I corresponded this week with a business associate who is running for the U.S. House of Representatives from another state. First, I sent a contribution to his campaign, because he is prepared to push for term limit legislation. I have long argued that legislators will not concentrate major efforts on the solutions to our country’s top long-term priorities until we reduce the frequency of standing for reelection. The rest of the communication, which follows, addresses the question of the wisdom of encouraging the private sector to take risks in the interest of promoting economic growth.
We must be willing to assume certain risks if our economy is to grow. On the other hand, assuming additional risk is not a guaranteed prescription for success either for businesses or for individuals. Over the decades one can observe a cyclical pattern of alternating insufficient risk assumption and excessive risk assumption.
For businesses, too much risk assumption leads eventually to excess inventory, excess capacity and excess debt. When that becomes prevalent in an economy, recessions result. The most excessively indebted go out of business as inventories and excess capacity are worked off. That natural selection process is short circuited if government intervenes, as it did recently by bailing out banks, insurance companies and automobile companies. Moral hazard results when companies no longer fear the consequences of their own mistakes. The current disgust of the populace is clearly understandable when profits are enjoyed privately and losses are borne on the backs of taxpayers.
While risk assumption takes many forms, one of the most easily measured is debt. The first of the graphs below, both from Ned Davis Research, is one I have pointed to frequently over the past dozen years. The explosion of debt that began in the 1980s had a salutary effect on the economy for many years. It reached excessive levels, however, eventually exacerbating the decline that began in 2000. What we have been experiencing for the past decade has been far worse than a normal cyclical inventory recession. Rather, it has been a credit crisis involving massive deleveraging and monetary crises in many parts of the world.
The Bush administration initially and the Obama administration over the past year and a half have attempted to solve a problem caused by too much debt by creating massive quantities of new debt. I have objected vociferously to government attempts at solving economic problems our generation created by issuing promises to pay that will have to be borne by future generations. It’s a moral issue. The rescue attempts may or may not succeed, but the undeniable consequence will be a huge anchor weighing down the economic ship to be sailed by our grandchildren and their grandchildren.
An additional moral question attends the Federal Reserve’s attempt to promote risk- taking–and hopefully business growth–by reducing short-term interest rates effectively to zero. All else equal, such a rate reduction will reduce business costs, improve profitability and hopefully lead to increased employment and greater general prosperity. We see very little comment, however, about the intergenerational inequity that such actions produce. A growing number in our society are past their income-producing years and are dependent largely on fixed incomes to live. If they choose to accept no risk with their savings, they will earn essentially nothing in a money market fund comprised of U.S. Treasury securities. If they let the government borrow their money for two years, they will be paid the royal return of 0.61%. They can earn slightly more each year, 1.74% and 2.98% respectively, in five and ten year U.S. Government notes. With all the new debt the government has recently created, however, many are worried that inflation over those time periods might exceed the nominal returns, leading to negative real returns. The government has effectively said to a vulnerable segment of our society that you must take risk if you want to earn any return. Unfortunately this group has little capability of rebuilding capital should the risk-bearing investments fail.
A few years ago I had dinner with Robert Parry, then President of the San Francisco Fed. I made in essence the same observation about the highly negative effect on retirees from what was then an even less aggressive Federal Reserve interest rate stance. He acknowledged such a negative effect with some distress but justified it as a form of unintended collateral damage in the war against business stagnation and unemployment. The elderly, unfortunately, have a far weaker voice than that of the business community. And they contribute far less to political campaigns.
When most people talk about the desirability of risk assumption, they are typically speaking about businesses. It applies also to individuals as consumers. For individuals there are obviously times and conditions more appropriate for risk-taking than others. As a populace we have become increasingly more risk-bearing over generations. Perhaps the quintessential example of excessive risk assumption was the past decade’s mania in which a greater percentage of our population than ever before opted to own homes. This, of course, was good for business while the surge was in full bloom. Only in its aftermath did the extent of foolish risk-taking become apparent. A great many bought homes that they could afford only if prices continued to rise and mortgages could be serially refinanced.
To a lesser degree the same principle applied to consumer purchases generally. We became increasingly enticed to purchase whatever we wanted. Not having enough money was no barrier as long as new credit card applications appeared regularly in our mailboxes. Because the government fought with a vengeance any semblance of a recession, we became convinced by personal experience that tough times and unemployment were things of the past. In such an environment, there was little need to save. We could buy with abandon and take other risks and a favorable future was our birthright. Unfortunately, the bankruptcy statistics of the past few years are the sobering testimony to the folly of that behavior. The second Ned Davis Research graph below shows how dramatically leveraged the average household remains. My concern is that promoting additional risk assumption, which might provide a short-term economic lift, could intensify long-term negative economic consequences in an economy still highly overleveraged.
It is far from clear what the optimum level of leverage is for either businesses or households. Almost certainly, the appropriate level will vary over time depending upon a great array of conditions. Certain conditions create a situation which some have called the paradox of thrift. If the individual is overindebted, it may be prudent to cut back on consumption and reduce debt. What may be wise for the individual may, however, be destructive to the overall economy, which relies on the expansion of consumption and risk-taking. There is no easy answer.
If You Want To Promote Term Limits
While not a highly political person, I am a strong advocate for term limits. If you would like to support the campaign of a candidate for whom the first issue addressed on his website is term limits, email us and we will be pleased to pass along contact information. You can then decide whether you agree with the candidate’s positions and whether you wish to contribute.
Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.