Few people can match the economic expertise of Alan Greenspan, former Chairman of the U.S. Federal Reserve. He served as the senior economic advisor to Presidents Ronald Reagan, George H.W. Bush, Bill Clinton and George W. Bush. He set the bar for instructing an often ignorant and easily distracted Congress on matters of intricate economic policy. And he served as the Chairman of the U.S. Federal Reserve.
So when he took the stage as a keynote speaker at KPMG’s 2014 Insurance Industry Conference Tuesday, he came with his bona fides in order, and ready to speak to an audience that was keenly interested in any vision he could provide on 1) where the economy is going, 2) why, and 3) when (if ever) is it likely to improve.
The short answers to those are: 1) nowhere fast, 2) because nobody is willing to invest, and 3) eventually, but nobody can tell when.
As he dug into the issues, he highlighted several key points on which our economic growth is hung up, and how the insurance industry plays into all of it. Read on.
9. Lack of confidence.
The U.S. economy is in a state of extraordinary change, Greenspan said, the likes of which he has never seen before. The most interesting thing about the current recession and recovery, he said, is that in the 10 recoveries we saw since WWII, every one except the current one was led by construction, essentially. This recovery is so sluggish because construction is, as Greenspan so delicately put it, “dead in the water.” The reason why construction is so dead is due, in part, to excess capacity built up before the economy crashed in 2008. But more importantly, businesses and households across the board are so skeptical of the future, they’re not willing to invest in it. Nobody is putting money into longer-lived assets, and until they do, the economy won’t really return to form.
Case in point: in the early 1990s, the amount of liquid cash assets companies were willing to invest in illiquid, long-term assets was way higher than it is now. You also see this in the yield spread in 5-year U.S. Treasury notes versus 30-year U.S. Treasury bonds, which is the widest in U.S. history. Why? Because people are far more willing to invest on a 5-year return than a 30-year one. That speaks to the depth of the worry people have in the future. And that kills growth.
8. Renting instead of buying.
The same is true in U.S. households. The single-family home construction market collapsed in the 2008 crash, and it induced a major shift; many more houses that are being built now are meant not for sale but for rental. Home ownership is way below where it was years ago, and there is no evidence that even with rising home prices that this will change any time soon.
That speaks to the degree of economic malaise in the U.S., Greenspan said. Unless we can change that, then we can’t change the effective demand needed to move the economy forward. And with effective demand several points below where it ought to be — with our economy working well below capacity — that is where our unemployment and overall economic weakness comes from, hanging around like an unwelcome house guest.
7. It’s a global problem.
This is not unique to the United States, Greenspan noted.
The “very tricky fiscal problems” that the United States is facing are fundamentally the same that are being faced by developed economies across the world, from the UK. Germany and the Eurozone, Ukraine, Japan, and elsewhere. Construction as a share of GDP is the same in these places as in the U.S., essentially, and construction remains down across the board. People are heavily discounting the future, Greenspan said.
One example is in how corporations evaluate the probable rate of return on a specific facility and then wonder what the variance on that return might be. That variance is really what the executive committees of corporation are really interested in, Greenspan said, and if a project is supposed to have a 30% yield, but there is a 10% chance of it returning a -10% yield, then the project will be dead in the water.
In this kind of environment, corporate tax rates become impossible to estimate, and that results in a serious curtailment of expenditures. When people don’t have a clue what the tax rate will be 20 or 30 years from now, and they have projected income from those years, then it drives up the effective cost of current projects.
China is the one part of the world where this isn’t a problem, but that’s about to change...
6. China’s debt bubble is going to burst.
China’s overall level of debt has gone from 140% of its GDP to 230% of GDP, which Greenspan glibly remarked is a sure sign that the Chinese economy is becoming overleveraged. It is requiring ever-larger amounts of social debt to fuel the country’s growth rate.
