Is This Time Any Different?
Life hasn’t quite been the same since sometime in 2008 (some know-it-alls observe that change really began in 2006 and certainly 2007). Whatever! For most of us who have been waiting out the not too subtle pains of “the Great Recession”, our day to day personal and professional lives seem to have warped into a galaxy far away from our previous experience of the last decade or two. Not quite a world turned upside down, but definitely a professional environment different in tone, priorities, emotion, resources available and perspectives of participants. The question we pose in this issue is what best explains what has happened, what is happening, and what is likely to happen. This article first appeared in January 2011 and has been edited and updated for this issue.
An excellent starting point for regaining one’s professional perspective is to increase our altitude to 40,000 feet so we can sense the prevailing direction of the various jet streams which propel our macroeconomic environment and set the tone, if not compel the day to day practice of those of us who labor in America’s states, regions and communities. Accordingly, we respond to our introductory question by focusing on an explanatory paradigm, “the New Normal”, which has achieved, if consensus is too expansive a word, prominence in the world of global finance. The principal author associated with the New Normal is Mohamed El-Erian, CEO of America’s largest asset manager, PIMCO (Newport Beach, California).
El-Erian, a former IMF economist, banker/analyst, Harvard endowment CIO, and now perhaps the dominant commentator of contemporary international finance, developed and announced his concept as early as 2008 in his award winning book When Markets Collide (McGraw-Hill, New York, 2008). He has since fleshed out his original concept, the New Secular Reality, in response to the events and consequences associated with our infamous Great Recession, and by June of 2009 developed a model which has arguably held up extraordinarily well to the present. The New Secular Reality has been renamed, the New Normal, and its impact and influence today is pervasive, deep, and approaching what I, at least, think is a consensus in the global finance.
To our best knowledge, the New Normal is mostly a “virtual” paradigm in that there is no one single article or publication which contains it all. We draw heavily on a series of copyrighted investment letters found on the PIMCO web site, newspaper, magazine, and broadcast interviews (especially on CNBC) which have reiterated and translated the theory into specific predictions, explanations, and policy prescriptions/commentary.
To really regain one’s footing in this new environment, however, the editor believes it best to concentrate on the core, platform, assumptions and drivers which constitute the foundation principles of the New Normal. We are less concerned in this review with why/why not QE2 will work/ not work, than with what the heck is going on out there and what does it mean to our current and future economic development strategies, tools and policy priorities. To this end, our second review in this issue will focus on specific strategy and policy reactions by several entities and communities and observe/comment upon their adjustment to the Great Recession and the New Normal.
Why Are We in the New Normal?
There is a “fundamental realignment of global economic power and influence” away from the developed nations, principally the USA, toward the newly developing, previously without “any systemic influence” nations such as China and India.
The editor suspects the most uncomfortable aspect most Americans will have with the New Normal is its foundation assumption: there is a “fundamental realignment of global economic power and influence” away from the developed nations, principally the USA, toward the newly developing, previously without “any systemic influence” nations such as China and India. The world is indeed turning upside down: the South (developing nations) is beginning to overtake economically the North (developed nations).
Because of the “pronounced accumulation of financial wealth by a set of countries … that were previously more used to being debtors and borrowers than creditors and investors”. The Developing nations are now capital rich.
Because the formerly powerful, previously lending, nations (USA, et al) had relied over an extended period of time on debt to mask the reality they were spending/consuming more than they produced or earned. The major source of developed nation’s debt financing was the export fueled economies of the developing nations (think of Saudi oil sheiks, Chinese manufacturers, and Indian outsourcing firms). The wealth accumulated through export allowed vast amounts of developed nation dollars to flow to the central banks of developing nations. In turn the developing nations formed nationally-owned investment banks called sovereign funds. These sovereign funds returned/reinvested the profits derived from exports to the original developed nation in the form of purchase of treasuries (federal deficit) and mortgage debt from the decade’s long housing boom in USA, Ireland and England.
This worked more or less well through the ‘90s and early 2000s but all good things come to an end.
In case you missed it, the last years of this fantastic debt/consumption boom were sustained by “the proliferation of new financial instruments”, the now ever-popular derivatives (swaps (AIG), CDOs (large banks)) and structured investment vehicles (SIVs or off balance sheet debt holding corporations—yes, think of Enron, AIG, Lehman and the large banks which even today own 80% of all residential mortgages). Economic developers saw an explosion in TIF financing and municipal debt in general.
