Debt ceiling: Understanding what's at stake

CBS News:
By 

ALAIN SHERTER / 

MONEYWATCH/ October 7, 2013, 7:40 AM

(MoneyWatch) It is the economic calamity that no one expects and everyone fears.

Experts agree that failing to raise the nation's debt ceiling by Oct. 17, when U.S. officials say the government will run out of money to pay its bills, would gravely wound the economy, and perhaps even throw it back into recession. Because Treasury bonds and the dollar are cornerstones of the global financial system, meanwhile, the shock wave would be felt around the world.

Play VIDEO

Bank CEOs: Don't play games with debt ceiling

"The potential is disastrous," said Gus Faucher, senior economist with PNC Financial Services Group. "We would see interest rates spike across the board. We'd see a huge crash in the dollar. People count on lending their money to the federal government and getting it back, and if that trust is taken away -- it's never happened that we haven't met our obligations as a nation -- then that has very, very negative consequences for the U.S. economy."

The consequences are so severe that, even as the government shutdown enters its second week, most seasoned political observers still expect Congress to ultimately reach an eleventh-hour deal to lift the government's borrowing limit.

But what exactly is the debt ceiling, and exactly how worried should Americans be that it could come crashing down?

What is the debt ceiling?

English: Chart of the United States' debt ceiling from 1981 to 2010 in $ trillion. This chart tracks the debt ceiling at the end of each calendar year. Years are color coded by congressional control and presidential terms highlighted. Data source: http://www.treasurydirect.gov/NP/BPDLogin?application=np Modified chart by http://commons.wikimedia.org/w/index.php?title=User:LibertyUSArocks&action=edit&redlink=1 to remove New York Times logo and make more NPOV. (Photo credit: Wikipedia)

The debt ceiling is the total amount of money the U.S. government can borrow (by selling Treasury bonds) to pay its obligations, including interest on the national debt, Social Security and Medicare benefits, and many other payments. That limit is currently $16.7 trillion, although technically the government already exceeded it in May. The Treasury Department has since used various measures to continue borrowing. 

During World War I, amid uncertainty regarding the total costs of funding U.S. involvement in the conflict, Congress created the cap in 1917 to put an upper limit on federal borrowing. Since 1960, Congress has raised the debt ceiling 78 times.

How is the debt ceiling changed?

Lawmakers can adjust it by passing a standalone bill or by including it in another piece of legislation as an amendment.

U.S. debt from 1940 to 2010. Red lines indicate the Debt Held by the Public (net public debt) and black lines indicate the Total Public Debt Outstanding (gross public debt), the difference being that the gross debt includes that held by the federal government itself. The second panel shows the two debt figures as a percentage of U.S. GDP (dollar value of U.S. economic production for that year). The top panel is deflated so every year is in 2010 dollars. (Photo credit: Wikipedia)

Does raising the debt ceiling increase the federal debt?

No. Lifting the borrowing limit simply allows the government to pay its existing bills. That debt exists whether or not Congress authorizes additional borrowing, and to avoid default it must be paid.

Why can't Congress and the White House avoid lifting the cap by cutting federal spending?

Because preventing the government from borrowing to meet its obligations would require all discretionary spending, such as for defense, education, housing and other annual appropriations, to stop, according to the Congressional Research Service. Most of the outlays for mandatory programs, such as Social Security, also would have to be halted, while taxes would need to rise to ensure the government had money to spend. Deep spending cuts and tax hikes would throw the economy into recession.

Why is Oct. 17 a critical date?

Play VIDEO

Lew: Raise debt ceiling to avoid default "abyss"

Treasury Secretary Jacob Lew recently forecastthat on Oct. 17 the government would have about $30 billion on hand. That isn't enough because the government spends as much as $60 billion per day. "If we have insufficient cash on hand, it would be impossible for the United States of America to meet all of its obligations for the first time in our history," he said last week in a letter to congressional leaders.

What happens if Congress doesn't raise the debt ceiling?

