Budget cuts to test banks’ mettle
James Saft is a Reuters columnist. The opinions expressed are his own.
While it may well be a case of cut the U.S. budget or suffer a bond crisis, the current debate begs a question: who will pick up the slack in the economy and who exactly will finance them?
Democrats and Republicans raced, in a plodding sort of way, on Wednesday to reach a compromise budget deal that would keep the government operating past a Friday deadline.
Regardless of what may be wise, the likelihood is that there are going to be further substantial cuts in government expenditure, though this won’t begin in earnest until after the 2012 elections.
That is when the fun is going to start.
It is a simple fact that every dollar less in government expenditure is a dollar less received by the private sector.
Households in the U.S., being already in a sort of adrenal failure, are in no shape to expand spending and borrowing when the government contracts. Even the most extreme monetary policy over the past three years has only managed to bring on a tepid resumption in consumer spending, and, given the state of the housing market and the depressing path of wages, families beneath the top 10 percent are simply not going to go on a spree.
That leaves the corporate sector, and that is where we come to the role of the banks; their fantastic profits and their doubtful ability to finance a substantial recovery.
“The current balance sheet ratios of U.S. banks remain a serious impediment to the economy’s sustained recovery,” according to Andrew Smithers, economist at Smithers & Co in London.
If government is cutting and households are moribund, corporations are going to feel the strain in the form of reduced cash flow. This may mean increased investment, which implies taking on additional debt, or it may mean a fall in profits from their current historically high levels.
The state of corporate profits, as outlined in the national accounts released at the end of March, are really astounding. Overall corporate profits margins are at a record above 35 percent, their highest level ever in records stretching back before the crash of 1929.
The lion’s share of these profit margins are being generated by financials, which are at about 54 percent, well above their previous 1929 peak and more than 40 percent above mean. While that mean argues for a reversion, it is interesting to consider exactly why profits in finance recovered so quickly and with such an extreme trajectory.
ECONOMY TAILORED FOR BANKS
All of this is because the economy has been engineered by the authorities to allow for a bank recovery via profits, almost certainly at the expense of the rest of the economy. It is especially striking that while financial firms are far smaller than the rest of the corporate world in terms of the value they generate, they are twice as profitable per dollar of output. We also can’t expect banks to lead an investment recovery; they make fixed investments of only about a tenth of what nonfinancial corporations do.
Of course Geithner, Bernanke and Co were frantic to save the banks because they play a vital role in the economy; they must finance the assets that lead to expansion.
The problem though is that retained profits of the banks are only barely sufficient to support the growth in assets that would come with a healthy recovery, according to Smithers. If financial profits revert to mean, as is likely, especially in a rising interest rate environment, the banking sector may not have the muscle to fulfill its role. Bank equity ratios too, though high compared to recent standards, are not when looked at in the longer term.
Asset growth is crucial; looking at FDIC figures, asset growth in the banking system is running at about 6.75 percent, below the 7 and 8 percent growth of most of the last decade. Considering that securitization remains largely shut down, with the exception of the government-backed housing markets, this implies really quite tepid asset growth.
So, we have a government that is going to embark on painful cuts, a household sector that will suffer rather than compensate and a corporate sector dominated by finance, which leaks huge amounts of its profits in excess compensation and can’t even be relied upon to play its role in financing the economy.
It would have all been very different if the U.S. had forced proper writedowns and banking recapitalizations. The economy would not have had to be engineered for bank health and Main Street malaise, as it is today, and the healthy financial sector would be better able to support growth.
Budget cuts are coming, they will be painful and they will expose the weaknesses remaining in the banking system.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)