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"Transitions are dangerous," said the late Charles Kindleberger, an economic historian with a vast knowledge of financial manias, panics and crashes, in 1983. That was No. 9 of 10 lessons he summarized from the early years of the Great Depression.
Kindleberger noted that pursuit of smart public policy in that tumultuous time was handicapped by three transitions: The 1928 death of Benjamin Strong, the forceful head of the Federal Reserve Bank of New York, which caused power to pass to the Federal Reserve in Washington, a more timid group of central bankers; the victory in the 1932 Presidential election of Franklin D. Roosevelt over the incumbent Herbert Hoover; and the difficult transition of international economic hegemony from the world of Pax Britannica to Pax Americana.
Since economist James Tobin got the Nobel prize in 1981 for stating "don't put all your eggs in one basket," Kindleberger said he planned on submitting to the awards committee his one-sentence insight: "Be very careful if you have to change horses."
Kindleberger never got the nod from Oslo, but his admonition rings true a quarter-century later. The midterm election is over, and the results have changed the balance of power in Washington, with the Republican Party picking up at least 60 seats in the House—the biggest sweep since 1948. Democrats held on to the Senate, but with a slimmer majority after Republicans picked up at least six seats.
Voters are understandably angry over the lack of jobs and economic growth. And the news remains grim on the employment front. While the U.S. economy added 151,000 jobs in October, the unemployment rate held at 9.6 percent, the Bureau of Labor Statistics reported on Nov. 5. That's the 15th month the jobless rate has remained at 9.5 percent or above, the longest such period since government statisticians started collecting the numbers in 1948.
Indeed, the major force behind the slow recovery isn't going away soon: America is turning away from debt and embracing thrift, and the epicenter of change is the household. History suggests that the transition toward a high-saving, less-debt balance sheet will be long and painful before vibrant growth resumes.
The Federal Reserve is smartly trying to bolster the economy during the transition from profligacy to thrift with its latest round of quantitative easing, QE2 (a fancy term for printing money). The Fed announced Nov. 3 that on top of its existing program of reinvesting the proceeds of its portfolio, it will buy $600 billion of long-term government bonds by the middle of 2011. In the meantime, the message for Capitol Hill and the White House is, at minimum, "do no harm" while the Great Deleveraging runs its course.
Considering the well-publicized extravagance of many chief executives, it's underappreciated just how much money Corporate America has been hoarding cash during the downturn. Corporations have accumulated nearly $1 trillion in cash and equivalents, up 22 percent since 2008, according to an Oct. 27 report by Moody's Investors Service. Apple Computer (AAPL) alone has $51 billion on its balance sheet. "The investment opportunities are more limited, and most can wait until management is more confident about demand," says Charles Roxburgh, the London-based director of the McKinsey Global Institute.
The recent corporate embrace of cash is really part of a longer-term trend. It started after the economic trauma of the 1970s, when companies were battered by one shattering experience after another, from double-digit inflation and interest rates to the U.S. government abandoning the gold standard, to the two OPEC oil embargoes. Despite all the headlines devoted to LBO buccaneers in the 1980s and private equity financiers in the 2000s, the average cash-to-asset ratio for U.S. industrial companies increased 129 percent from 1980 to 2004, according to scholars Thomas Bates and Kathleen Kahle of the University of Arizona, Tucson, and Rene M. Stulz of Ohio State University. In "Why Do U.S. Firms Hold So Much More Cash Than They Used To?" the researchers note that the creation of the cash hoard has been so dramatic that "on average, American firms could have paid off their debt with their cash holdings."
Now that's thrifty. Many factors combine to create such a degree of corporate frugality, but the most important are the unsettling combination of changing technology, the gale winds of deregulation, and increasingly tough competition from emerging-market companies.
