In last week’s Economist, this amazing statistic:
America, in particular, relies too much on financial firms as a source of profit growth. Since 1982, the profits of financial firms in America have risen from 4% of overall profits to more than 40%. (Neither Europe nor Japan has experienced the same phenomenon.) As a whole, the finance industry makes up nearly one-quarter of America’s overall stockmarket capitalisation, up from a bit over 5% in the 1970s. Bill Gross, a bond-market veteran, adds these numbers to soaring consumer debts to arrive at what he calls the "finance-based economy"–a perilous venture sustained by the Fed’s super-low interest rates.
Parallel to that, the Financial Times talks about the "crack cocaine of global finance"… (more below)
The FT first explains the case why not to worry, which is probably the version you are most familiar with if you follow business news at all:
The case for downplaying the…worries is, first, that the global economy is stable and growing. Much has been done to enhance the robustness of the financial system in the US…since the LTCM debacle. Banks have diversified their credit exposure…[and] have been reporting high profits for an extended period. They thus have an impressive looking cushion of capital as a defence against loss-inflicting shocks.
However, the FT is not convinced:
…banking is a cyclical business, in which the seeds of future trouble are sown precisely at times like this.
(…)
Timothy Geithner, president and chief executive of the Federal Reserve Bank of New York, in a recent speech :"Most financial crises involve a shock whose origins lie in the realm of macroeconomic policy error, often magnified by the toxic combination of poorly designed financial deregulation and an overly generous financial safety net. Probably the most important contribution policymakers can make is to avoid monetary policy mistakes and external imbalances that increase the risk of large macroeconomic shock"
Measure the US…against that template and warning lights immediately flash.
The FT then notes
- the huge fiscal and current account deficits
- the very low interest rates that "do strange things to a highly deregulated financial system" and "fuel an increase in risk appetite and leverage"
- most of the assets of US financial institutions are not subject to the regulations that apply to banks
- a growing concentration of financial assets and liabilities
- houselhold debt at a peak, both in absolute amounts (close to 10,000 billion $ – yes, that’s billion) and in relative terms (120% of disposable income, as compared to 60% in the 70s and 80s)
- the phenomenal growth of unregulated hedge funds, which banks are desperate to finance (the "crack cocaine of global finance" quip above refers to prime brokerage for hedge funds, i.e. the services that banks provide to these funds to buy and sell shares – and finance the transactions)
- finally, the amazing concetnration of derivatives, with 5 (five) banks holding more than 95% of all outstanding (84,000 billion $ at the end of september 2004) – with JP Morgan Chase aholding half of that. The FT notes that credit derivatives have never been tested in times of acute market stress and that "there is a risk that any attempt[by the 5 banks] to reduce their exposure in the face of shock could magnify rather than diminish the shock".
The FT concludes: "Far too little is known about the risks that are being run".
As the Economist notes in the article linked to above, one of the reason for high profits is that companies have a tendency to overstate their profits by having, once in a while, a "horrible year" with whopping losses which allows to show good results in subsequent years:
…firms consistently overstate reported profitability. They tend to punctuate periods of oddly rapid growth with occasionally awful years of massive write-offs: admissions, in other words, that past profits were overstated. In 1989-2004, says Goldman Sachs, write-offs among the firms included in the S&P 500 index tended to fluctuate between 5% and 15% of total reported earnings per share (EPS) each year. But there were two notable exceptions: in 1991-93, write-offs rose to 30% or more of reported EPS, setting the conditions for lots of weirdly quick profit growth later in that decade. In 2002, write-offs soared to an astonishing 140% of EPS.
So:
- the one bright spot in the US economy is the record profits of its corporations;
- these are subject to accounting tricks, even today;
- additionally, an amazingly high portion of these profits come from financial firms, who seem to be making these by taking advantage of very low interest rates to take growing risks, especially in lending to hedging funds and buying untested derivatives.
With interest rates on their way up, big macroeconomic imbalances in the US economy (record debt, record deficit, record current account deficit) and the probability of outside shocks (oil, dollar, terrorism, tension with Iran, Middle East, etc…) quite high, the probability that a serious crisis could be triggered – and amplified by the financial system – is worringly high. Add in a financial sector in denial (we have big profits, why worry?), an administration oblivious to the situation and most likely unable to react, and you have a lot of ingredients for a "perfect storm".