A proposal to generate back jobs and $3.5 trillion in lost wealth

The past five years have given policymakers and regulators the chance to implement traditional and extraordinary policy options. The worst outcome appears to have been averted, but we are in a path that is unsustainable whether or not we continue to reduce the size of the government or tax the rich, as some desire. Perhaps it’s time to consider policies that are more sensitive to the pain of American investors - and which could indirectly help in job creation.

$3.5 trillion. This is the approximate amount U.S. households lost from 2005 to 2009 even after getting unprecedented help from the U.S. Federal government. 

Capital markets are in disarray and will yet get messier before a clearer picture emerges. I’ve stated in previous writings that the biggest problem we are confronting is a messy and highly interconnected capital markets. The subprime mortgage crisis leading to a credit crisis is a notable example of this problem.

The job creating engines are stuck in the mud and will remain so until the current system breaks down and leaves policymakers/industry no choice but to replace it with something. That collapse appears too-close-for-comfort, but why not take this time to focus our energy on rebuilding a smarter set of policies that foster sustainable economic and job growth?

1. FOLLOW THE MONEY TRAIL

The first key to facilitate job creation comes from having a good grasp on the money trail. The way in which money is allocated within the economy or particular types of investments reveals the changing preferences of people and corporations.

Once we understand what markets want, we can evaluate a number of things, such as what type of investments are in high demand and what structural changes might be in order if there are capital bottlenecks — such as price bubbles for particular types of investments.

As a case in point, let’s look at the behavior of capital in the United States through the end of 2009 using the latest data compiled by the U.S. Fed and Aite Group.

• Americans consume more services than goods. Personal consumption of services totaled US$6.9 trillion in 2009, equivalent to 48% of the gross domestic product (GDP) and up from 45% of GDP in 2005.

• America is increasingly dependent on foreign trade. Foreign trade of goods and services has experienced a remarkable growth over the same four-year period, rising from 18% of GDP to 26%. But the U.S. share of global exports has steadily decreased from 12% in 1999 to 8% in 2009.

• The ‘trading economy’ is rising fast. New York and Chicago have played a key role to help global exchanges and over-the-counter (OTC) operations reach trading volumes of US$20 trillion/day — with compounded annual growth rate (CAGR) of eight percent since 2004.

• American wealth relies heavily on two areas. The accumulated wealth of U.S. households reached US$68.2 trillion in December 2009, with 66% invested in financial assets (such as the stock market and bank deposits) and 25% in real estate holdings.

• Bank assets are similarly concentrated. The financial assets of the U.S. commercial banking system totaled US$14.3 trillion in 2009, with 27% tied to mortgage loans and 18% to various types of market securities. The capital banks hold on hand to support their lending activities has risen to US$2.1 trillion in 2009 from US$1.2 trillion in 2005.  

2. FIND THE PAIN

Entrepreneurs are always on the lookout for unmet market needs they can help satisfy, for a profit. Likewise, it makes sense to see financial pain as an unmet market need. Here are statistics that quantify this pain.   

• Real estate losses. The value of real estate assets held by U.S. households dropped 24% to US$5.5 trillion in the 2005 to 2009 period. The value of mortgage loans in the banking system, however, has risen by more than 20% over the same period - a sign that it is not viable for the banking system to mark-to-market the value of its real estate portfolio.

• Stock market losses. U.S. household stock holdings dropped in value from US$9.5 trillion at the end of 2006 to US$5.2 trillion in March 2009, and recovered nine months later to US$7.7 trillion. Losses in mutual funds and pensions funds holdings were of a similar magnitude and compounded the financial pain of U.S. households.

• Investment lineup changes. Over the 2008 to 2009 period, U.S. households reduced holdings in mortgage bonds and money markets funds by US$900 billion—much of it financed by the U.S. Fed. Simultaneously, the holdings of individuals rose by US$950 billion in mutual fund shares and US Treasuries securities.

• Self-directed trading is in. Compared to 2005, self-directed brokerage holdings in 2009 were up 16% at US$670 billion, self-directed individual retirement accounts (IRA) balances rose 8% to US$1.5 trillion, and exchange-traded funds (ETFs) skyrocketed 157% to US$773 billion. Losses in equities markets during the 2006 to 1Q 2009 period were considerably milder for individuals in these groups than those experienced by professionally managed investment accounts.

3. POLICY IMPLICATIONS 

The pain described above speaks of investors licking their wounds, exiting the riskiest assets (mortgage bonds) for the safest investments (U.S. Treasuries). The complexity of keeping up with changes in capital markets probably led many investors (without the aptitude for self-directed trading) to switch more of their capital to mutual funds. I also observed considerable interest among investors at large and money market mutual funds to seek modest positive yield through traditional banking products - time and savings deposits.

The past five years have given policymakers and regulators the chance to implement traditional and extraordinary policy options. The worst outcome appears to have been averted, but we are in a path that is unsustainable whether or not we continue to reduce the size of the government or tax the rich, as some desire. Perhaps it’s time to consider policies that are more sensitive to the pain of American investors - and which could indirectly help in job creation:

• The securities-trading economy. The securities-trading economy, if restructured in better terms than those proposed under the 2010 Dodd-Frank Act (DFA), will remain a viable means for tens of millions of self-directed traders and investors to generate wealth, in large measure, regardless of what happens in the real economy. The troubling precedent  with MF Global illustrates that much work remains ahead. The restructuring should be along the lines of government bringing  together market participants and technology providers, and giving them a reasonable time to find solutions that contain systemic risk across and within asset classes. Top-down DFA mandates regarding derivatives trading venues, such as swap execution facilities (SEFs) or rules that hurt development of retail currency trading, are simply the wrong medicine.

• The real economy needs targeted trade barriers (and inflation). Targeted trade barriers to products originating from countries which peg their currencies to the U.S. dollar (China, some Asian nations) would have an inflationary and job-creating impact in the United States. This inflation, although relatively mild, would also spur demand for stocks (natural inflation hedges) and would increase the value of homes – two areas where much of American wealth is concentrated. Feeling a little richer, Americans will start to ramp up their consumption levels, clear the housing backlog by snatching bargain real estate assets, and essentially kick the economy back into action.

• Carrot and stick with multinationals. “What have you done for me lately in terms of jobs” should be the attitude of U.S. policymakers vis-à-vis multinationals domiciled in the United States. There should be a more assertive set of policies to foster anew the development of industry/manufacturing capabilities in the United States — much like Germany and Brazil have done successfully. The carrot could be certain temporary tax benefits/credits for job creation.

I should clarify that I am not advocating doing away with recent bilateral trade agreements or with NAFTA, as these can be effective ways to increase the ‘soft power’ of the United States and gain over time a greater share of the trading partner’s overall imports.