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March 16, 2009

RECOVERY – A SPELUNKER’S GUIDE

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NOTE: This follows my last post (March 14) “Recovery of Fantasy”

 

RECOVERY – A SPELUNKER’S GUIDE

 

 

Think of being cast into the bottom of a crater.  At first, the process of climbing out seems daunting to the point of despair. 

 

Your New Leader is chanting “YES WE CAN!”  This seems be addressed to no one in particular and everyone in general from a safe place on the crater rim.  Members of the immense mob below the New Leader have joined in the chanting.  After a while, you notice that as voices begin to tire and a few have stopped.  Many in the crowd have become disillusioned by the exercise. 

 

The members of the Leader’s Team have tossed down a series of strings, none of which is capable of bearing your weight, most of which don’t even reach the bottom.  “See!” they shout.  “We are helping!”

 

So you study the situation with a critical, discerning eye.  You notice that a few self-reliant souls have located a PATH.  This is a distinct trail that leads out of the crater via a series of well staged turns.  The PATH, which few in the bottom so far have noticed, is located as far away from the dangling strings as the diameter of the crater allows.  No one mesmerized by the cant and the strings has noticed the PATH

 

Of course the devil is in the details, and those details are best left to the climbers themselves.  As a bottom-up economist, I recommend bypassing the pundits, politicians and pollsters in favor of the folks with their feet on the ground and their minds firmly planted in the real world.  So as I outline the PATH below, you are invited to retain your critical intelligence; study the details as they emerge from interviews of the folks who live and work on the ground. 

 

As an exercise, I invite you to talk to a successful small business owner.  Yes, there are several left.  Get the real story.  “Just how did you get this business off the ground?” you might ask.  “Just how helpful were all those government bureaucrats at the municipal, county, state and federal level?  Tell me about earnings, labor costs, taxes and regulations.  What is the failure rate in your line?” 

 

 

THE PATH IN OUTLINE

 

 

The path to recovery consists of several discrete strands, some of which will be initiated by government, but most of them must be taken by private individuals and organizations.  And that is our first little secret.  Until the private, profit-making economy recovers, there will be NO recovery.  Therefore it follows as summer follows spring that the all of the effective and necessary government recovery-engendering actions have to be carefully crafted and here is the second secret:  A majority of economists in the US now are of the opinion that the stimulus plan produced by the current congress will do more to retard a full recovery than to stimulate one.

 

THE MAIN MEASURES

 

 

Keep in mind that  the current crisis was set off by an over-reliance on credit mechanisms to finance the private economy following the drying up of accumulated well of private investment capital due a long standing, world-wide pattern of government parasitism. 

 

The POP heard around the world was the sound of a giant credit bubble bursting, exposing that about half of the world’s economy was being funded by funny money.  We were living on over-borrowed over-lent and under-capitalized debt instruments masquerading as legal tender.  

 

It follows (brace yourself for a blast of common sense here) that a crisis caused by a debt craze should not be addressed by a new debt craze.  What most of the misguided governments in the world, ours included, are attempting to do is a dangerous bait and switch scheme:  Governments are now attempting the substitution of massively failed system of imprudent private debt using a massively imprudent expansion of public debt.  This is like getting out of a crater by shoveling at the bottom for so long that you forget that it is a crater and that YOU’RE STILL IN THE BOTTOM.

 

1. Fiscal Triage

 

A.   Stabilize the finance system by allowing all of the unsound lending institutions to fail and using federal lending to quickly restore liquidity to the ones that survive.  Bankruptcy with FDIC protection beats nationalization, the government purchase of overvalued assets (some of which, truth be told, have the negative values of a polluted superfund site), and all the other schemes that have the effect of pouring good money after bad.

B.   Confine any stimulus spending appropriations to measures that meet a three part test: (i) a strong positive private-sector employment-growth impact within 18 months or less, (ii) acceleration of necessary infrastructure projects, especially in the energy, agriculture and transportation sectors, that will facilitate robust private, profit-making enterprises downstream, (iii) a design that fits into a ten year business restoration template (as in the ICE BREAKER agency idea at the end of this piece).

C.  Compartmentalize institutional borrowing risk.  It was a dangerous error to allow high risk financial institutions to commingle operations, assets and governance with low risk ones.  This process started when savings and loan institutions became banks and it accelerated when the boundaries between high octane investment lenders and the rest of the financial system were allowed to dissolve.  Recall that the Titanic was designed not to sink because it floated on several independent separate water-tight compartments.  The mutual interpenetration of risk levels in the world economy was like floating an ocean going ship on a single compartment.  If Teddy Roosevelt could employ federal anti-trust powers to break up one or two oil companies, we can certainly find the political will to resection the financial world so that future failures will be confined to their own compartments.  Doing this now will accomplish more immediate gains in financial stability than bailing out one more major bank.  Remember the real lessons of Titanic:  No ship is too large to sink.  There always will be another iceberg.  Check those compartments.