When these financial innovations exploded post 2007 (triggered by the busting of the American housing boom, itself triggered by the incredibly abusive sub-prime mortgage lending), the developed nations (and their financial systems) were for all intents and purposes INSOLVENT, i.e. facing bankruptcy. When a financial system collapses (very rarely) currency collapses, credit and lending terminates, existing debt is foreclosed and the overall economy collapses. How does one recover from this? Ask FDR, Hitler, Churchill and Stalin. The lesson of the Great Depression (a la Keynes and Bernanke) is to avoid this financial collapse in the first place. Avoiding a financial collapse is very hard to do because who is left with sufficient resources to purchase all these toxic assets, thereby injecting massive capital into the economy. Put it another way, to whom do the major insolvent banks mail the keys to their assets?
To the Lenders of Last Resort: The Central Banks (Federal Reserve) and the National Government
So much (about half) of the now worthless derivatives and significantly depleted loan/mortgage portfolios were duly purchased by (in the American case) the Federal Reserve (our central bank) and the Department of Treasury which became the administrator/executor of Fannie/Freddie May/Mac and TARP (several trillion dollars in these transactions). To further ensure the economy didn’t fall off the proverbial cliff into the Great Depression, a massive + trillion dollar stimulus followed. Viewed in its most positive sense, the federal government had injected nearly $3 trillion dollars into the 2009 economy. This does not include GM, Fannie and Freddie, and AIG.
In essence, the federal government purchased nearly half of the toxic assets and derivatives incurred by the private banking and finance system. That’s where the toxic stuff went, and that’s where it remains today! It hasn’t gone away—it’s still alive and well, buried in the books of the federal government. The unpurchased portion of the toxic assets remains in the banking system; only half of that has been written down to this point.
The point of all this is that the financial system has collapsed. In its wake the relationship between many developing nations and developed world has been irretrievably reversed. The page has turned. We are NOT going back (according to El-Erian) to the old system. It’s over. Kaput! Instead we have now entered into a transition era, the New Normal.
What is the New Normal?
Excessive debt is the problem and DELEVERAGING (debt reduction) is the critical dynamic of the New Normal.Why can’t we go back to the good old days? For the same reason we are now in an era of New Normal. We are in debt and we can’t go back until we have reduced the debt sufficiently so we can free up cash for business investment and consumer consumption. Excessive debt is the problem and DELEVERAGING (debt reduction) is the critical dynamic of the New Normal.
Household/credit card debt, home mortgages underwater, housing prices decline while other houses are foreclosed (25% of all sales 2010), commercial real estate enjoys excess supply, commercial mortgages still need to be refinanced and corporate balance sheets need to be repaired before we can even think of leaving the New Normal.
No one is predicting when all this will clear up, but moderate estimates assume the better part of a decade and El-Erian himself has hinted it could last a generation.
According to El-Erian (and others as well) the US and the developed world will “revert to the mean” by which he means that the artificially stimulated “sugar high” growth of the last decade (6-7% nominal GNP) cannot be sustained. Instead we will, after recovery from the Great Recession (which by the way has been over nearly a year), grow GNP in a restrained 2-3% annual rate, insufficient to quickly re-employ the nearly 10% unemployed and additional roughly 10% who are part time employed or who have left the labor force entirely. We will have restrained growth because the costs of excessive debt rob the consumer and the corporation’s discretionary income for consumption or investment. Since consumer demand will be muted, the need to grow the production capacity of firms (equipment and hiring) is also muted. Wage increases, in an era of widespread unemployment and under employment, will also be muted. We will grow mostly through organic (i.e. natural growth in population) growth incrementally propelled by weaker immigration, impaired social and geographic mobility, and reduced birth rates.
Besides deleveraging (and real estate oversupply) there is a second reason why we cannot pass quickly through the New Normal and return to the old ways. Re-Regulation! All these bailouts and stimulus deficits, not to ignore the simply wonderful time we had coping with the Great Depression, created the rather illogical belief that we don’t want to go through this again. This preference for avoiding future pain was entrusted to governments and their response was/is to regulate the institutions and practices which were responsible. As of this writing, the shadow finance market (derivatives)) has been enlightened by reforms which have fundamentally reshaped the derivatives market, the investment banking system, and the secondary markets. Indeed, this regulation has been global in scope, with Basel III setting a new framework for a semi-regulated international finance system. There will be no more sugar highs in the intermediate term.