If the government runs low on cash, it will have to withhold a range of payments. Retirees might not get their Social Security checks, especially worrisome for the millions of Americans who depend almost entirely on the social insurance program for income. The same goes for Medicare and Medicaid recipients. Holders of Treasury notes, from Wall Street and other global banks to foreign governments, also could get stiffed, jeopardizing the solvency of many financial institutions and choking off global credit flows.

Play VIDEO

Financial markets wary of looming debt ceiling deadline

The U.S. also would struggle to pay the interest on its debt, including a $6 billion payout due at the end of the month. At that point, the U.S. would be in default of its obligations. The value of Treasury bonds and the dollar would nosedive. The nation's borrowing costs would soar as anxious investors demanded a higher return to buy suddenly shaky U.S. debt. And because the interest rate on Treasuries provides a benchmark for rates on other loans, from mortgages and credit cards to car and student loans, borrowing would become far more costly for consumers and businesses. Stock markets in the U.S. and elsewhere around the world would almost certainly plunge.

"When stock prices fall, investment or other spending to expand a business is more costly," the Treasury Department said in a report last week outlining the potential impact of the debt-ceiling fight. "The effects on households and businesses, moreover, are reinforcing. Less capacity and willingness of households to spend, when businesses have less incentive to invest, hire and expand production, all lead to weaker economic activity."

In short, the already fragile economic recovery could stall.

Haven't we been here before?

Play VIDEO

Not raising debt limit would make Congress "a deadbeat," Obama says

There is recent precedent for such turmoil. Consumer confidence plummeted after lawmakers squared off over the debt ceiling in the summer of 2011, while the Standard & Poor's 500 stock index dropped nearly 20 percent. Hiring among small businesses slowed. Ever after a deal was struck to raise the cap in August of that year, credit rating agency Standard & Poor's downgraded U.S. debt for the first time ever.

Beyond the immediate economic fallout of defaulting on its debt, for the U.S. the symbolic blow might be even greater. In the post-World War II era, Treasuries and the greenback have -- for better and for worse -- served as the foundation of the global financial system. A default would shatter the faith on which that system relies.

How much danger are we in?

Although financial markets are not yet in panic mode, the standoff in Washington has them worried. Unlike during the 2011 dispute, when Republicans and most Democrats favored cutting federal spending, the stark division over Obamacare suggests there may be less room for compromise this time around. One clear sign of distress: Interest rates on short-term Treasury bonds rose last week, as investors seek greater yields to offset what they perceive as the greater risk of holding the debt.

Still, most economists, stock analysts and, for all the pointed rhetoric on Capitol Hill, even congressional leaders themselves downplay the chances of a default. The belief is that common sense, or at least a sense of political self-preservation, will prevail.

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Daylight Saving: Energy Policy or Placebo?

Cover of Richard M. Nixon

POWER Magazine

In December 1973, President Richard Nixon explained to the American people his administration’s critical initiative to confront the “energy crisis” du jour (precipitated by the 1973–74 Arab oil embargo): “Many [energy savings measures] require inconvenience and sacrifice. But daylight saving time... will mean only a minimum of inconvenience and will involve equal participation by all. Unlike many of our other initiatives to deal with the energy crisis and to accomplish the goal of self-sufficiency in energy... these savings will not require research, new technology, diplomacy, or exploration.”

Cover of Jimmy Carter

In the almost four decades since President Nixon resurrected daylight saving as a critical component of national energy policy, our populace has clung to the hope that such a “no cost/no sacrifice” silver bullet would rescue us from each succeeding energy crisis. The nation accordingly ignored President Jimmy Carter’s admonition that confronting our energy exigencies required great sacrifices approaching the “moral equivalent of war.”…

Historical Background

Benjamin Franklin is credited as the first to identify the potential fuel savings associated with adjusting the clock. …

Retailers generally favor DST. United Cigar Stores hailed a 1918 DST bill. (Photo credit: Wikipedia)

In 1918, U.S. federal law standardized the start and end dates for daylight saving. During World War II, Congress mandated daylight saving throughout the 50 states. Following the end of the war, other than 1973 and 1974, the daylight saving time period was 26 or 27 weeks. Beginning in 1988, federal legislation extended the period to 29 or 30 weeks. A 1975 federal study concluded that these measures reduced overall electric consumption by 1%. In a 1976 report to Congress, “Review and Technical Evaluation of the DOT Daylight Saving Time Study,” the National Bureau of Standards found no significant energy savings.

