The New Normal

It is increasingly clear that the current downturn is fundamentally different from recessions of recent decades. We

are experiencing not merely another turn of the business cycle, but a restructuring of the economic order.

For some organizations, near-term survival is the only agenda item. Others are peering through the fog of uncertainty,

thinking about how to position themselves once the crisis has passed and things return to normal. The question is, "What will

normal look like?" While no one can say how long the crisis will last, what we find on the other side will not look like the

normal of recent years. The new normal will be shaped by a confluence of powerful forces—some arising directly from the

financial crisis and some that were at work long before it began.

Obviously, there will be significantly less financial leverage in the system. But it is important to realize that the rise

in leverage leading up to the crisis had two sources. The first was a legitimate increase in debt due to financial

innovation—new instruments and ways of doing business that reduced risk and added value to the economy. The second was a

credit bubble fueled by misaligned incentives, irresponsible risk taking, lax oversight, and fraud. Where the former ends and

the latter begins is the multitrillion dollar question, but it is clear that the future will reveal significantly lower

levels of leverage (and higher prices for risk) than we had come to expect. Business models that rely on high leverage will

suffer reduced returns. Companies that boost returns to equity the old fashioned way—through real productivity gains—will be

rewarded.

Another defining feature of the new normal will be an expanded role for government. In the 1930s, during the Great

Depression, the Roosevelt administration permanently redefined the role of government in the US financial system. All signs

point to an equally significant regulatory restructuring to come. Some will welcome this, on the grounds that modernization

of the regulatory system was clearly overdue. Others will view the changes as unwanted political interference. Either way,

the reality is that around the world governments will be calling the shots in sectors (such as debt insurance) that were once

only lightly regulated. They will also be demanding new levels of transparency and disclosure for investment vehicles such as

hedge funds and getting involved in decisions that were once the sole province of corporate boards, including executive

compensation.

While the financial-services industry will be most directly affected, the impact of government's increased role will be

widespread: there is a risk of a new era of financial protectionism. A good outcome of the crisis would be greater global

financial coordination and transparency. A bad outcome would be protectionist policies that make it harder for companies to

move capital to the most productive places and that dampen economic growth, particularly in the developing world. Companies

need to prepare for such an eventuality—even as they work to avert it.

These two forces—less leverage and more government—arise directly from the financial crisis, but there are others that

were already at work and that have been strengthened by recent events. For example, it was clear before the crisis began that

US consumption could not continue to be the engine for global growth. Consumption depends on income growth, and US income

growth since 1985 had been boosted by a series of one-time factors—such as the entry of women into the workforce, an increase

in the number of college graduates—that have now played themselves out. Moreover, although the peak spending years of the

baby boom generation helped boost consumption in the '80s and '90s, as boomers age and begin to live off of retirement

savings that were too small even before housing and stock market wealth evaporated, consumption levels will fall.

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