THE TRILLION DOLLAR MEAN REVERSION

Ben Bernanke’s great reflation gamble appears to be working. Unfortunately, it appears to be working in all the wrong places. While unemployment remains high, small businesses continue to struggle and the recession on Main Street endures, it’s back to business as usual at the banks. In 2007 & 2008 Jim Reid of Deutsche Bank issued a popular chart he called the “trillion dollar mean reversions”. The chart showed the excess profits in the financial sector when compared to the rest of the economy. Banks had massive excess profits and Reid’s thesis was simple – this is not sustainable and would revert to the mean – Reid was correct. He recently re-published the chart and the results are not pretty. The only thing experiencing a v-shaped recovery in the last year is bank profits. While the consumer continues to de-leverage and your average business struggles to produce year over year organic revenue growth the banks are raking it in:

Reid isn’t all that concerned with the excess profits, however. He comes to a very different conclusion than myself. He believes the economy would still be mired in a Depression-like environment were it not for the bank profits. I think the economy would have continued to struggle in the short-term (as it has), but that an RTC style approach to the bank failures (or a controlled demolition of sorts) would have done a great deal more in securing the long-term sustainability of a recovery. Reid elaborates on his position:

“With hindsight it’s clear that had financial profits not rebounded in the manner they have done over the last 12 months then the Global Economy would still be mired in a deep recession with the risk of Depression high. The footprints of the ever larger size of the financial sector is all over the Global economy and to leave financial earnings back down at trend levels would be to leave a trail of destruction in the real economy. So whether it was luck or judgement, allowing financial to return to super-normal profits again allows the economy to resemble 2007 in many ways. Previously we’ve dubbed this 2007-like.”

As I mentioned above I disagree. I believe the excess profits and the gross size of the financial sector was a function of unregulated markets, excessive risk taking and Central Bank policy that was a bit too friendly to the banking sector. The market downturn was the market imposing its will on this sector of the economy which produces little, but takes much. Of course, the U.S. government and Federal Reserve did not allow this market correction to fully play out. This is not unlike the problems in Japan where the government continued to meddle in the free market and have continually kicked the can down the road.

The implication that a return to 2007 is good is also incorrect in my opinion. A healthy economy sustains growth through real production and innovation – not through a sector that is entirely based on keeping its customers indebted and creating products that essentially shift money from the left pocket to the right pocket. The market and the U.S. economy functioned beautifully before the banks became 25% of the S&P 500 earnings in the late 90’s. Bank profits were never in excess of the overall market and the economy functioned perfectly fine. Who is to say we can’t function well (if not better) with a much smaller banking sector? Why do we need record bank profits to thrive as an economy? It’s time for a little perspective from policymakers. A financial sector this large is not healthy for the long-term sustainability of economic growth.

Where I agree with Reid is his outlook going forward. The U.S. financial sector needs to be substantially downsized. Reid says:

“However now the tougher battle begins. The Global economy would be better served by slowly bringing down the size of financials and weaning the global economy off its reliance on the sector slowly over time.”

Unfortunately, I think the necessary downsizing of the financial sector has the potential to play out for years. Because we did not utilize the FDIC, bankruptcy courts, or an RTC type process it is likely that the banks will maintain their stranglehold on the global economy as they battle with the remaining time bombs of the credit crisis. Bernanke has succeeded in reflating the banking sector. Unfortunately, for rest of us, he mortgaged the future growth of the United States in doing so.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • percolator

    Spot on with your analysis, TPC!

  • van
  • van
  • boatman

    thanx for the excellant link van,now in my everyday reading

  • boatman
  • chris

    i like jesse’s blog too, never came across it before…there is no profile page, who is this guy? nice food pix also

  • csodak

    A decade of loss jobs, domestic productivity numbers polluted by offshore production facilities, gutting American production capacity, reduced investment in R&D as a catalyst for future domestic based capital deployment, leveraging public and private sectors beyond the point where deployment of investment dollars becomes severely constrained…yes…we need more of the same.

    Perhaps we have to many public and private decision makers and policy influencer’s being carted around in limousines. We have an advanced feudal system where the rich are allowed to remain overwhelmingly influential in guiding policy in our country because the citizens believe that there has been an equitable and prudent deployment of resources. The citizens were under the belief that an equitable exchange in value existed, enough value at least to keep this implied agreement in balance. However Mr Reid prefers to rationalize his opinion, if Mr. Reid thinks that this agreement bestows the right of divine authority to the rich he is mistaken.

    Mr. Reid would benefit from understanding that citizens are just NOW contemplating whether this trade off is beneficial. It is possible that if the current inbalance remains, the citizens who are now being scoffed at in the media as ‘populists’ may decide to create a new order. The preferable course would be to demonstrate that equitable balance within the implied social order is a preferable outcome.

  • http://na.com alex west

    who’s in right mind will believe that kind of chart-of-crap? profits up,,, ???
    its from BEA.. same who publish GDP…

    check out mothly treasury statement.. corp taxes -50 % yy.. if profits are up
    why dont firm pay taxes ?? did they relocate??

    alex

  • jt26

    2008-to-today bank “profits” were from ZIRP … the “profits” came from implicit expropriation from dollar holders/savers and dollar fixed-income assets. China has been doing this as well (except China sacrificed savers to fuel high growth; we’re doing it to save banks).

  • Mike “Mish” Shedlock

    Reid elaborates on his position: ….
    You failed to provide a link to who you are quoting!

    You did it in here as well in reference to small business lending
    http://pragcap.com/the-recession-on-main-street-continues

    That is an extremely poor practice, at best

    Mish

  • http://www.pragcap.com TPC

    And I am sure you never overlook minor details and were flawless in sourcing all of your work when you started your site, right Mish? Besides, how do you link back to a piece of research that is behind DB’s password protected site?

    I cite my work far better than most bloggers do and always keep a keen focus on giving credit where it is due. Let’s not lose sight of the forest for the trees here Mish. You and I are money managers, not professional writers and editors.