Energy Policy Act of 2005: Same Old, Same Old

From the early 1980s … oil prices remained around $25 a barrel. However, prices began a run-up in mid-

An illustration of the beginning of Daylight Saving Time. (Photo credit: Wikipedia)

2003, reaching $60 a barrel by summer 2005. Congress passed the Energy Policy Act of 2005 (EPACT) to respond this “second energy crisis.” Prices ultimately peaked at just under $150 in mid-2008, before declining due to the financial crisis and associated global recession.

… Congress, however, essentially “dropped back 30 years” and … reverted to President Nixon’s political acumen to prioritize a policy promising “no cost/no inconvenience.”

… Our clocks now “spring ahead” on the second Sunday in March and “fall back” on the first Sunday in November. This 34-week period observed by most of the United States likely represents the world’s longest daylight saving period, exceeding the period in European nations by three or four weeks.

Energy Policy or Legislative Placebo?

At one level, EPACT’s expansion of daylight saving time could be viewed as a success: Almost no

An illustration of the end of Daylight Saving Time. (Photo credit: Wikipedia)

government funds were spent. The Department of Energy (DOE) also claims the extension reduced energy consumption … less than 0.5% and, moreover, only during the additional weeks of daylight saving in March and October. Critics challenged the validity of even this near-negligible energy reduction and argued further that on an annual basis this transitory savings is probably statistically insignificant. Furthermore, the fundamental debate over whether daylight saving time saves total energy consumption at all times and in all localities remains; critics contend that having more daylight hours increases air conditioning electric load and “leisure” gas consumption.

… Our nearly half-century experience responding to energy crises demonstrates that national energy policy must be developed with the understanding that there are no quick fixes and that success demands public and private investment, measured risk-taking (not all of which proves successful), and technological advances.

Energy policy must be crafted based on current facts and circumstances. President Nixon’s reliance on daylight saving made sense—increasing daylight hours in the 1970s represented the easily attainable “low-hanging fruit” of energy efficiency. However, EPACT expanded daylight saving only because “it worked before” and to avoid the political awkwardness of pursuing meaningful energy measures. … . Daylight saving should be assessed on its comparative social and economic costs and benefits. As a means to reduce energy consumption, daylight saving, particularly any further expansion of its duration, must be dismissed as a distracting placebo.

— Steven F. Greenwald (stevegreenwald@dwt.com) and  Jeffrey P. Gray  (jeffgray@dwt.com) are partners in Davis Wright Tremaine’s Energy Practices Group.

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The Power of the Post-Recession Consumer

An analysis of attitudes and spending reveals a return to traditional values, driven by consumers searching for quality, affordability, and connection.

strategy+business magazine
February 22, 2011 / Spring 2011 / Issue 62
by John Gerzema and Michael D'Antonio

Illustration by Lars Leetaru

Image via WikipediaThe wave of hyper-consumerism that propelled the U.S. economy through the last decades of the 20th century and into the first years of the 21st century has passed. …Consumer spending patterns are changing as part of a trend that has been quietly gathering strength over the past 10 years. …People are returning to old-fashioned values to build new lives of purpose and connection. They also realize that how they spend their money is a form of power, and are moving from mindless consumption to mindful consumption, increasingly taking care to purchase goods and services from sellers that meet their standards and reflect their values.

This change in consumer attitudes … is …, in part, a reaction to economic hard times. But it is also closely related to the civic dissatisfaction that is rocking the political establishment, and additionally has some roots in environmental awareness and changing aspirations. That is why this Spend Shift movement, as we call it, is here to stay. It will create opportunities for businesses that heed its message, and penalize those that do not. (For another perspective, see “Values vs. Value,” by Timothy Devinney, Pat Auger, and Giana M. Eckhardt, s+b, Spring 2011.)