We have indeed turned the page. We cannot go back to the 2007 financially induced liquidity. The major banks themselves, despite their predilection for bonuses, are still quite fragile, with shattered business models, and still holding considerable amounts of toxic assets in their portfolios. Despite all the “official” encouragement from populists and elected officials, they cannot easily lend at volumes seen pre-2007. The revamped, more regulated financial system is still healing.
Because growth is muted and regulation increasing, we will not create an “escape velocity”, i.e. growth that is sufficiently high for a “sustained economic expansion to set in”.
We need time to heal and that is precisely what defines the New Normal.
If You Thought It Was Simple This Far…
Now it gets complicated!
The patient in the New Normal hospital (consumer and corporations) has been told to rest in bed, take their medicine and diet. Fat chance the patients will do what they have been told.
After ten or twenty years of hearty partying, it is not likely we will willingly lay back, diet, and heal. For the New Normal to work, however, the patient has to cooperate. But no one without a job (and one out of ten is) is willing to live on unemployment benefits forever, even if they could. Many patients will demand immediate solutions, magic pills, dramatic action and even revenge. El-Erian suggests that in the present initial phase of the New Normal “We are leaving the ‘old’ world but we are not quite in the ‘new’ one… we are at the point of maximum confusion… human nature is to resort to an ‘active state of inertia’”—El-Erian’s words for we want to go back to the good old days and party and will insist on immediate solutions and a quick recovery period. And who can provide this speedy recovery? Why the National Government and the Federal Reserve of course!
There is one, very obvious problem, built into the above scenario – how did they pay for it?
At this point we will detour from El-Erian and inject a second supplementary perspective drawn from This Time Is Different: Eight Centuries of Financial Folly (Carmen M. Reinhart and Kenneth S. Rogoff, , Princeton University Press, Princeton, N.J. 2009). Reinhart is a professor at the University of Maryland (and a former IMF economist) and Rogoff, a former chess grandmaster at age 25, has been a researcher for the Federal Reserve, and in 2001 was the chief economist for the IMF. The IMF today is the designated central bank of the entire international finance system (G20).
Reinhart and Rogoff’s work is less than a book and more like 400 pages of graphs and charts. They analyze the effects statistically of the last 800 years of financial crises and offer some startling findings. These findings after considerable peer review remain substantially unaltered and hence are taken quite seriously, despite one’s ideological tendencies. Their central focus is why and what happens in a collapse of the finance system. Their 800 year database reveals (in support of El-Erian) the paramount cause of financial crisis is debt accumulation or currency / trade imbalances. In virtually every instance, several years after the debt-induced collapse of the private finance system a second wave deterioration, and sometimes collapse, of the public finance system occurs.
For Rinehart and Rogoff, the paramount result of these crises (again supporting El-Erian) is debt deleveraging over an extended period of time (say a decade or two). They add to El-Erian’s thought, however, by discovering that in virtually every instance several years after the debt-induced collapse of the private finance system, a second wave deterioration, and sometimes collapse, of the public finance system occurs, (i.e. in our case the federal government’s finance system. For a second, more detailed yet short, summary of Rinehart and Rogoff, the reader should peruse Urban Land’s “Back Page” by Bowen H. “Buzz” McCoy (Urban Land, November/December 2010, p.120).
Why Does the Public Finance System Deteriorate?
The Federal government bought all the debt and losses that accompanied each house that is now underwater. It bought much of the debt associated with household credit/credit defaults, of both the evil banks and the noble individual consume. Presently (through Freddie and Fannie) the Federal government owns 75% of the housing stock of the entire United States. Much of the debt we accumulated over the last ten or twenty years has not disappeared, it is still on the books of the Federal Reserve and the Department of Treasury. Having bought the debt, government must now find a way to pay it off (tax increases because you cannot pay off debt by incurring more debt) – or write it down (.i.e. force somebody in the private economy to absorb the loss, for instance the individual mortgage holder). This is one hell of a choice, and democracies are not especially good at making “hell of a choice” decisions.
In such situations, governments don’t always make “the right” decision, witness the lost decade (now moving into a second decade) enjoyed by the formerly most competitive economy in the world, Japan.
Whatever the future decision will be in our case, the accumulated debt must be managed. There is no escaping it. At present, the United States enjoys somewhat artificial benefits associated with being the “reserve currency” of the international finance system (i.e. capital rich developing nations are semi-locked into purchasing our federal debt in order to protect their own national finance systems/economies). This, combined with the stimuli and bailouts, has pushed us out from the Great Recession. It is over. A modicum of prosperity has been restored and we are growing again.
