Why Things Aren't a Whole Lot Worse


By Christopher Farrell Why are so many market participants willing to describe the current economic downturn as a recession, despite the resilience of consumers and a low unemployment rate of 4.4%? The belief that the economy is in recession largely stems from the stomach-churning volatility in the financial markets over the past year, especially when the stock market plunged into bear territory.

The striking divergence between the performance of the economy and the markets may be no coincidence. Thanks to the rise of a freewheeling, deregulated capital market over the past quarter century, the financial markets may now be acting as a buffer for the real economy of goods and services. For instance, "Bond yields are much more volatile these days, which means bonds adjust more quickly, and by a greater magnitude than before, to early evidence of the economy overheating or underheating," says James W. Paulson, chief investment officer at Wells Capital Management. "So there probably is not as much overheating and underheating in the real economy as, say, 15 years ago."

The financial system has undergone a revolutionary transformation in recent decades. Historically, households deposited their savings in commercial banks and thrifts and, in turn, these institutions invested the money by making loans to consumers and businesses. Coming out of World War II, commercial banks accounted for some 60% of all financial assets, and Depression-era laws prevented insurance companies and investment banks from competing with them. Wall Street was a colorful but relatively small sideshow in America's finance. "The capital structure in the 1950s and 1960s was very simple," says James Griffin, chief investment strategist at Aeltus Investment Management. "Everything was intermediated through the banks."

"BANKS AREN'T AS IMPORTANT." Little wonder bank problems were quickly transmitted to the real economy. A lack of bank credit was a major contributor to economic downturns. The classic example is the housing market. Regulations imposed strict caps on the rates banks could pay savers. When inflation concerns drove interest rates up or the Federal Reserve tightened monetary policy, money would flow out of low-yielding bank and thrift deposits and into higher-yielding bonds. Banks would then quickly ration credit, and real estate activity, which accounts for about a sixth of the economy, would dry up. The economy would lurch into recession.

The financial system today is vastly different. In essence, securities have replaced bank loans. The bank share of all financial assets has shrunk to 20%. Households are pouring their savings into the capital markets through their retirement-savings plans and mutual-fund investments. For instance, the share of household assets held in bank deposits has dropped, from 25% a decade ago to 12% today, even as savings in mutual funds and individual stocks has soared, from 22% to 39%.

Corporate America finances its business through the equity and bond markets. The change is most striking in the housing market. More than $2 trillion in home mortgages have been bundled into securities, and investors from around the world own these securitized mortgages. A mortgage is now always available for a price. "Banks just aren't as important any more," says Robert E. Liton, director of economic studies at the Brookings Institution. "Risk is spread out to the rest of the system."

FAST MONEY. The stock market may be less prone to manic enthusiasms than the banks, too. Yes, bankers have a reputation for probity, while professional investors are known as the gunslingers of the financial world. Yet banks have long gone to excess with their willingness to make loans -- and then turn off the credit spigot at the first sign of trouble. Remember the Third World debt crisis? How about the savings-and-loan debacle? In sharp contrast, the capital markets are full of professional bottom feeders, vultures, and risk takers. The more pervasive the financial market, the faster money can move from a failed strategy to profitable opportunities. Indeed, Old Economy stocks have fared well even as high-tech equity prices cratered over the past year.

Of course, many factors influence the shape of the business cycle, including fiscal and monetary policy. Nevertheless, if this analysis is right, the swings in the real economy could be moderate, as the financial markets absorb the brunt of the downturn's impact. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online


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