 

2. Shifting from Debt to Capital Accumulation

 

A    Adjust incentives to favor fiscal restraint in the public sector (see #3 below) and to promote investment capital formation.  We first need to stop punishing capital accumulation.  The most dramatic and effective measure that could be taken in the short term:  Allow cross the board investment tax credits for all US enterprises and industries with a minimum secure ten year continued benefit guarantee and a concomitant commitment not to punish success with higher corporate or personal taxes when the plan works.  An investment tax credit is a “non-subsidy, subsidy” in that the government forgoes tax income in order to “permit” enterprises to plow profits back into growth-engendering investments.  But businesses are cautious because (surprise!) they don’t trust government to keep its commitments for long.

B.   We’ve relied on high debt levels to sustain the economy or more than a generation.  An addiction of decades cannot be undone in a heartbeat...at least not with out a heart attack.  In 20th Century Britain, the quasi-socialist welfare economy was established effectively by persistent gradualism; it was called Fabian socialism (http://cepa.newschool.edu/het/schools/fabian.htm ).  I’m proposing a Fabian capitalist recovery.

C.   The subtext of this problem is our one trillion dollar indebtedness to Communist China, held mostly in the form of interest-bearing treasury-issued instruments, by faux-private, Chinese government-run entities.  The first step in the long journey to recovery from this creditor-hostage situation is to announce a new US public policy, backed by a presidential declaration, a joint resolution of congress and specific enforcement mechanisms:  Not more than 15% of total US indebtedness can be held any country (including its agents, politically controlled enterprises and agencies) that does not have robust free elections, free media OR lends any support (overt or covert) to countries or non-state actors that are actively hostile to US citizens, allies or themselves support such countries or non-state actors.  Can we do this soon?  Of course not, but the policy will create new pressures and its own fiscal and political dynamic.  It took the Fabians decades to ossify the British economy.  It will take us much less to free up ours, if we can get our fiscal together within the next six years.  The ancient Chinese understood the power of gradualism.  We Americans can learn from them; we need to understand the power of firm direction and long term goals.

 

3. Fiscal Restraint

 

A.   Fiscal restraint means fiscal accountability.  The principle applies with equal force in the public and the private sectors.  All borrowing, especially borrowing for investment purposes, must be restructured.  This is a legal problem and can be resolved by simply rewriting the law.  We need to ensure a tight span of authority and accountability.  We need to call a decisive end to the days when a broker can treat a loan as a paper asset, floating it to another lender-investor who sells the same loan-set to buyers who then can do the same until only a powerful computer algorithm running for days can untangle the allocations of risk and accountability.  Management theory talks about span of authority, as in I supervise six managers who in turn head divisions with six other managers and down the pecking order to the anonymous night security employee who steals office secrets and sells them to a competitor.  It is like the seven degrees of separation idea that measures how close you are to a public figure you’ve never met, but whose uncle knows the neighbor of the boss of your high school classmate.  The fraudulent success of Mr. Madoff was based on the illusion of trust across a vast cohort where somebody knew somebody and...we suddenly have achieved blind trust with no actual verification.  Critical loan and investment transaction must involve much shorter spans of control in which no one escapes accountability and everyone in the chain has an incentive to blow the whistle.

B.   Present federal fiscal spending can be restrained and reconfigured to stimulate private business activity.  The two go together.  Federal money squandered unproductively is made unavailable for more productive purposes.  In the current crisis, Step One is drastic, simple and very effective.  [Remember, the goal here is to free up money to spend on private sector stimulus without increasing taxes or building in powerful inflationary forces, the silent tax.]  You simultaneously freeze the entire federal budget at the current level, section by section, agency by agency, department by department, but you also unfreeze salaries and staffing levels, allowing operations to continue with the necessary cuts in pay and adjustment in staffing levels and tasks.  You want to increase staff in an area?  You – the manager – are empowered (recall this is a emergency) to promote, demote, terminate and find money from salary cuts and unfilled positions.  But what you cannot do: abandon your department’s mission or spend funds you don’t have.  Step Two is more difficult, but it involves making inter-department and interagency adjustments, firing and replacing managers who attempt to game the system.  Again, a this level, no one gets to abandon the mission or spend money – in the overall aggregate – than is available.