Our view of the Spend Shift is based on two years of gathering and analyzing data, and traveling around the U.S. to discover how the recession has affected people’s lives. We started with Young & Rubicam’s BrandAsset Valuator (BAV), which is a poll of consumer values, attitudes, and shopping behaviors that goes back nearly 20 years. …

The BAV data revealed that even before the recession took hold in mid-2008, there were dramatic shifts in what people expected in the consumer marketplace and how they defined and pursued what they considered the good life. … More recently, the BAV surveys show sharp increases in the number of consumers who want positive relationships with marketplace vendors and who focus more on corporate behavior. Between 2005 and 2009, a growing number of people rejected status-driven values such as snobbishness and exclusivity, and embraced attributes related to bringing people closer together or making the world a better place. Among the once-prized brand attributes that declined in this period were: “exclusive” (down 60 percent), “arrogant” (down 41 percent), “sensuous” (down 30 percent), and “daring” (down 20 percent). On the opposite side of the scale, the brand attributes Americans found more important as they began to sense the impending recession and then suffered through the crisis were: “kindness and empathy” (up 391 percent), “friendly” (up 148 percent), “high quality” (up 124 percent), and “socially responsible” (up 63 percent).

… Between 2005 and 2009, U.S. consumers expressed a nearly fourfold increase in their preference for companies, brands, and products that show kindness in both their operations and their encounters with customers. This desire for companies to be more empathetic toward consumers is the biggest shift in any attitude that we have ever seen during the BAV survey’s two-decade history. …

1. United by Change

The Spend Shift is a far-reaching and inclusive phenomenon that can’t be defined by any particular demographic. According to our data, 55 percent of all Americans are part of this movement; in addition, about one-quarter of the U.S. adult population embraces many of the Spend Shift attitudes and characteristics (we call them Fast Followers). Although the word values tends to polarize U.S. citizens, the Spend Shift is blind to geography, education, age, and income. …

What unites all these Spend Shifters is a common sense of optimism and newfound purpose. As the shock of economic loss wears off for many people, they are redefining what it means to be successful and happy. They are living with less and yet feeling greater satisfaction. …

2. The New Thrift

…Consumer spending will no longer be able to grow faster than personal income, as it did during the 30 years leading up to the crisis. … If you look at historical savings rates in the U.S., people have on average saved 10 percent of their income going back as far as six decades. It was only in the mid-1980s that … ordinary people [ere encouraged] to get out over their skis. In only 20 years, average American households swung from being net savers to being net borrowers. Now, however, consumers are returning to traditional values that have long defined the U.S. ideal.

Image via Wikipedia… In the post-recession economy, resourcefulness and self-sufficiency are viewed as virtues, and excessive consumption as a sign of weakness. … We examined the 2009 performance of a basket of “retooling” companies — those that are in the top 10 percent of our data on being “helpful,” “reliable,” “educational,” and “durable,” such as LeapFrog, Weight Watchers, Craftsman, and DeWalt, because they help people help themselves. The performance of these companies against all others is notable: They performed 249 percent better than other companies when respondents were asked whether they would recommend these brands to a friend, 234 percent better when respondents were asked if they used the products regularly, and 210 percent better on whether the products were worth a premium price.

…[Many] people, … are seeking ways to experience a sense of competence, self-sufficiency, and accomplishment. … If you have an idea for helping people learn new skills and connect with others, your business has a good chance of success.

3. Transparency Breeds Trust

… Companies serving these customers, who know more and expect more, will need to continuously listen, respond, and innovate. They are in for a challenge: Our data shows that confidence in all types of big organizations, including big government and big business, has declined by nearly 50 percent in the past two years. …

Wary consumers are going beyond just reading labels to get the best products and the best deals. The most tech-savvy are using online services as they stand in the supermarket aisle to get instant access to information on prices and on a company’s social or environmental record. …

… Today, however, customers have equal (and sometimes superior) access to data. As a result, transparency becomes all the more crucial. Today’s stakeholders … crave a true, authentic story. They will be interested in how a company thinks and how it makes decisions. …

4. Companies That Care

… The ability of a company to identify with its customers is now a prerequisite for any brand in the post-crisis age. Today, openness, humility, and understanding are critical. Generosity binds a company to its community and its stakeholders.

