From the June 22, 2008 Sunday Times
June 23, 2008
by Irwin Stelzer
“This too shall pass,” King Solomon’s advisers told him to engrave on a ring, and refer to it whenever he felt depressed. Or so the legend goes. Not a bad idea for bankers beset by still more dodgy paper to write off, for shareholders at loss-making Lehman Brothers and ailing Morgan Stanley (first-quarter earnings down 58% year-on-year), and for homeowners as they watch the equity in their homes evaporate. Some of our current crises will indeed pass.
However, it would be a mistake to believe that when these crises are over, the world will be as it once was. It won’t. For one thing, the entire system of regulation to which investment banks are subjected will be different.
Ever since the Great Depression, governments have recognised that large commercial banks cannot be allowed to fail, and that depositors have to be protected when banks did fail. But nobody imagined that investment banks are too interconnected to be allowed to fail - that the risks to the financial system of a failure by an investment bank are every bit as great as the risks posed by a failing commercial bank.
Bear Stearns put paid to the notion that if a big investment bank fails, the next day will be just another day at the office for those who trade with it. So the Federal Reserve Board worked with the US Treasury to bail out Bear Stearns, or at least prevent it from going bankrupt. Take the Fed’s shilling, and you are the Fed’s man: in modern terms, be too big or too interconnected to fail, and the government will regulate how you do business.
That won’t pass. One highly knowledgeable observer tells me that the days of 30% to 40% returns on equity in the investment-banking business are over. No longer will these institutions be allowed to leverage themselves as highly as they did in the past - too risky for the taste of the Fed regulators. Investors will have to satisfy themselves with a 20% return on their equity which, as they say in New York, ain’t chopped liver.
Nor will the dependence of America’s banks on foreign investors pass. We are witnessing a massive transfer of wealth from American consumers to oil producers. The sovereign wealth funds set up by producers have more cash than they can reasonably invest in skyscrapers in their own cities. Their investments in America’s financial institutions have proved a costly adventure so far, but these are long-term investors, the best kind from the point of view of the managers of our banks - so long as they remain passive - and so will remain key players in American financial markets.
The world of banking is not the only one that will never again be the same. The troubles of entire American industries will not pass, and they will be unrecognisable only a few years hence. The most obvious are the motor and airline industries.
Oil prices might come down a bit, but General Motors’ four shuttered 4x4 plants will not reopen and the 8,000 laid-off workers will have to hope that the company can find jobs for them producing small vehicles and hybrids. Chrysler says it plans to “break some of the old paradigms”, and Ford speaks of a “transformation”. Read, downsizing.
As for the airlines, they cannot even hope that their present difficulties will eventually pass, leaving them unchanged. Their business model is broken: some will disappear; others will find ways of extracting more money from travellers, and not merely by charging $15 to check in a bag; still others will continue paring schedules and finding new ways to make passengers cuddle even closer to their fellow sufferers. But nothing they do will stop the shift from flying to tele-conferencing, from hopping on a once-cheap flight on grandma’s birthday to a congratulatory telephone call or family video conference. Yes, there will still be airlines a decade from now, but they won’t look anything like the ones limping through America’s skies in the days of $40 or even $80-a-barrel oil.
Businesses are not the only institutions that will be changed forever by the current flow of billions from the treasuries of western countries to oil producers and to the emerging Chinese and Indian nations. Governments also will have to adjust. Taxing consumers who are already experiencing downward pressures on their living standards as they fill up their cars, and heat and cool their homes, will become more difficult. So will taxing footloose companies. Even politicians of the left have learnt that lesson - witness the backlash against Gordon Brown’s ever-upward tax regime, and Barack Obama’s tentative promise to lower corporate tax rates.
There will be more unpleasantnesses that will not pass. It will take the wisdom of a Solomon to predict just where they will appear, and how to cope with them when they do. My own guess is that the emergence of richer Chinese and Indians as competitors for the world’s resources will mean a gradual decline in American and western living standards as more food, oil, iron, coal and other resources head for Asia and the Middle East. Unless . . .
Unless the western industrialised countries can figure out how to raise their games. Workers will have to produce more every hour, which means that their governments will have to provide some substitute for today’s failed state-run education systems and turn out better-educated workers. Western countries will have to improve their transport facilities so that goods can move more cheaply. They will have to change their tax systems to encourage investment and discourage consumption. Unfortunately, the number of Solomons serving in our Congress is quite limited. So the outlook is less than bright.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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