C.   Temporary macro-functional adjustments can be made within the overall federal system if emergency measures are seriously implemented.  The brutal fact of the matter is that much of the federal government’s activities do nothing at all to promote or sustain an economic recovery, however laudable or popular some programs may appear to be at the moment.  As a common sense conservative, I would protect the law and justice and national security sector from major structural cuts, relying more on a McCain-style waste-housecleaning exercise.  As to the rest of the system, we are restrained only by the weight of political tradition, a lack of imagination and the illusion that laws long in place cannot be changed.  At the end of the day, in an emergency, the discretionary spending part of the federal budget is 100%.  Permit me just two examples, again bearing in mind that I am treating this as an authentic emergency and presuming bold leadership worthy of the moment: 

(1)  We need to jump-start the energy revolution.  For reasons abundantly set out in other articles (references below) the cleanest, safest, most cost effective move is to go swiftly to a large scale conversion to a nuclear-electric economy.  All the groundwork has been done.  The reactor designs, the safety standards and measures, the waste handling and recycling strategies, even a primary waste storage facility in Nevada are awaiting implementation.  But plug in your Prius and Chevrolet Volt?  Not on a hot summer day.  The current grid cannot handle an electric powered transportation system.  The next steps are not rocket science; they are off-the-shelf engineering.  We don’t need to make the grid more “windmill friendly”; we need to double or triple its power handling capacity.  We have a growing pool of underemployed labor and skilled engineers.  We need to divert funds, now being taxed for less productive purposes, and use them to rebuild our energy infrastructure.  Whether this initial push is primarily federal appropriations or a mix of public and private money, it will be the seedbed of powerful long term growth in the private commercial sector the main engine of real economic growth. 

(2)  To fund the recovery we need to make large, painful reductions in some less economically productive sectors of government and funnel the same money via tax incentives and direct spending to productive, job-creating activities in the private sector.  In FY 2006, so-called mandatory federal spending amounted to more than half the entire budget (at 1.4 trillion), social security .544 tr., Medicare .325 tr., Medicaid .186 tr.  While the miscellaneous programs like food stamps, disability, unemployment, and the like came to .357 tr.  In the same year, discretionary spending was under .40% of the total (about 1.1 tr.), of which about half was for non-security spending (think health, education and human services).  Again, my premise here is that we are in a real emergency and that the appropriate leadership emerges.  All reductions to need to be reasonably immediate but not retroactive.  This sort of decisive step would require an unprecedented level of coordinated and intelligent action at the federal level.  But let’s just imagine the ideal for a moment.  Two hundred billion dollars, appropriately targeted to income-generating infrastructure represents a lot of jobs and a lot of proactive economic activity, particularly if it represents a mix of direct spending a longer term tax incentives.  The reallocation process begins with across the board salary reductions and means-adjusted benefits reductions.  These are expressed as temporary, but their re-growth as the economy recovers should be kept at or below the general rate of inflation. Social security is sacrosanct only in the sense that retroactive reductions in status are off the table.  But several obvious measures are not:  Moving up the minimum non-disabled retirement age from 62 to 72, with a concomitant federal policy that discourages mandatory retirement before then; means tested Medicare, especially for the drug supplement piece.  I modestly propose that the government change its operating culture to a more flexible, entrepreneurial one.  Only a true emergency and the prospect of even more dire consequences can concentrate the dull bureaucratic mind.  We could do really large scale cuts, say as high as 15% in the overall budget in given sectors, but couple them with highly empowered management who are held accountable for results.  The necessity of making large salary cuts can be mitigated when good managers are given a freer hand in making do with fewer subordinates.  Most of us have served in organizations salted though with marginal, but hard-to-fire employees.  Fire the marginal employees first.  Do away wit all civil c=service impediments to good management.  Fire and replace the bad managers with good ones.  Clean house.  You get the idea. 

 

 

4. Creating and empowering the ICEBREAKER

 

As I’ve indicated in my last post, the recovery in already underway.  Somewhere, not far from where you are reading this, a new business has begun, money has been committed to construction or someone has been newly hired in the private sector.  These tendrils and shoots of growth are not unique or miraculous.  The overwhelming majority of people who need to work are employed.  California is something of a basket case yet employment is still north of 90%.  The fact is that most people have some money to spend, that there are unmet needs and untapped demands for new products and services all over the Us, which is a way of saying that there are business opportunities. 

