Blindness About the Weak U.S. Economy Is Itself Blinding

Blindness About the Weak U.S. Economy Is Itself Blinding
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We live in an age of zombies. In cultural terms, they are everywhere from the movie theater and television to the popular imagination. It’s been entirely fascinating to watch the increasing fascination, and then contemplate on another level what that might say about the zeitgeist. The Walking Dead as a monetary parable?

Late February in 2009 wasn’t a great time to be Chairman of the Federal Reserve. Let’s just concede that Ben Bernanke was a busy guy, most of which had to do with what he had done in that job up to that point. In reality, it should have been much harder for the former Princeton professor, given where things were going on his watch, but at that moment there was little mood for directing blame and pointing fingers.

Everyone wanted Bernanke to be the hero. Though he might have screwed up badly to that point he was, many if not most believed, the world’s best hope for it not getting any worse. Facing the prospects of Great Depression 2.0, charity born out of desperation was on the official agenda. It became something of an after-the-fact agreement, as if the Fed Chair was given, despite so much economic carnage, a mulligan, a do-over.

On February 24 that year, Bernanke was called to Congress, as all Chairmen are during their time, for the first of the regular twice-yearly Humphrey Hawkins charade. Alan Greenspan had made a mockery of this last remnant of the Full Employment and Balanced Growth Act of 1978, the law created during the worst of the central bank’s prior screw ups. It was Greenspan who had become famous for, and celebrated a great deal about, what became known as fedspeak.

Bernanke amidst the last stage of financial panic had left for himself no such luxury. He had to be straightforward in that time, an unusual predicament for the Fed and its high officials. Failure really was an option.

His message to Congress was plain. It had to be given the circumstances. Fix the banks, fix the economy he said. Calling it “black and white”, Bernanke asserted:

“If there is one message that I'd like to leave you with, if we're going to have a strong recovery, it has got to be on the back of a stabilization of the financial system.”

Not doing so, the Fed Chair warned, risked a situation where, “we’re going to flounder for some time.” And then he was asked about the zombies.

The issue for Congress at that moment was nationalization. It was a serious, serious step in need of careful consideration. Everything that had been done up until that point had failed to quell the massive global run. Despite ZIRP, TARP, QE, and a whole host of other acronyms, they were still talking about government takeovers in Europe and now were doing so here in America almost two full months into 2009 – six months after full panic first erupted in September 2008, and just about two years since Bernanke had claimed subprime was contained.

Senator Bob Corker pointed the Fed Chair’s attention to that potential scenario, especially since everyone was in late February still stuck on Citigroup.  Worse, they really didn’t know why, so here these poor Congressmen were left to quiz the top central banker about a subject so unfamiliar especially to the American psyche they had to import well-worn terminology from popular culture.

"It seems to me that this has been creating this sort of dead man walking, sort of zombie like, banking scenario. While I have been not using these words out around, it seems to me that what you have explained is a creeping, a creeping nationalism of our banks.”

No, assured Bernanke. “I think zombie was not an appropriate description for any of the banks," including, clearly, Citi. They all had, in the Chair’s esteemed estimation, “substantial franchise value, they’re all lending, they’re all active, they have substantial international franchises.”

The idea of zombies in banking was not, of course, original to the United States situation in 2009. The term was first applied fifteen or so years before to their Japanese counterparts.

We should probably take a moment here first to define our terms. What is a zombie bank?

There are a couple of definitions, but the conventional standard is where the government (of whatever country) keeps alive an otherwise failing concern for largely non-economic purposes, and for whatever actual economic purposes more so fall in line of fearing worse consequences from letting the firm(s) die off.  That’s what Senator Corker was getting at, hoping that it wouldn’t ever come to that.

Indeed, that was largely Japan’s pitiful starting position and the one in which Bernanke was attempting to address in the negative. That might be his own corollary to Japan’s zombie problem, meaning that “substantial franchise value” was a specific trait not found in any zombies. But why should that mean what the Fed Chairman claims it did?

In the Walking Dead franchise, it is perhaps appropriate or instructive that they never really say what started the Zombie Apocalypse, nor was it ever specified (in the TV show version, it may have in the comics) how it works on human beings keeping them in an undead state. The idea broadly speaking is pretty simple, as whatever and however zombies are and act they take up resources (eating living flesh) and generally create end-of-world type havoc.

