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Combination of factors may mean very slow economic growth for some time

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  • Written by  Richard Bove, Rafferty Capital Markets, LLC
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  • Comments:   DISQUS_COMMENTS
UNconventional Wisdom is a periodic guest blog where the conventional wisdom is held up for fresh inspection. If you have some "UNconventional Wisdom" to share, email UNconventional Wisdom is a periodic guest blog where the conventional wisdom is held up for fresh inspection. If you have some "UNconventional Wisdom" to share, email [email protected]

The global economic system has too much productive capacity. Demand has simply not grown as rapidly as supply.

The financial system is burdened with too much debt. Moreover, in recent decades a great deal of the debt created was designed to stimulate financial profit and not income growth. Because income has not grown at the same pace as debt, there is not enough income in place to reduce the debt.

Banking regulators, recognizing this last problem, have put in place a series of regulations that slow the growth of debt in the banking system and redirect the debt being created away from the creation of financial profit to income creation.

In essence, the system is attempting to adjust demand with supply in both the economic and financial realms. This adjustment can be short and ugly, as was the case in housing, or it take 15 to 20 years in what would be a very slow growth economy.

Productive capacity

A simple method for making the determination that there is too much productive capacity is to assess capacity utilization in manufacturing over a series of cycles. Based on numbers provided by the Federal Reserve, which extend back to 1948, it can be seen that in virtually every cycle from the 1950s to the present, utilization has been declining.

In stock market terms, a utilization chart shows that there are lower highs and lower lows in utilization. In essence, in every cycle demand has been less and less available to make use of the available supply.

Capacity utilization

Excessive debt

One reason that so much capacity exists is because debt has grown at a very rapid pace. From 1947 to 2015, total liabilities in the U.S. have grown at the rate of 7.8% per year. The expansion in liabilities has paid for federal deficits, personal borrowing, and productive capacity expansion.

The biggest problem with the expansion of debt at this pace is that personal income has not kept up. Income has grown by 6.6% per year, versus the 7.8% cited above. The differential appears to be small but over an extended period it causes a significant gap between debt and income to develop.

For example, in 1951, debt was 1.75 times personal income based again on Federal Reserve data. In 2015, debt peaked at 4.51 times personal income.

Financial Loans at Commercial Banks

Looking at demand

If one considers personal income to be the leading source of product demand and debt repayments, these figures demonstrate a problem.

There is simply not enough income to buy the necessary products and/or pay down the excess debt.

One reason that personal income is not growing as fast as debt or productive capacity is that at some point the growth of debt was not being oriented to creating facilities that employed people and increased income; it was being directed toward the maximization of financial profit.

A very simple way to see this is to divide the amount of loans in the banking system oriented toward commercial and industrial activities by the amount of loans directed toward financial purposes. The ratio here, in 1973, based on the first available Federal Reserve numbers was 1.01%. The ratio peaked at the end of 2004 at just under 30.00%.

Financial Loans

Interestingly a book entitled Banking and the Business Cycle, by Phillips, McManus, and Nelson, written in 1934, noted a similar phenomenon following the Great Depression.

In 1921, commercial loans in the banking system were 53% of the industry’s assets. By 1929, these loans represented 36% of the industry’s assets. Loans on and investments in securities has risen from 33% to 44% in the same time frame.

Bove Chart

Now we have a conundrum

Various economists, when analyzing the seeming inability of today’s economy to grow at historic rates, have offered a series of explanations. Larry Summers believes in secular stagnation; Kenneth Rogoff sees a debt overhang; Robert Gordon sees the end of large productivity increases; Ben Bernanke writes of a savings glut; and Paul Krugman sees a liquidity trap.

Based on the numbers shown here, the two theories that seem to make the greatest sense are Rogoff’s arguments concerning the problems created by a debt overhang and Krugman’s pulling out the Keynesian theory of a liquidity trap. This latter theory basically argues that a central bank can drop interest rates as far as it wishes and it can print as much money as it wants but neither policy will help stimulate growth because there is not enough effective demand.