The rising importance of generosity reflects the fact that the post-crisis era will be defined by inclusion rather than exclusion. … Spend Shifters are buying artisanal food because they trust companies that reveal how their food is produced and handled. They patronize cooperative small businesses because such businesses use their profits to build up their local regions. Passionate customer groups will also band together to fund niche offerings that speak directly to the areas about which they feel most strongly. Because 71 percent of U.S. consumers are now aligning their spending with their values, businesses that practice in a new way will find a vibrant marketplace. Instead of selling shoes, such businesses sell empathy and respect. … Instead of serving food, companies create communities of hope. Instead of making cars, they promise fairness, openness, and shared discourse.

Consumers will be looking for signs that companies care about their impact on communities and are investing in making things better. … The vanguard companies understand that showing kindness and humanity is now a competitive advantage.

Microsoft is a telling example. … In our BAV survey, Microsoft always scores high on measures of its reputation, exceeding Apple by a wide margin. … Despite its massive size, Microsoft is still widely associated with the single personality of its founder, Bill Gates. He gives Microsoft a human face and, more important, his philanthropy gives the company a heart. …

When we talked to Akhtar Badshah, Microsoft’s senior director of global community affairs, he told us that in its response to the recession, Microsoft pursued three main areas of focus: education, innovation, and jobs and economic opportunity. … The key point is that Microsoft uses both its money and its true areas of expertise to maximize the good it can do as a citizen corporation, showing how a company can be charitable by redeploying its existing assets and infrastructure as tools for social and economic development.

The Consumer Connection

… Although the growth of consumer spending appears to be slowing, we believe that people are simply reallocating the way they spend — looking for a connection to the creator of the product; banding together to get better deals; and pushing service and product creators to do more, price better, and connect more deeply to their wants and needs.

Image via WikipediaEven as people find themselves less rich, they are deploying their dollars in a more calculated and strategic way to influence institutions such as corporations and government. …

The most successful companies will respond to this shift by adopting a business model in which all three parties — the business, the customer, and the community — win in every transaction. Although the Spend Shift will dampen domestic demand for some products, the market for values-oriented goods and services offers opportunities for growth in what might otherwise be considered mature categories. We examined the performance of a group of companies and brands that scored in the top 20 percent in the BAV survey on the values we had noted were becoming increasingly important — self-reliance, adaptability, honesty, quality, and community. And we found that in aggregate they enjoyed nearly three times as much usage and preference as brands that did not represent these values.

We believe that the future face of capitalism will be defined by delivering value and values. Those that embrace this reality and adapt will find extraordinary opportunities. Those that ignore it will do so at their peril.

Reprint No. 11107

Author Profile:

• John Gerzema is president of Brand Asset Consulting, a Young & Rubicam Brands company. He is a pioneer in the use of data to identify social change and to help companies both anticipate and adapt to new consumer interests and demands. Gerzema oversees the BrandAsset Valuator, the world’s largest database of consumer insights. Follow him on Twitter at @johngerzema/Twitter.
• Michael D’Antonio is a Pulitzer Prize–winning journalist based in New York. He is the author of more than a dozen books, including Forever Blue: The True Story of Walter O’Malley, Baseball’s Most Controversial Owner, and the Dodgers of Brooklyn and Los Angeles (Riverhead Books, 2009).

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Henry Kaufman Roubini And Other Prophets Of Doom Say Financial Crisis Continues - Industry News - Portfolio.com

Economist Henry Kaufman became famous in the 1970s as the bear with the dire view. Now he and his heirs warn that the financial crisis is far from over and that systemic risks threaten to spread from the markets to the geopolitical realm.