 

Indulge me for a moment.  I need to revisit my article, The False  Bottomed Boat in order to establish the context for my proposal:

 

As I wrote in that earlier posting:

The individual, well managed enterprises that make/sell/.move the “real stuff” on which day-to-day commerce depends will link up with the “better mousetrap’ ideas and the surviving sound financial sources.  This is where the real recovery will begin. 

And this is where a whole set of government impediments, tolerable in a boom, are fully capable, during a fragile recovery, of aborting the new stirrings of economic life in utero. 

What impediments, you ask?  Think of tariffs, business licenses, building permits, mindless approval loops, excise taxes, sales taxes, capital gains and income taxes, land use barriers, fees, more fees, hearings, slow-moving bureaucrats, all standing in line, blocking the path to economic growth....  You get the idea.  This is why successful businesses in the Third World have line-item budgets for bribes. 

Collectively I call this the “Political Commerce Load Factor” (or PCL). 

The existing PCL has been augmented by an environmental set.  NOTE: the even more oppressive “evil carbon” set that is now in the queue could take down a prosperous economy.  The PCL factors (extant and contemplated) are dangerous enough by themselves.  But when combined with price/cost instabilities induced by haphazard political market manipulation (the unintended consequences of non-productive subsidies, leading to artificial supply scarcities and-spot inflation), the effect is the same as putting a heavy foot on the national carotid.  Unchecked, political good intentions will consign us to Japan’s fate. 

ENTER THE ‘ICEBREAKER AGENCY’

 

The interstate commerce clause and the supremacy clause of the US constitution, the source of the federal anti-trust powers, gives the US government the power, should it have the wisdom and courage to use it now, to break through the Political Commerce Load Factor in the service of robust economic recovery.  It is both legally and practically feasible for a specific, as yet unnamed federal agency to be created, empowered and charged with the mission to break clear paths through the ice floes of bureaucratic red tape and punitive taxation so that nascent, privately funded commercial enterprises can flourish more quickly and robustly than anyone though possible, especially in the pre-recovery economic environment.  In the same way that an Arctic ice breaker can break open a clear path for a fleet of fishing trawlers, a federal regulation and taxation ice breaker can do the same for a strong business recovery.  This would be proactive, creative conservative-liberal policy at its very best.  It would serve the same, practical function in the tangled web of business-killing regulations, licenses, permits, delays and kleptocratic taxes that bribes to in corrupt Third world economies.  Except that its operations, in partnership with cooperating state governments would be above board, transparent, subsidy-free and legal. 

 

Business people are not fools.  The protections afforded a start up would need to provide a clear path that could relied upon to remain clear for a reasonable time, say, a full decade or more.  And the political leaders who back this plan should not be fools, either.  ICEBREAKER protection is reserved for privately funded ventures only, the kind where the cost of failure is born by those who took the risks in the first place, the same investors who can reasonable expect to be allowed to retain the rewards of their success.

 

I happen to know that this model (or something very much like it) will work.  But just stop for a moment to think about the implications.  How far we have come....  Pandering politicians were compelled by circumstances, their own ideological inclinations and the electoral reward system to act as the public parasites of success.  Now they have nearly brought down the whole beast.  The fleas have almost killed the lion.  We are now forced to see ourselves as a Third World Country.....

 

I promised to outline a Path out of the crater.  The heavy lifting?  That takes place in about two years, or just as soon as the Beltway crowd figures out that our crater is deeper than anyone had been willing to admit.....

 

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SEE - THE NUCLEAR OPTION -  http://jaygaskill.com/RecessionBusterTheNuclearOption.htm 

JBG

March 14, 2009

RECOVERY OR FANTASY? DIGGING A DEEPER HOLE

Welcome to the Policy Think Site: http://www.jaygaskill.com    
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A Printable HTM Version is posted on The Policy Think Site at this LINK: http://jaygaskill.com/Recovery09.htm

 

 

RECOVERY OR FANTASY?
Digging a Deeper Hole

 

I’m not given the shadendfreude (http://www.merriam-webster.com/dictionary/schadenfreude) especially when the stakes are so high.  I still want this president to succeed, but I share the growing doubts and concerns about his economic policy that the polls are now showing.

 

Check out the piece published by the Wall Street journal on Friday the 13th, under the headline

OBAMA'S POLL NUMBERS ARE FALLING TO EARTH”...

 

Pollster Scott Rasmussen and former Clinton pollster Douglas Schoen describe the growing disconnect between the popular wisdom and Mr. Obama’s “grand gesture” approach to economic policy.  For the reasons that I outline in this article and the one to follow, I urge Mr. Obama to listen more to the moderates in his own party and to the hundreds of economists who are ringing the alarm bells even as I write this.