Regulators attempt adjustment

Regulators may have been influenced by Rogoff. They concluded that the growth of debt had to be slowed and the use of debt dollars had to be diverted from the financial to the “productive” sectors. Therefore, they put a series of regulations in place that would accomplish these goals. Note the following:

• The Basel outlines adopted by U.S. bank regulators allow the Federal Reserve:

* To heavily penalize banks that grow to sizes that the regulators deem to be systemic risks.

* Through the new risk weighting system, regulators can force assets into desired channels.

* * Banks are penalized, for example, if they lend money to businesses that the government does not like.

** They can also be penalized if they operate their businesses in a fashion that the regulators do not accept.

• The Supplementary Leverage Ratio (SLR) gives regulators even more control over the size of banks.

• The Liquidity Coverage Ratio (LCR) allows the regulators to take control of the asset side of the bank balance sheet.

* LCR requires banks to place an estimated 18% to 20% of their assets into liquid investments like Federal funds and Treasury securities.

* Through the High Quality Liquid Asset (HQLA) rule the regulators are effectively forcing the banks to buy government debt both directly and indirectly.

• The Total Loss Absorbing Capacity (TALC) regulation allows the government to take control over the funding sources of the banks.

* It requires banks to add long term debt, and

* Avoid “excessive” use of the wholesale funding markets, which the government deems to be systemically risky.

• The Net Stable Funding Ratio (NSFR) reinforces TALC by taking punitive steps toward banks that use the wholesale funding markets.

• The Living Will requires banks to establish exit strategies if the bank may be failing. This orients managements to think first about how to deal with failure and second about expanding their businesses.

• The Volcker Rule prevents banks from using their assets as they see fit.

• The Comprehensive Capital Analysis and Review (CCAR or stress test) allows the regulators to

* Determine if banks are meeting their new responsibilities, and to

* Set new more stringent requirements should the regulators see fit.

• Outside of banking supervision there is the Consumer Financial Protection Bureau (CFPB) which sets rules as to how loans should be made related to individuals and small businesses:

* The Qualified Mortgage Rules (QMR) are one example;

* The rules now being promulgated for auto loans is another; while a third is

* Rules as to how much banks can charge for selected banking services.

There may be somewhere around 200,000 people who have been put in place in the regulatory authorities and the banks to insure that the banks do as they are told. And, the banks have definitely done what they have been ordered to do.

And the results are …

Whether it is due to these regulations or the self-adjusting mechanisms in the economy and financial system itself, the data from 2009 to 2015 is encouraging. Personal income is now rising faster than debt once again. Debt has dropped from 4.40 times personal income to 4.04 times.

Total Debt

The ratio of commercial and industrial loans to financial loans in the banking system has adjusted even more rapidly. If one compares the almost 30% mark reached at the peak in 2004 to the present, the adjustment has been shocking. The commercial and industrial loan to financial loan ratio has dropped back to just under 19%.


Some considerations going forward

The growth problem facing the economy and financial system appears to be meaningfully related to the fact that there is an excessive amount of productive capacity and an excessive amount of debt.

It was demonstrated in housing in 2008, that this problem can be solved quickly by wiping away the excess capacity and defaulting upon the excess debt. This is quite painful, however.

A second route would be to force a reduction in debt creation and let the excess capacity be dealt with by normal economic forces. Bank regulation appears to be focused on this approach. This is also painful because the economy is held back from growing at historic rates and hidden unemployment remains high.

A third approach would be to stimulate demand. To this point the techniques necessary to do this have not been deployed.

Overall, this means that the U.S. economy may grow very slowly until demand and supply are equilibrated and the debt levels become more manageable.

About the author

Richard Bove is a veteran bank stock analyst and the author of Guardians of Prosperity: Why America Needs Big Banks (2013). He is vice-president, equity research, at Rafferty Capital Markets, LLC.

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