in real economic progress. It is just as easy, if not moreso, that the drastic expansion of credit might be unproductive in its effects on prices. And, as we know, the evolution of banks and banking meant that prices were more than consumer in nature; assets gain favor under easy debt as well, swelling at times to bubbles.

A financial economy of this nature, to be cute, consumes itself. The inattention to productive innovation in favor of resources dedicated to financialization is a real cost to future growth. The Summers interpretation is that some "exogenous" shock has reduced the long-term growth rate of the economy to such a point that long-term real rate of interest on safe assets is negative. Do we really have to wonder what that "shock" might have been since the early 1970's?

Further, negative natural interest rates imply that we should expect negative growth. That pretty much sums up the state of affairs after massive asset bubbles created by debt. However, we should be clear here that any negative interest rate (regardless of whether Summers' hypothesis is actually valid) is not "natural." The intrusion of soft central planning into interest rate mechanisms invalidates that idea on its face. The natural rate of interest in any economy will always be positive, and therefore any "tendency" toward negative rates is, in my mind, a conclusive pathology of that interference.

What the Summers' supposition really is, is a convoluted attempt to explain what is otherwise obvious on its face outside of the orthodox of mainstream economics. When Sears sets out to become the largest financial services firm in history, only to be outdone by Gulf and Western and Ford, then economic orientation is seriously misdirected and misplaced. And it traces back to the idea that the PhD's from Ivy League schools can readily replace a hard anchor to banking and money. As we know, that is the founding legacy of the Federal Reserve and its place in orthodoxy.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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