Money and Finance

Hussman Weekly Market Comment

Now, assuming that the government is able to persist in misusing public funds and abusing public trust in order to protect the bondholders of these institutions from losses, it's reasonable to ask: Could the banks eventually “earn their way out” of their losses over the longer-term?

To answer that question, you have to think in terms of equilibrium. Even holding GDP constant, the earnings to recover the losses have to come from somewhere, which implies a redistribution away from where they were going before. Really, money doesn't grow on trees. We've got an economy running with outstanding debt of about 350% of GDP. Even a moderate percentage of that as loan losses will represent a significant share of GDP. To reallocate enough funds to fill that hole, we would have to keep deposit rates near zero, and corporate lending rates high, so that financial institutions would earn a persistently wide spread, or “net interest margin.” Over the short-term, that's what's been happening, so ironically, banks are more “profitable” today than they probably will ever be. Unfortunately, that “profitability” is an artifact of a) unsustainably wide net interest margins, and b) a failure to adequately book losses, at the encouragement of government bureaucrats.

Consider the economic landscape. The U.S. government is running huge deficits, selling debt to foreigners in order to make the bondholders of mismanaged financial institutions whole. This will put a claim on our future national output and allow foreign owners to scoop up U.S. businesses in the years ahead. We are also running a large current account deficit (though somewhat smaller than in recent years thanks to a collapse in U.S. gross domestic investment).

In order for U.S. financial institutions to earn their way out of the losses, they will have to accrue and retain an amount on the order of 25% to 35% of GDP. From where will they reallocate that amount? Well, prior to the recent earnings downturn, corporate profits were running at about 8% of GDP, a figure that was already based on unusually high profit margins (the sustainable norm is less than 6%). The personal savings rate was about zero, but has increased to about 4% as consumers have scaled back consumption. If banks were able to sustainably charge high interest rates on loans and pay low interest rates on deposits, the earnings of the banks would come at a cost to what would otherwise have been retained: corporate earnings and private savings. Essentially, savers will earn less, and corporate borrowers will pay more. To accrue 25-35% of GDP to cover the debt losses (which is a mainstream estimate, not a worst-case by any means), you would have to persistently depress non-financial corporate profits and personal savings by about 25% for well over a decade.

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Money and Finance