"As economies have become more dynamic, the ability of profitable corporations to say five years from now they will still be highly profitable has declined," says Jay Ritter, finance economist at the University of Florida, Gainesville. What's more, companies aren't going to risk that money soon
Now it's the household's turn to be thrifty. People learned the hard way how financially insecure they had become when the debt bubble burst. There has been progress: According to the Federal Reserve Bank of New York, U.S. households have reduced their debts over the past seven quarters. In the second quarter of this year, households owed $11.7 trillion, down 6.5 percent from the peak of $12.5 trillion reached in the third quarter of 2008. (The next report on total household debt is scheduled for release Nov. 8). The personal savings rate as a percent of disposable income in September was 5.3 percent, the Bureau of Economic Analysis said on Nov. 1. That's significantly higher than the low of 0.8 percent reached in April 2005.
Still, Americans have a long way to go before their personal finances are healthy. For instance, total household debt equaled 118.4 percent of after-tax income in the second quarter of 2010, according to Christian Weller, senior fellow at the Center for American Progress, a liberal think tank in Washington, D.C. That's down from a record high of 130.2 percent in the first quarter of 2008 but well above the 100 percent figure of the early 2000s, let alone the 60 percent to 80 percent of the late 1950s to the early '90s.
Of course, there is no magic debt ratio. Nevertheless, a recent study published in the September 2010 BIS Quarterly Review is suggestive. A look by Gary Tang and Christian Upper of the BIS at private sector debt after 17 of the 20 systemic banking crises suggests that the trend to deleveraging the U.S. household may be, at best, only one quarter complete.
It's also why the pressure on government to reduce its debt won't go away. It has to be dealt with. The Republican resurgence and fulfilling a major campaign promise are factors, of course. But an even more important reason is that households struggling for greater thrift will insist that government also embrace a new frugality. Even economists that scorn calls for government austerity at the moment call for reduced debt levels tomorrow. "The deleveraging still has a long way to go for consumers," says Roxburgh. "The U.S. government's deleveraging hasn't started yet."
The return to frugality isn't fun. The transition is definitely painful. Yet an economy with a healthier savings cushion and a greater reliance on equity financing is a society with the financial wherewithal to take greater risks. The great deleveraging offers the prospect that thrifty companies, households, and government will create the foundation for a more prosperous, innovative economy.
Yet, as Kindleberger noted, transitions are dangerous. Washington can ease the burden of the great deleveraging by heeding the sage's Lesson No. 8: "Formalism, politics, and ideology impede crisis-solution." Any debt-reduction blueprint that federal policymakers embrace should keep in mind that a fragile, vulnerable U.S. household will take a long time to reduce its leverage. It's one reason why even suggestions that the federal government might default on its debt are so dangerous. For example, CNN's John King asked Senator Jim DeMint (R-SC) on Nov, 2 that if there is a vote in Congress on raising the debt ceiling, should Republicans say no? "I think Republicans will say no, unless that raising of the debt ceiling is accompanied by some—some dramatic spending cuts, something that would direct us toward a balanced budget in the future, Republicans will not support an increase in the debt limit," said DeMint.
Gridlock is not good public policy, especially with the full faith and credit of the federal government and the value of the U.S. dollar on the line.
That's why the best opportunity for devising a realistic plan for bringing down the federal debt over time comes from the efforts by two blue chip commissions. The Bipartisan Policy Center's Debt Reduction Task Force, headed up by former Senator Pete Domenici and former Congressional Budget Office Director Alice Rivlin, releases its suggestions on Nov. 17. The National Commission on Fiscal Responsibility and Reform, established by the White House and headed up by former Republican Senator Alan Simpson and former Clinton White House chief of staff Erskine Bowles, has a Dec. 1 deadline for its recommendations.
Normally, the suggestions of commissions headed by well-credentialed and well-meaning but aging wise men and women are a snoozefest, quickly tossed into scrap heap of history by practical politicians. But sometimes timing is everything on Wall Street and in politics. These commissions offer Washington a path to cut a deal. Republicans and Democrats, acutely aware of the electorate's desire to rein in massive government borrowing, should take it.