River Twice president Zachary Karabell penned a compelling op-ed for the WSJ today. Some important passages follow (emphases added), and those who follow our writings should hear some familiar themes.
First, Karabell observes that the U.S. now risks following a path similar to Great Britain’s in the 20th century, something we termed ‘Superpower Past Tense’ in 2006, and an outcome that seems more likely to us now than it did then:
In 1945…the United Kingdom emerged militarily victorious only to see itself economically exhausted…unable to find capital and on the verge of collapse. It had nowhere to turn but the U.S….The U.S. is not yet in the position of Great Britain, and our creditors in China are not yet as we were then. But absent a more humble and realistic attitude toward capital in Washington, that is the path we’re headed down…
Second, he observes that the 1970s were a period of relative decline, especially in manufacturing, due to anti-competitive practices and a suboptimal policy mix (which in our view, along with other factors, accelerated the social breakdown of some regions and communities of the U.S.):
What is happening to finance today is similar to what happened to manufacturing beginning in the 1970s…Germany and Japan began to exert themselves as manufacturing titans. So did Taiwan, Singapore, Korea and others…
Karabell doesn’t refer to this explicitly, but we believe it’s critical to understand the role that the domestic policy mix played in accelerating the loss of manufacturing in the 1970s–uncompetitive taxes, tariffs and regulations combined with easier monetary policy were the wrong way to deal with the crisis then, and are the wrong way to deal with the financial crisis now–though we clearly appear to be headed in that direction.
Third, he observes that the financial world is becoming increasingly less U.S.-centric:
Few major deals were brokered without involvement from a U.S. bank or access to Wall Street financing. That is now at an end…for two reasons. One is structural. There are now vibrant economies that don’t depend on the U.S., are not heavily levered, and have a burgeoning…middle class. But is is also at an end because those newly affluent regions of the world do not find the U.S. a welcoming home for capital…
Fourth, Karabell articulates why he believes this is happening:
Uncertain growth for the United States is one reason. But the nature of the American regulatory regime is also to blame. Sarbanes-Oxley and the Patriot Act…combined with a tax code that places a heavy burden on corporations doing business in the U.S. has meant that…there is less and less inclination…to place…capital in the U.S.
In addition, the regulatory requirements of listing a company in the U.S. have led many companies to look to other markets and other exchanges for financing, hence the boom of financial centers such as Hong Kong, Dubai, and even London…
And finally, he observes what this means for policymakers, where we appear to be headed, and what we must do to change course:
…The U.S. government can no longer dictate to global capital. Once, when the U.S. was the engine of global growth, when the world needed Wall Street for funding, capital could be taxed and controlled by the fiat of the U.S. government…
The current debate in Washington gives no indication that this reality is understood. Both sides of the aisle are susceptible to a false sense of American economic sovereignty…[when] in reality there is increasingly less inclination and less need for the world to go either to Wall Street or to Main Street…the crisis hitting Wall Street is leading the rest of the world to form bonds that bypass the U.S.
…we must understand…that attempts to unilaterally force capital to stay here will only lead to its continued flight…A more secure domestic capital base depends on the U.S. being seen as a desirable place for investment…
OK, not officially. Instead, the Federal Reserve has begun paying interest on excess reserves that banks have on deposit with it. But that has a real impact on the cost (and existing supply) of money, and based on recent money market and inflation data, the cost of money is as low as it has been since the 1970s. Here’s how we arrive at that conclusion:
The Fed announced that it will now begin paying interest on banks’ reserves at a rate of 75 basis points below its fed funds rate target. Today, that equates to interest of 1.25% (2% – 0.75%= 1.25%), and can thus be viewed as a 125-basis point cut in its nominal rate target (banks can borrow from the Fed at 2%, and lend to the Fed at 1.25%, for a net funds rate of 0.75%).
However, it’s important to look at the effective fed funds rate, which is the actual market price of money, based on the Fed’s attempts (or lack thereof) to keep the interbank rate close to its nominal target. The effective fed funds rate as of October 3rd was 1.10%; on October 2nd it was as low as 0.67%. The fact that the effective funds rate is well below the Fed’s target of 2% indicates that (a) banks have excess liquidity but are keeping it on deposit with the Fed rather than creating new credit or lending to other banks, and (b) the Fed is unwilling to extinguish excess monetary reserves under current financial and economic conditions. Using the lower effective rates of last week, an interest payment of 125-basis points against an effective fed funds rate of 0.67% or 1.10% would equate to an effective funds rate between -0.58% and -0.15% (0.67% – 1.25% = -0.58%, and 1.10% – 1.25% = -0.15%).
Furthermore, those are only effective nominal rates, unadjusted for inflation. Although recent market indicators show that the level of inflation is expected to fall, perhaps to a range as low as 1.0-1.5%***, the effective funds rate is still below zero. Conservatively, the real effective cost of money could be -0.25% (2% fed funds, minus 1.25% interest, minus 1% inflation = -0.25%). More aggressively, it could be as low as -1.15% (1.10% effective funds rate, minus 1.25% interest, minus 1% inflation = -1.15%). And if our prediction of long term inflation in the neighborhood of 3% or more is accurate, then the real effective cost of funds could be as low as -2.25% to -3.15%. And as we’ve pointed out previously, a negative cost of money is territory that the Fed has only visited twice in the last thirty years: during the 1970s, and in the prior Fed easing cycle. Granted, if inflation rates fall to zero or less, then the Fed’s current stance could turn out to be appropriate–but only if it stands ready to reel in a good deal of liquidity, once the velocity of money picks back up.
*** For example, subtract the current yield on 10-year Treasury Inflation Indexed Securities from the current yield on 10-year Treasury notes (Bloomberg and other websites update this information daily).