Dancing at Davos (Again)

Each year, a group of 2,500 of the famous, powerful and beautiful gather for a week in Davos, Switzerland to solve the world's thorniest problems. The traditional hubris that accompanies the World Economic Forum established by Swiss economist Klaus Schwab in 1971 was noticeably absent this year. Perhaps frightened off by the serious tone that took hold in last year's conference, we were even spared the obligatory press conference by some rising Hollywood starlet. This year's official theme was "Improve the State of the World. Rethink, Redesign, Rebuild." The unofficial theme seemed to be a morphing of Shakespeare's famous line about lawyers: "First, kill all the bankers."

There was consternation over the lost innocence of the new U.S. administration. Happy to see the end of the perceived cowboy arrogance of the Bush years, attendees were astounded that the great promise of the Obama White House had been so quickly circumscribed by the rise of a mob of unsophisticated yahoos from nameless places in the interior. To some, the one thing worse than American hegemony was a weakened U.S. unable to maintain moral leadership. Few wanted to imagine China — or worse, Russia — stepping into that role.

The Americans were also noticeable by their very thin participation. Bankers were lying low, in general, for obvious reasons. Democratic Wall Street stalwarts, Lloyd Blankfein of Goldman Sachs and Jamie Dimon of JP Morgan, cancelled at the last minute. The executive branch was modestly represented by sub-cabinet level functionaries. French finance minister, Christine Lagarde, complained about the inability to have useful discussions given the absence of ranking U.S. officials.

Susan Collins, senator from Maine, noted the compete failure of regulation, but neglected to underline the critical failure of Congress to implement effective controls over their own homegrown mortgage behemoths, Fannie Mae and Freddie Mac. Barney Frank, who was both a key promoter and protector of Fannie and Freddie's catastrophic lending practices (which continue to this day), noted that, "I expect the President to be signing a financial reform package this spring." It was, after all, massive U.S. government regulatory intervention in the mortgage markets that ignited the fuse to the global conflagration. Frank appeared convinced that they could get it right this time around. We wish we were that confident.

Friday found the numerically-inclined staring wistfully at the sunny slopes and sifting though the robust 5.7 percent fourth quarter U.S. GDP growth. When it was determined that the number derived mostly from a slowing of inventory liquidation, all wondered nervously about the importance of that second derivative effect. The truth is we are still waiting for companies to begin building inventories in anticipation of renewed end-user demand. Obama advisor Larry Summers put a point on this anomaly stating that the U.S. is experiencing a "statistical recovery and a human recession." It is unfortunate for incumbents that, with elections approaching, only the humans can vote.

"One in five men in the U.S. between the ages of 25 and 54 is not working right now," according to Summers. This did not bode well for the future when, after the recovery, it will still be only "one in seven or one in eight." That compares to the mid-1960s, when 95 percent of men in that demographic cohort were working. Jobless claims continue apace, hitting above 400,000 a week. History implies that meaningful job growth (above 200,000 per month) will not happen until jobless claims drop to the 300,000 per week level.

The consumers still have not returned to their pre-crisis profligacy. With a massive debt load, impaired net worth, job uncertainty (or no job at all) and a deepening political angst, it is difficult to picture American households picking up the growth baton from the sputtering business sector. One technical analyst noted that the 5.7 percent jump only increased the probability of a negative GDP print in Q1 or Q2.

As the banking system came a cropper last year, it was obvious to all that new political controls and global regulations were urgently needed. No one seemed to notice that the current crisis occurred in the midst of recently implemented global banking regulations named Basel I and II. In fact, the invention of credit default swaps was in part a mechanism for banks to evade the capital requirements of Basel. By selling off credit risk they could recharge their balance sheet for more lending thereby increasing their leverage mainly via those mysterious over-the-counter derivatives. Rather than going under the old fashioned way with mountains of bad loans, banks could now fail and take a few dozen counterparties with them.
(We note with a grin that Basel is only a short drive from Davos.)

Considering this case and knowing how the distortions brought to the U.S. mortgage market by government intervention were exported to global balance sheets, regulators hope to be more thoughtful this time around. Despite all the political grandstanding, it is tautological that more political control of a financial system will lead inexorably to corruption and misallocation of resources.

Regional banking crises of the past have always been followed by a government debt bubble. A glance at Iceland and Greece might convince some that this particular disease has begun to spread. With U.S. deficits forecast to continue as far into the future as the visible horizon, it appears this linkage will be no different for us. Well, there is one difference this time, since the "world is flat" the problem has no regional boundaries. The only solution is austerity, higher taxes and much slower growth.

Austerity does not fit the script at conferences like Davos. The platitudinous aspirations that normally infuse these events have given way to a simple hand-wringing over the imponderable complexity of the world we inhabit. Or as The New York Times had it, "the only certainty is that the uncertainty will continue."

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