Hidden Leverage

When assets deflate, a lot of hidden problems emerge.  Long term guarantees seem quite expensive, as the ability to safely receive cash flows in the future diminishes.

That affects defined benefit [DB] pension plans.  When times were good back in the late 90s, DB plans raised their expected earnings rates on assets, which depressed contributions, and made the plans look even better funded than they were.  Flash forward to today — one decade later pension assets have done little to nothing, but the liabilities have inexorably accrued forward at their discount rate.  Now corporations and states need to make contributions to their DB plans when they can least afford it.

Think of endowments.  They are shrinking at a time when it is more difficult to get charitable donations.  Charities are shrinking activities as a result, at a time when more charity could be socially useful.

Think of charitable giving from the rich, which stems from the donation of appreciated assets.  There are few appreciated assets at present, and who wants to give extra from their operating cash flow when times are so uncertain?

Consider companies that bought other companies near the peak of the boom, or soon thereafter.  They are facing a hard road in debt service.  This applies to private equity as well.

Now think of governments.  They happily expanded programs, with little care for the future, as long as real estate and stock values were expanding.  The wind was at their back.  But now, with asset prices down, and transaction volumes diminished, the economic winds are in their faces.  What state (aside from Alaska) has a big enough “rainy day” fund?  Now states and municipalities are squealing for bailout cash.  Wonderful.

Even the Federal Government in in the same spot, but they have a printing press behind them, whether they issue money or debts.  They don’t have to run a balanced budget, so long as lenders comply.

Even foreign countries are exposed to hidden leverage.  Countries with large export sectors, where the government helped promote economic growth though subsidizing imports, are hurting now.  There was only so much additional demand that could be generated, and those markets are saturated now.

“You don’t know where the rocks are in the harbor until the tide goes out.”  Well, the tide is out, and most of the rocks are visible.  Firms with bad balance sheets have been revealed.  Entities relying on prosperity are being shamed.

I have said for a long time that leverage needs to come out of our economic system, and our government is fighting something that is inexorable.  We pushed too hard at the limits of what our economic system could deliver, and now the system demands a big pause to reconcile bad debts.

We will go down kicking and screaming on this one because the Keynesian received orthodoxy is so blind.  But eventually the need to reduce total financial leverage will be heeded, after every other wrong solution is pursued.