Portfolio.com - a bizjournals property
by Suzanne McGee Oct 15 2010


Image: Portfolio.com; designed by Sean Driscoll

Henry Kaufman is far from upbeat about the outlook for the U.S. economy or the financial system.

That should come as anything but a shock to anyone familiar with Kaufman’s background as an economic pundit. After all, he earned the nickname “Dr. Doom” nearly four decades ago for his bearish outlook on interest rates and the bond market and for his fear that financial havoc might spread to the political environment and society as a whole.

Even as politicians and others try to take comfort from the passage of the package of financial reform measures known as the Dodd-Frank Act, Kaufman is reluctant to relinquish his pessimism …“It’s a very cumbersome piece of legislation and creates a tremendous amount of uncertainty,” the economist and financial consultant says. “Many aspects will take years to come into effect, and there are many issues that still have to be resolved by regulators in negotiation with the private sector.”

That, Kaufman says, means that the Dodd-Frank Act has at least two major flaws … In the short term, he argues, rather than accelerating the rate at which credit is created in the economy, the uncertainty means credit growth will actually slow. The longer-term problem is more acute, he says: The legislation doesn’t address the problem of financial institutions that become “too big to fail,” as the saying goes.

“Over a longer period of time, the result of Dodd-Frank will be to increase the size of the government’s role in the economy and in the financial system specifically,” Kaufman says. “Instead of adopting policies that help to downsize financial institutions, we are making this more like the European or Japanese system.” That, he argues, is not a good thing for the financial system or its users. …

Image via WikipediaBut while Kaufman may be the original “Dr. Doom,” these days he is just one figure in a pantheon of prophets of doom. Among his heirs are figures like Nouriel Roubini, a professor at New York University and head of his own economic-forecasting consulting firm, who was one of those who diagnosed the credit bubble and forecast that it would come to an early end. Since 2008, Roubini has warned repeatedly that the financial system and the economy haven’t yet emerged from the crisis and that an intractable public debt problem still looms.

While Roubini has emphasized sovereign-debt problems of the kind that became all too evident in Greece this year, others are trying to draw attention to a different source of concern: … It is the emergence of cash-rich and commodity-rich states as political powerhouses rivaling—and in some cases trumping—traditional geopolitical powers such as the European Union and the United States.

Cover via AmazonThat is the focus of two recent books, one by Ian Bremmer, president of the Eurasia Group (The End of the Free Market: Who Wins the War Between States and Corporations?), and the other by journalist Eric Weiner, entitled The Shadow Market: How a Group of Wealthy Nations and Powerful Investors Secretly Dominate the World.

As the titles imply, the next generation of prophets of doom are focusing on different sources of systemic risk than those that brought the financial system to the brink of disaster in 2008. Weiner, for instance, suggests that if the problems associated with the shadow financial system (all the mortgage originators and architects of structured products) were scary, the problems that could follow the evolution of a “shadow market” composed of countries that view their economic power as something to be deployed in their geopolitical interests could prove far more threatening to the U.S. financial system.

Weiner chooses some well-known examples to prove his point. Among them are China’s ability to use its importance as a source of liquidity in the global markets and as a large investor in U.S. government securities to win favorable treatment in some disputes and fend off criticism of its human-rights policies. … He envisages a secretive new financial world emerging, one in which transactions take place outside of the public arena and end up being hard for regulators or the public to monitor. …

---

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A better way to anticipate downturns

Credit markets, though harder to follow than equity markets, provide clearer signs of looming economic decline.

McKinsey Quarterly
OCTOBER 2010 • Tim Koller
Source: Corporate Finance Practice



What executive isn’t challenged by the daily barrage of conflicting economic reports attempting to clarify the question of the hour: will the global recovery build or lapse into another recession? Indeed, executives around the world are evenly split on the topic.¹ And while the savviest executives and investors know better than to get caught up in the short-term fluctuations of the economy, many others, looking for evidence of longer-term trends, still fixate on movements in the equity markets.
They shouldn’t. The fact is that those markets, … don’t predict downturns effectively. Credit markets are a better place to look for signs of impending trouble, in no small part because they have been at the core of most financial crises and recessions for hundreds of years. Parsing the credit markets isn’t easy—there’s no single number remotely like a share price to monitor, and there are many moving parts. But for executives willing to take the time to understand the relationship between the financial and real economies, the credit markets can provide clearer indicators that a recession is on the horizon.

