Cyprus, Long-Term Pain, and a Slow-Moving Economic Train Wreck

 

Takeaway

  • Before 2007, economists thought the market would self-correct with occasional fine-tuning
  • The FDIC has just $25 billion in reserves to guarantee up to $9 trillion in bank deposits
  • Spellman supports supply-side policies such as research and development and labor training

Five decades ago, a top Federal Reserve official called Lewis Spellman “really dangerous.”

The remark came after a presentation in which the newly minted MBA grad boldly informed a panel of Fed researchers that their job — manually fine-tuning monetary policy every six weeks — could essentially be automated with the help of a computerized simulation he developed.

The Fed governors in the audience that day, who were somewhat disconcerted that a 24-year-old kid was trying to turn their art into a science, warned young Spellman’s boss to keep an eye on him.

Fifty years later, Spellman — now a finance professor at the McCombs School of Business — is still speaking truth to power. At the Texas Enterprise Speaker Series on May 9, he outlined a full slate of economic challenges the country is facing today and offered a grim forecast for the future. (A video of the talk can be found below.)

“Every few months the meltdown goes into a new phase,” he said. “It’s a slow-moving train wreck.”

A Disastrous Path

Resolving any doubts as to his level of optimism about the country’s economic outlook, Spellman opened his presentation with an image of the 2003 Space Shuttle Columbia explosion. “This is where we’re heading,” he said.

Just as Columbia met its tragic fate after being cleared for re-entry, the U.S. economy suddenly derailed in 2007 after years of forward momentum. The problem in both cases was that everything seemed okay right up until the end.

When the first signs of the recession began to appear, it looked to most observers like a routine market correction.

“We thought we were in a normal process by which an economy continues to grow,” Spellman said. “In the context of a normal cyclical economy, if you’re in these normal bounds, it will self-correct, and then policymakers can fine-tune it even better. And they did, from about 1951 until 2007.”

But there was a big problem with that strategy: “What that requires is the basic structure of the model to remain intact — and what I want to tell you today is that the structure of the model and the economy have not remained intact.”

Instead, he said, years of deficit spending and demand-side policy are finally taking their toll on the country’s ability to bounce back from the Great Recession.

Passing the Buck

At the forefront of Spellman’s pessimistic economic outlook is the federal government’s aversion to pulling back on entitlement spending. It’s not a new problem.

Cost was not a major consideration in the plan to roll out Medicare in the ’60s, said Spellman, who witnessed the proceedings first hand as an economic adviser in Lyndon Johnson’s administration. When concerns about expense did come up, proponents said future administrations would be responsible for coming up with a solution, he said.

“They said, ‘We’ll worry about it then.’ Well, ‘then’ is now, and we’re worried about it,” Spellman said. “They didn’t think about where the money would come from. Honestly — I was there. They didn’t.”

In the ensuing decades of economic expansion, people got comfortable with the idea that things could only keep going up. This expectation of perpetual growth gave rise to a spirit of “shared prosperity,” which expressed itself in the form of ballooning entitlement programs, Spellman said.

That philosophy was fine during economic boom times, but things quickly changed when the recession evaporated the resources needed to fund government programs.

“The barbarians are now at the gates demanding their entitlements,” Spellman said.

Private Wealth at Risk

Another trap the government has set for itself lies in the financial guarantees that prop up the banking sector — agencies like the FDIC that supposedly safeguard depositors in the event of bank failure.

Spellman estimates the total value of insured deposits in the U.S. banking system is between $8 trillion and $9 trillion, while the FDIC only has about $25 billion in reserves to guarantee those deposits.

That’s a problem because if a bank’s assets decline and the bank goes down, suddenly the government’s financial guarantee can’t be honored. A chain reaction ensues: Currency falls in value, causing inflation, which depreciates the value of fixed-income assets. International investors then pull their money out of U.S. banks and move it to institutions in Brazil or other countries with stronger currencies.

“Financial guarantees are thought to be costless, but that is not the case,” Spellman said. “This is what took Cyprus down.”

With few other options on the table, a government in this situation could become desperate enough to start confiscating private wealth, Spellman said — an outcome that seems unfathomable in a democracy, yet is becoming more likely as time wears on.

While Washington may not come charging in to overtly raid private bank accounts like Cyprus’ government did, Spellman predicts U.S. agencies will find more underhanded means to achieve the same ends.

One example could come in the form of mandatory “guaranteed retirement accounts,” which the government could use to tap into IRAs or other income under the guise of helping people invest their savings for when they retire, Spellman said.

“It’s another 5 percent tax that looks to you like a retirement plan,” he said. “It’s totally a Ponzi scheme, because the only way it’s going to get funded is by kids 20 years down the road.”

Supply-Side Solutions

To prepare for the turbulence ahead, Spellman says investors should seek the help of lawyers, financial planners, and tax advisers who understand the global risks presented by government financial strains.

On the policy front, he believes the U.S. should move away from demand-side initiatives and entitlement spending in favor of supply-side policies aimed at boosting production and giving businesses room to grow.

“We have maxed out on demand-side policies,” Spellman said. “The only way to get out of this hole is on the supply side: research and development; incentives to build plant and equipment and products we can export to other parts of the world; and to train the labor force. We have major labor force training problems across the world.”

Dr. Spellman's slides for this presentation on posted on Slideshare.

See video

Mentioned in this Article

Lew Spellman

Professor, Department of Finance McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

About the Author

Rob Heidrick

Writer, McCombs School of Business

Born and raised in Austin, writer Rob Heidrick has spent several years as a contributor and editor at local magazines and community newspapers. He...