That’s a pretty fair characterization of Japan’s banking system particularly in the nineties (it hasn’t been much better in the 21st century). To account for zombie banks, the Bank of Japan believed it was left no other choice than to become hyperactive in response. There was no single program or combination of policies, however, that would do the trick and turn zombies back into productive firms and therefore produce sustainable and meaningful economic growth. Japan’s economy has remained largely undead-like for going on three decades now.

The second part in the United States was easy enough to diagnose even as early as February 2009. The Fed had come to take on an enormous role. Even though it hadn’t had any success since the onset of the crisis, ignoring and downplaying it for months at first, by 2009 most people just wanted to believe they had come to figure it all out. Better late than never.

That’s not what happened, of course, as that’s never what happens. Like the Bank of Japan, the Fed sunk itself deeper and deeper into the morass, first with a second QE, then a third and a fourth.  It was followed by overactive central banks practically everywhere, including, no surprise, the Bank of Japan who proceeded with seven more QE’s up until QQE (and then QQE 2, and today QQE 2 with YCC) from late 2008 forward.

Hyperactive central banks were and are easy to spot, but what about the banks?

If we think first about currencies in a fixed exchange system that are overvalued, the phenomenon that follow are typically associated with hyperactive central banks. A currency par value set above market supported levels usually means that whichever central bank (often in combination with others) will have to use up an inordinate amount of foreign reserves defending its high-priced, badly set parity.

It was this very situation that Winston Churchill created for the UK in 1925. Bringing Britain back onto the gold standard was uncontroversial, but doing so at the historical price that had existed from Isaac Newton to the outbreak of WWI was just too much of a burden. The result was not just a flurry of Bank of England actions, but also those of the Swiss National Bank as well as the Federal Reserve (and, to say the least, the various money center banks operating in NYC on behalf of other foreign interests official and otherwise).

It didn’t work because ultimately it couldn’t. Overvalue is overvalue, the original sin, if you will, in trying to shoot for a goal that isn’t realistic – and then being left to deal with consequences as you get sucked in further and further the longer you hold onto it.

That brings us back to Ben Bernanke in February 2009 extolling the grand basis for recovery – the “substantial franchise value” that in his mind made all the difference between US firms in operation and the Japanese zombies of the 1990’s; between successful and unsuccessful monetary policy, designed to assure their avoiding the latter’s fate down the road; between full and complete economic recovery and the other option too dark and chaotic to even contemplate.

Very simply, franchise value was Wall Street doing Wall Street things, money to be made, profits to be had, so much of them that given the chance these firms would do them all again at the drop of a hat. QE was, in essence, Bernanke’s chance to drop that hat and let them be free to live again, for which he was sure they would (if more discerning this time around).

JP Morgan had been using the term “fortress balance sheet” almost from the time Chairman Bernanke was before Congress outright dismissing the idea of zombie American banks. I can’t find exactly when the firm’s CEO Jamie Dimon first used the phrase, but the label and the idea behind it became ingrained in that particular bank’s operations. In mid-July 2011, for example, just two weeks before the general outbreak of serious liquidity problems globally, Dimon defended $3.5 billion in Q2 2011 buybacks because they had, “maintained our fortress balance sheet.”

The term has proved successful, and you can’t deny that JPM’s balance sheet is anything other than a fortress – but that’s the point. In its quarterly earnings presentation released just this week, JPM still refers to its “fortress balance sheet” which is entirely at odds with the idea of recovery (why do they still need a fortress if things have been so good for years now?) as well as what Bernanke believed should drive that firm’s franchise value.

To end 2017, JP Morgan says it’s fortress totaled $2.5 trillion in assets. When Dimon was talking about it in 2011, the bank reported $2.3 trillion in assets. To close out 2008, JPM held $2.2 trillion.

This was, obviously, a stark departure from the bank’s prior operating paradigm. It had begun the 21st century as JP Morgan Chase with fewer than $400 billion in assets. Rapid growth predominated, through organic wholesale efforts as well as frenzied merger deals, up until late 2007 you got bigger at any cost. That’s what banks did.

JPM was and is no outlier. All the major firms on Wall Street and beyond trace the same pattern in their quarterly filings. Parabolic growth is observed for all of them – until 2007 or 2008. What has followed afterward has been a curious sideways condition, almost like a once vibrantly beating heart was stopped and never truly revived. It is the pattern of the undead, the zombie.