Greenspan noted that China has had “a remarkable run” the likes of which have never been seen before in measurable history. But, its gains in productivity and standards of living were all done with borrowed capital and technology. Annual lists of the world’s most innovative companies feature no Chinese companies, and nearly half of those lists are made up of American companies. This is leading to a narrowing productivity gap between China and the U.S. that is putting serious pressure on the Chinese economy.
The reality is that China is hitting the ceiling and its growth rate must slow. But when you have a one-party political system, there usually isn’t a whole lot of out-of-the-box thinking, which is precisely what China needs right now. And since you can’t divorce economic thought from political thought, this does not point toward good things for China. The Chinese hierarchy is acutely aware of this, Greenspan said, and it plans to allow a number of companies go into bankruptcy.
This is big, since most of the institutional lending in China has been backed by the government. There is a substantial amount of essentially shadow banking that operates with the same presumed backing of the government, but that backing is not really there, and the government is about to let some companies know that the hard way. Look for some Chinese defaults in the future, perhaps in its seriously overextended steel industry or elsewhere in tis manufacturing sectors.
That said, Greenspan also noted that while bubbles, by definition, burst, not all bubbles are toxic. The dot-com bubble bursting in the 1990s was individually ruinous for many people, but it was not an institutional bubble. The subprime mortgate situation in the late 2000s was an institutional situation. China knows the difference and is doing everything to ensure that when its bubble bursts, it'll be the first kind of problem and not the second kind. Will they succeed? Who knows.
5. A diminished U.S. military means an unstable world.
Greenspan noted that at the end of the Cold War, the U.S. was left standing as the sole superpower, and it used its military heft to act as the world’s policeman, suppressing conflict in a number of hot spots for a number of years.
Until recently, the share of gross domestic savings from business, households and government as a share of various forms of entitlements remained relatively constant. What we’re talking about here, really is Medicare and Social Security, which Greenspan described as the “third rail of American politics.” And there is serious growth there that is not going to stop, as the Baby Boomers get older and as Seniors live longer lives. These entitlements, Greenspan noted, tend to rise the most during Republican administrations, but they’re rising across the board, and unless we slow the rate of growth in our entitlements, the reality is that eventually, we will have to cut military spending to afford it all.
Greenspan pointed to Russia’s “Czarist” expansionism in Ukraine, and Vladimir Putin’s implication that what would be best for Russia was to restore the Soviet Union. He pointed to clear commitments to protect NATO nations against Russian aggression. And he pointed to the rise of ISIS in the Middle East means that the U.S. will have to get further involved in that region to protect the world’s oil supply — something only the U.S. can do.
This all points to severe strain on the U.S. military at a time when our spending on it is poised to fall, and fall dramatically. This means that hot spots that had been kept calm are likely to explode, and this will create further uncertainty across the world, which will help the economies of exactly nobody. The military budgets will have to go up, but with no will to raise taxes or cut other costs, the only solution to this particularly sticky wicket, Greenspan said, is “to repeal the laws of arithmetic.”
4. Interest rates and inflation.
Eventually, interest rates have to rise, Greenspan said, with the kind of vagueness that comforts no insurer who has seen their investments wither on the vine for the last five years or so. Greenspan said that a figure that interests him is that interest rates in 5th century Greece are pretty much the same as what they have been in the last 50 years or so across the globe.
There is something inbred into the system, he said, and inbred into the propensities of human nature that regulate interest rates. The long-term yield on things like stocks, real estate, earnings, etc., are critical and can’t stay at zero forever, and wouldn’t even be there if we weren’t keeping them there. The rates are suppressed, Greenspan said, because the Federal Reserve has absorbed so many mortgage-backed securities and U.S. Treasuries.
We have to taper at some point, and things will only turn around once we see commercial and industrial loans tease that money out of the federal system and paid out to the commercial markets. This is a necessary condition for inflation. It is not happening yet. But it will. And when it does, Greenspan says, it will surprise us with how quickly it moves. Be prepared.
3. Regulatory over-reach.
Greenspan is not a fan of recent regulatory developments, especially Dodd-Frank.