Europe does not enjoy reserve status, however, and what we are now watching, the resolution of the so-called sovereign debt crisis in Euroland, is the first evidence of Reinhart and Rogoff’s second stage effect, the deterioration of the public finance system.
HAPPY NEW YEAR!!
So What’s An Economic Developer To Do?
We have put the reader through this more or less depressing tale for a good reason (we think?). We are not (if you subscribe to the New Normal) going to quickly return to the Old Normal (or the Great Moderation-don’t ask!). Worse, there may be more disruption and difficulty ahead, for an extended period of time. If this is the future reality there is no benefit to Pollyannaish optimism, gilding the lily, or whistling past graveyards. It is time for us to roll up our sleeves and begin to think about how this brave new world will affect our communities. It’s tough love time, baby!
It certainly is not our purpose to predict which direction policy makers will turn in the next few years. What is initially a key starting point, however, is that macroeconomic and national budgetary/fiscal policy will set the tone for the local economic development environment. Your city may be better than mine, and her cluster may be more dynamic than his, but both need contend with the forces unleashed by the Federal Reserve, reform of Freddie and Fannie (if that ever occurs), budget deficit commission suggestions, and the absence/return of civility and bipartisanship to federal policy-making. All of this matters locally and should be monitored closely by local economic developers. This is not the time for magic bullets and the latest academic/think tank fad of the month.
In this environment, political leaders, policy makers and corporate executives of all sized businesses are, as my wife would say, stressed. The local economic developer will share that stress. The initial emphasis has been to watch Washington DC and catch its drippings (excuse me, Recovery Projects and Federal grants). If Rinehart and Rogoff are accurate, this is going to be an increasingly fragile source of funding.
Certainly, attraction and recruitment, in an atmosphere of corporate consolidation, business plan modification and resizing, will be used by many municipalities; tax abatements and incentive packages will prosper, but targets are likely to be fewer and the controversy more intense. Unemployment will continue at high levels and the reality of a serious structural employment crisis will underscore a high priority for education and job training, as opposed to traditional economic development.
The financial sector has not completely recovered and small S&Ls, credit unions, and small banks, or any bank continuing to hold toxic commercial real estate loans will continue in crisis for the next year or two. Banking consolidation and mergers and acquisitions will typically alter the local finance system and remove decision-making and corporate good citizen involvement from the community. This could put pressure on public lending programs as local banking partners drop out or become even more conservative. Lines of credit may not be renewed and this may be a new opportunity for local RLFs. Small business, in general, start ups in particular will operate in an environment with considerably more headwinds and vulnerability. While many will cry for increased “innovation and entrepreneurship” (especially tenured faculty in the classroom), economic developers would best respect the risk and the danger in an era of austerity. Failed start up businesses result in crippled lives, fractured families and destroyed credit and retirement savings.
Communities and states are likely to be the ground zero of Rinehart & Rogoff’s public sector finance deterioration. It is quite possible the federal government, partially protected by its reserve currency status and its ability to print money, will muddle through. It could leave states and municipalities to their own devices. The currently intensifying municipal bond market situation is our manifestation of their second stage financial crisis. This rapidly deteriorating situation will not be measurably helped by slightly higher tax revenues as these will eventually succumb to property reassessment, higher interest rates, and a stagnant housing market. While we suspect outright bankruptcies will be relatively few and far between, more and more communities will seek protection from state operated pre-bankruptcy programs which will transform the local policy/budgetary processes.
The real estate and construction industry is “hurting for certain” and will stay that way for a little while longer. Half finished projects and housing developments, marginal strip malls, and retail consolidation will consume economic developer’s attention. New projects will struggle with a real estate financing system which has changed noticeably over the last two years. Publically traded REITS will in short order likely replace or control the local building community which up to this point has taken the lead in TIF and local commercial redevelopment projects. Small scale projects in particular will find the going very rough. Big projects almost always find a way to get funded, and nationally based REITS and private equity firms will gravitate to big projects rather than infill, brownfield and rehabilitation.
While the last section is certainly daunting, it should not be depressing in that for each crisis/problem area there is an opportunity for meaningful involvement by local economic developers. Our business may be changing, but we are not about to be tossed into the scrap bin of history. We will bring these topics up in more detail in future issues but until then our suspicion is that the best and most productive local economic: development strategy will be a return to the basics: modernizing infrastructure, rebuilding decaying neighborhoods, creating and restoring town centers, transit corridors, downtown, RLFs for small business lending and counseling, but above all worker training and education.