Recap of the last 15 years

This was taken from the Alleghany Corporation 2008 annual report, from the "To Our Stock Holders Section"

http://www.alleghany.com/Documents/2008annualreport.pdf

Thoughts on the big picture

The imbalances that are evident today in the global economy trace their origins to August of 1994,when China embarked upon a course of a managed, nominal currency peg of the renminbi (RMB)against the U.S. dollar. Few remember today that as recently as 1981, the RMB/USD exchange rate was as strong as 1.53 yuan per dollar; by 1994 it had weakened to as low as 8.76 yuan per dollar, and was pegged at 8.28 until 2005. Over the following decade and a half, this currency policy contributed to stagnant U.S. household incomes (real median U.S. household income is lower today than it was in 1998), as U.S. labor could not compete with a massive, artificially priced Chinese labor pool due to the currency devaluation. The mechanism with which China (and other countries with pegged currencies) kept its currency artificially depressed was to recycle dollars into U.S. treasury securities and agency securities, thereby keeping U.S. interest rates artificially low, exporting deflation, and importing inflation. The prime beneficiary of this policy in the United States and other OECD (Organization for Economic Cooperation and Development) countries was the financial services industry, which took advantage of excessively easy money and low interest rates to fund credit expansion to middle class households, who sought to improve their standard of living despite stagnant
incomes by borrowing to fund consumption.

With perfect hindsight, it is now clear that 2007 probably marked the end of a 25-year credit binge in the United States. By the third quarter of 2008, total debt in the United States—government, corporate, financial, and household—exceeded 350% of GDP, a higher level than was the case in 1929. Over the past ten years, each incremental dollar of debt in the U.S. economy produced less and less growth in nominal GDP, with the marginal productivity of debt headed toward zero by 2013. The global economy, increasingly unbalanced and held together by a highly unstable and complex financial system, began to teeter in 2007 and collapsed in 2008. Inflationary pressures, which were significant in the first half of last year, turned to a deflationary collapse in the second half of the year.

The epicenter of the credit collapse was the investment banking industry and other capital providers,including private equity firms, hedge funds, and a variety of securitization vehicles. This system—referred to by some as “the shadow banking system”1—became the dominant provider of credit to households to fund consumption through the creation of structured securities that linked global savers to, primarily, U.S. consumers. Household debt began to expand at a very rapid rate, doubling from $7 trillion in 2000 to $14 trillion by the third quarter of 2008. A casual review of the Federal Reserve’s Flow of Funds report makes clear that at least $3.6 trillion of this debt may never be repaid as growth in personal income was far slower than growth in household debt. The majority of these assets appear
to be held by the largest financial institutions in the world, placing their solvency at risk.

Like a finely-engineered Swiss watch, the global economy depends on the proper functioning of all of its pieces for the mechanism to work. As the weakest borrowers in the system began to collapse, the global economy came under increasing stress in 2008 and, following the collapse of several major
financial institutions, the system virtually shut down in late 2008.

Most economists view the world through a profit-maximization model. The assumption is that given stimulus—either tax cuts or cheaper money—consumers will consume, and businesses will invest. However, another model—the survival model—suggests that liquidity and debt reduction become the overriding factors in economic motivation following a long period of easy credit, inflated asset values, and ultimately an asset collapse.2 Moreover, it seems to us that we are likely in for a long economic
winter, as households attempt to reduce leverage and businesses fight for survival in deteriorating economic conditions. In such an environment, an abundance of caution is in order.

Governments and policy makers continue to attempt to address the problem of inadequate aggregate demand in the OECD economies by trying to increase demand for credit. Unfortunately, a reasonable case can be made that there is no demand for credit because borrowers are either insolvent or
financially impaired. The dramatic expansion of the money supply in response to collapsing velocity has not yet produced inflationary pressure, but this eventuality cannot be dismissed. A reasonable scenario, in our opinion, would be for a prolonged (3-5 years) period of negligible economic growth, continued credit problems, and rising inflationary pressure.


Any thoughts ?