Collective wisdom falls short

Subscribers to the theory that markets process all information efficiently would argue that equity investors should be in very good shape to recognize early indications of a looming downturn. If that were indeed the case, current market valuations might inspire confidence. … And since equity markets do a reasonably good job of tracking long-term economic fundamentals,² investors can expect longer-term returns—dividends and share price appreciation—that are in line with historical real returns, in the range of 6 to 7 percent.
Of course, the fact that the stock market is currently in line with the long-term trend doesn’t rule out the possibility of major fluctuations on the way to the longer term. The performance of equity markets shows that they have not been a good predictor of past recessions. Indeed, during every major recession since the early 1970s, most of the decline in the S&P 500 index occurred after the economy had already slowed (Exhibit 1). … Our analysis suggests that the equity markets give too much weight to current economic activity rather than to the situation likely to materialize in a couple of months or even a year.

Exhibit 1: Most of the decline in equity markets comes after a recession has already begun.

Moreover, when the index’s value does drop during nonrecessionary periods, this rarely signals a coming downturn. In the past 30 years, there have been few major declines in the market outside of recessions (Exhibit 2). Even an extreme case, such as the 20 percent drop during a couple of days in 1987, didn’t portend a systemic downturn, and the index was back to normal a mere two months later. In the past, such market fluctuations have been caused mostly by forces that didn’t have anything to do with the real economy—and any effect they had dissipated very quickly. Equity markets played the more typical role of bystander, buffeted by and reacting to economic events rather than anticipating them.

Exhibit 2: Stock market declines do not indicate economic downturns.

While the equity markets may not predict economic trends well, their depth does provide investors with liquidity, so they generally continue to function smoothly even in difficult times. … During that time, the S&P 500’s long-term trend value—the value you would expect to see if you were confident that the economy would recover to its long-term trend within several years—stood at about 1,100–1,300. Therefore, no one should have been surprised to see a drop to the 900–1,000 level, given uncertainty about the depth and duration of the recession. …

Incubators of crisis

Unlike equity markets, credit markets don’t always function smoothly during difficult times. That, in part, is why they are a better source of clues about where the economy is heading. The credit markets are where crises develop—and then filter through to the real economy and drive downturns in the equity markets. Indeed, some sort of credit crisis has driven most major downturns over the past 30 to 40 years (Exhibit 3). Such crises include not only the recent property debacle in the United States and the 1990 one in Japan but also the crises generated by excessive government borrowing in Latin America in 1980 and by excessive corporate borrowing in Southeast Asia in 1997. So executives who find reasons for optimism in today’s equity market levels might be less sanguine looking at today’s credit markets. It’s still not clear whether prices have stabilized in once overheated real-estate markets. Banks are still somewhat vulnerable. And the level of government debt in the United States and elsewhere is still an issue.

Exhibit 3: Most major downturns in the past 30 to 40 years have been driven by some sort of credit crisis.

Moreover, the pattern of crisis development shows clearly enough that the one thing we can know for certain is that economic crises will erupt in the future—in part because the credit markets work almost as if designed to cause them. That may be a provocative point, but consider this:

• The credit markets are extremely illiquid. The trading volume of most equities is many orders of magnitude greater than that of typical debt instruments. … This illiquidity sometimes makes it difficult for banks or other investors to sell credit assets at a reasonable price. In addition, providers of short-term credit—to banks, hedge funds, and other financial institutions—may be simply unwilling to extend new credit when old debt comes due, forcing debtors to sell assets to pay down debt just as they are least sellable.
• The banking system and many investors, particularly hedge funds, earn a significant portion of their profits on the mismatch between their assets and liabilities: they invest in longer-term loans and other investments and borrow with short-term deposits and debt. … Normally, this formula works well. But two things can happen to disrupt it. Sometimes the yield curve inverts, with short-term interest rates higher than long-term rates; then, normal banking profits disappear. More important, short-term credit markets sometimes freeze up, so banks, hedge funds, or financial institutions can’t get short-term debt at a reasonable price, or any price. As a result, they sell assets at distressed prices—if they can find buyers.
• The system suffers from chronic group-think. … Banks and investors observe which banks or other investors seem to be making the highest profits and then implement similar strategies. If contrarians in the market were to counterbalance credit excesses, the system should stay in equilibrium. But the system makes it very difficult for investors with contrarian views to apply them. …
• Expectations of government bailouts create tremendous moral hazard—… If the European Union hadn’t been expected to step in and rescue the country, the spreads on its debt would have been much higher, years before the crisis hit, relative to, say, German bonds or other euro bonds, given the enormous levels of government debt and its large social obligations. Instead, investors assumed that the EU or one of its members would bail out Greece and continued to lend to it at rates far below levels that would have reflected the true risk of the debt. And in the end they were right, as the EU stepped in.

Unfortunately, it takes several years for crises to develop, and once the conditions are in place, they are nearly inevitable. The only way to stop one is to anticipate it years in advance; for example, preventing the US subprime crisis would have required clamping down on borrowing in 2005. Avoiding the crisis in Greece would have required something similar in 2005, 2006, or even earlier.

Foreshadowing a downturn

The good news, relatively speaking, for managers of companies is that because the conditions for a crisis are in place several years in advance, it is possible to see the signs of one coming—and to avoid getting caught up in credit market hazards.³

Loose lending standards

One clear sign of trouble ahead is a deterioration of lending criteria. … [During] the 2005 real-estate bubble in the United States, buyers with little or no evidence of their ability to carry a mortgage could purchase houses.

Unusually high leverage

Another warning sign of crisis is unusually high debt levels and mismatches between assets and liabilities, whether by financial institutions, companies, governments, or individuals. For example, in the months leading up to the real-estate crisis that erupted in 2007, the leverage of both banks and consumers in the United States was at unusually high levels. In addition, many consumers were financing their homes—long-term, illiquid assets—with debt in the form of adjustable-rate mortgages that had the characteristics of short-term debt.
In the 1997 Asian crisis, companies financed production facilities—obviously long-term investments—with debt in US dollars. When the dollar strengthened, borrowers needed more local currency cash flows to service the debt. And as hedge funds have grown over the past decade, the importance to their returns of their financing model—short-term debt to finance less liquid assets at very high leverage levels of 90 percent or more—has largely been left unspoken. The general public couldn’t see how leveraged these funds were, but the banks lending to them could. And even with full access to their balance sheets, no single bank was willing to give up the business as long as the hedge funds were profitable customers.

Transactions without value

It isn’t always easy for casual observers to notice, but subtle signs often indicate that financial transactions are proliferating even when they aren’t creating value (for example, by substantially easing the allocation of capital). Indeed, many collateralized debt obligations, such as those blamed for the great credit crisis that resulted in the demise of Lehman Brothers two years ago, fall into this category. … Whenever a company tries to take debt off its balance sheet, investors would be well advised to wonder why. These transactions generate a lot of fees for bankers but rarely create any value.
Watching the equity markets for signs of future crises or downturns is unlikely to provide the kind of advance notice that can inform strategic decisions. Executives with the tenacity to follow the many moving parts of the credit markets are likely to be better prepared when the economy does turn sour.

About the Author

Tim Koller is a principal in McKinsey’s New York office.

Notes

¹ “Economic Conditions Snapshot, September 2010: McKinsey Global Survey results,” mckinseyquarterly.com, September 2010.
² See Richard Dobbs, Bill Huyett, and Tim Koller, Value: The Four Cornerstones of Corporate Finance, Hoboken, NJ: Wiley, November 2010.
³ Indeed, US industrial companies that entered the crisis with healthy balance sheets were able to withstand the crisis reasonably well, precisely because they were not overleveraged and had sufficient cash reserves to be flexible as the crisis wore on.

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