The principle of regulation, he said, is that it identifies a problem that exists in the system, and implies that if that problem is solved, the system will return to functioning as it ought to. This requires a good conceptual view of how the financial system works. The legislators who crafted Dodd-Frank did not have that view, and as such, they crafted an unholy mess of a law that can’t even be implemented.
Case in point: The day President Obama signed Dodd-Frank into law, Ford Motor Credit had a $1 billion asset-backed entity, but the SEC now required all asset-backed instruments to have a credit rating. But because Dodd-Frank stipulated that credit rating agencies must assume partial responsibility if the firms they rate go pear-shaped, Ford couldn’t get a rating for their instrument. So what did Ford do? They simply ignored the rule.
And they’re not the only ones, Greenspan noted. There are a huge number of cases where Dodd-Frank is simply not being enforced because the law doesn’t work.
The problem is that this is the kind of law that you can’t really unwind. Once you hire regulators, Greenspan said, their job is to regulate...and they will always find something to regulate. So while the law doesn’t work, we’re stuck with it.
“Undoubtedly, there were some very questionable practices prior to the financial crisis,” Greenspan said. A lot of it was in credit default swaps, which were a form of derivative. But interest rates are also a form of derivative, as are foreign currency exchanges and even wheat. There was a huge market for over-the-counter derivatives that went through the financial crisis without a single default because those markets worked exactly as they were supposed to, but now, they have extra regulation, essentially because of guilt by association.
None of this regulation helps the economy get back on its feet, Greenspan suggested. And just because there is evidence that Dodd-Frank isn’t working, and likely will never work, to think that is evidence it will be abandoned, he said, “is a non-sequitur.”
2. A lack of leadership.
Greenspan has worked with five Presidents, and he ws quick to point out the two which he felt were the most effective at getting what they wanted done, done. And those were Ronald Reagan and Bill Clinton.
“The President has got to have an extraordinary number of characteristics, both of which Reagan and Clinton had,” Greenspan said. “They have to have a sense of what kind of democracy we have in this country and value systems and rule of law. And they have to have a sense of the history of it all. And they have to be able to convey to the populace where they think they are wrong.”
As an example, Greenspan cited Bill Clinton’s decision to bail out the Mexican government in 1995, despite the fact that he knew for certain that had this gone to a vote before Congress, it would have failed, and overwhelmingly so. But Clinton knew it had to be done, and that it could cost him politically, and so he crafted a way to make the monies available to Mexico. Mexico ultimately never drew on them, but the crisis disappeared.
“That is leadership,” Greenspan said. “And there were many similar ways in which Reagan did the same thing. The crucial issue is, are you a leader or a follower?”
Both Reagan and Clinton knew how to read polls well, but they weren’t going to let themselves be run by them. Much as we like to believe that we could run the government by referendum, the reality is that all we’d get from it are 100% of the people wanting more spending, and lower taxes. The political world wants things that range from the unrealistic to the impossible, and it falls to the President to run counter to that, and not every President has been equally able to do that.
Greenspan didn’t call out President Obama by name (or either President Bush), but draw your own conclusions.
1. Nobody appreciates insurance enough.
The insurance industry as we know it — or at least the actuarial mathematics that underpin it — got rolling when two Scottish ministers in the 18th century devised a fund that would take care of their widows, and the actuarial methods they used were pretty spot on and have not really changed that much since. Insurance, Greenspan said, is really nothing more than saving for a rainy day. And insurance, by its construction, is a major form of savings for this country.
“The whole structure of the industry is the mechanism by which you’re converting consumption into savings,” Greenspan said, “and the only way the economy can grow is to save.”
Insurance, he noted, is the most formidable mechanism we have to save as a society, and the economics of insurance have not been given proper weight by economists in how they look at the world. That is why the insurance industry needs to thrive and to be given the support it needs to thrive; getting the optimum amount into savings and investing in cutting-edge technologies are the only real way to get our standard of living to grow. And insurance is at the heart of it.