Goldman Sachs ended 1999 with $250 billion assets and then built up its balance sheet to more than $1.1 trillion to end 2007. It reported this week $917 billion in total assets ten years on. Bank of America had $632 billion in assets to begin the year 2000, got to $1.8 trillion before it absorbed Merrill Lynch, putting it over $2.3 trillion for the quarter of Bernanke’s zombie protestations. As of the just-released numbers for Q4 2017, total assets are $2.3 trillion.

On and on it goes. We are left to conclude, unequivocally, that Ben Bernanke was absolutely right in 2009, and at the same time absolutely wrong.

He was correct in figuring that without a healthy banking sector there would be no recovery. The figures quoted just above show that the banking sector isn’t healthy today, and you can plot any economic series you like on a long-term chart and easily observe that the economy has likewise never recovered. Time doesn’t factor except now as the primary cost of that failure.

Thus, what Bernanke failed to appreciate was, in fact, the nature of zombies, at least so far as the idea applies to banks (for all I know he may be a big comic book fan and beat everyone to the Walking Deadbefore AMC executives picked it up). The key component, as it turns out, was never government intervention except insofar as that intervention signals the fact they are already zombified. In other words, government action isn’t the cause but an attempt to treat the previously infected. 

Even Citigroup has long since been removed of the largest bailout in American history; the result of which has been its own version of a fortress portfolio for all the trouble. The bank reported $1.9 trillion in total assets at the end of 2008, down from $2.2 trillion at the end of 2007, and now $1.8 trillion to end 2017.

To compensate for gravely overvaluing “substantial franchise value”, Ben Bernanke’s remaining tenure will be remembered for hyperactivity that ultimately didn’t work (and set off a chain of similar measures around the world).  He used the Fed’s resources in a futile gesture to sustain that theoretical value almost in the same manner as the Fed colluded with the Bank of England in the second half of the twenties.

If the pathology of these zombies doesn’t follow from government bailouts and constant support, where do they come from?

Franchise value for a bank, for any firm, isn’t derived from what it could do, though straight-line extrapolation is the prevalent form of estimating these things in the future, rather from what it can continue to do. That’s ultimately the big problem, the lack of recognition that what started in 2007 wasn’t some temporary setback, an actual recession. It was a paradigm shift that really should have been apparent very early on (had, of course, economists not stopped taking any interest in the global monetary plumbing decades before).

Again, for banks it was all riskless returns as far as their eye could see, especially in prop trading. A good part of that view was actually derived from the myths pervading Alan Greenspan’s later terms; that the Fed would come to the immediate rescue of the system should any firm get itself into trouble and jeopardize more than its own operations.  Though Alan Greenspan asked the FOMC to contemplate in June 2003 whether that was actually true, the belief would go untested until 2007. That was their franchise value, based in large part on the so-called Greenspan put.

After 2008 (and 2011), the banking system realized it needed instead “fortress balance sheets” because, among other things, there was no Greenspan put. Amounting to mere legend, it didn’t do anyone any good in the depths of crisis because legends aren’t often real. Bernanke spent the balance of his tenure actually proving it. The Fed had, starting in 2007, constantly undermined the perceived franchise value of not just Wall Street but really all global banks operating in the same way.

But we are conditioned to think about monetary policy only from the positive perspective; it of “stimulus” and economic aid. It can, in fact, prove to be highly caustic, particularly when used, as in Japan, to instead disprove the foundations of the prior paradigm. As I have written constantly, if you have to do QE twice, or more than twice, it didn’t work. Worse, you’ve actually confirmed that it didn’t work not just to the public but also to those on the inside.  It may even advertise that as a central banker purportedly central to everything and everyone you really don’t know what you are doing.

Trust is and has always been the essential part of any monetary system. Hyperinflation, for example, is never really about literal money printing so much as it stems from thoroughly abused trust (to be clear, I’m not saying we are on the road to hyperinflation). It is a huge component of any bank’s franchise value, and its increasing absence the central point of infection breeding financial zombies. I hope Jerome Powell understands Bernanke, both good and bad, as he gets set to take over at the central bank (there are no indications he does).

Nobody really cares at this moment, because so many are convinced the economy is booming again, or at least on the cusp of doing so (yield curve, of course, begs to differ). The blindness is itself blinding, the recency bias that inhabits so many chapters of all good horror stories. Fix the banking system, which is the monetary system in a credit-based regime, fix the economy. Monetary growth is energy and life; lack of growth is the proliferation of the undead where 3% GDP is counted as achievement rather than scorn and alarm. It’s an explosion of zombies (and not just in the financial sector, as the BIS recently explored at a conference in Paris), where at the end of it waits only Negan…and Lucille.

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

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