 

Here are a few highlights from the referenced Wall Street Journal piece:

 

[][][]
The American people are coming to express increasingly significant doubts about [this president’s] initiatives, and most likely support a different agenda and different policies from those that the Obama administration has advanced.

 

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Eighty-three percent say they are worried that the steps Mr. Obama is taking to fix the economy may not work and the economy will get worse. Eighty-two percent say they are worried about the amount of money being added to the deficit. Seventy-eight percent are worried about inflation growing, and 69% say they are worried about the increasing role of the government in the U.S. economy.

 

[][][]

Fifty-six percent of Americans oppose giving bankers any additional government money or any guarantees backed by the government.

 

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Only less than a quarter of Americans believe that the federal government truly reflects the will of the people. ...  [J]ust 19% of voters believe that Congress has passed any significant legislation to improve their lives. While Congress's approval has increased, it still stands at only 18%.  Over two-thirds of voters believe members of Congress are more interested in helping their own careers than in helping the American people.  When it comes to the nation's economic issues, two-thirds of voters have more confidence in their own judgment than they do in the average member of Congress.

 

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THOSE WHO IGNORE HISTORY ARE LIKELY TO IGNORE PRESENT REALITY, TOO

 

Keynesian wealth creation: The Egyptian slave model

 

Recall the ancient Pharaohs who drafted idle agriculture workers off-season, putting underutilized labor resources to the task of building the Great pyramids.  Many economic authoritarians see this period as the good old days. 

 

But there was more than a grain of sense to the notion.  When underutilized idle labor is looked at as a resource or profit center, it represents a particularly fleeting one.  Like the Pharaohs’ winter labor, the efforts of underutilized idle workers cannot be recaptured after the opportunity has passed.  Their jobs belong to the class of time-linked assets, much like those unsold airline seats that can’t be utilized after takeoff or all that unused electricity from the grid (not captured by batteries) that is either used as and when delivered to the user, or is forever lost for any economic purpose.  If you replace the notion of slavery with a motivated and able labor force, sitting idle because the movers and shakers of finance have screwed things up, John Maynard Keynes had a valid point.  [Sketch at http://cepa.newschool.edu/het/profiles/keynes.htm .]

 

Conservative Keynesian road kill

 

At its best, Keynesian theory represents a rational economic strategy to avoid losing labor value due to temporary dysfunctions in the financial system.  The conservative version of Keynesian economics had two key elements: 

(1)    Small scale deficits designed to ameliorate an economic downturn were to be balanced by coequal surpluses in better times to avoid the accumulation of long term public debt. 

(2)    Large public works projects were to be coupled with tax relief so that the private sector could swiftly recover in order to fund the deficit repayment [See (1).]

If you’ve been paying attention to the period since 1963, a series of undisciplined political leaders have thrown conservative Keynesian economics under the bus.  John Kennedy was the last of the conservative Keynesians.

 

The replacement of traditional capital formation with rampant borrowing

 

From 1700 through 1929, all major undertakings in the US economy (I’m thinking of the railroads and the innovations of Thomas Edison and Henry Ford) represented the traditional capital investment pattern in which accumulated capital was recruited to fund new ventures. 

 

Credit mechanisms were not primarily utilized to finance new business ventures.

 

But from 1929 through 2000, the major pools of accumulated capital sources became little ponds or dried up entirely.  They were replaced by borrowed money.  Why did this happen?  The shift to credit-supported investment did not take place because lending and borrowing are inherently superior as funding mechanisms for new commercial ventures.  It happened because the traditional methods for the accumulation of capital, based on the retention of profits were relentlessly taxed to the degree that they were virtually driven out of existence. 

 

The personal income tax, the taxes on corporate and business profits, the excise taxes on sales and capital gains taxes resulted in the successive taxation of the profits won through productive economic activity.  [See US Treasury Fact Sheet at http://www.treas.gov/education/fact-sheets/taxes/ustax.shtml , The 1997 Congressional Joint Economic Study  http://www.house.gov/jec/fiscal/tx-grwth/capgain/capgain.htm , among other sources.]

 

The multiple taxation of the same income, coupled with the normal losses from failed investments, was so confiscatory that the substantial depletion of all accumulated capital over time was inevitable.

 

Traditional bankers became business partners, then were replaced by non-traditional, increasingly imprudent lenders.  These were the new creatures on the financial planet, those men, women and their institutions for which “paper” profits became the measure of wealth.  This transition was a big deal indeed, and it initiated a self-reinforcing drive towards an unattainable goal: unlimited profits based on the unlimited growth of paper assets based on a credit bubble that was sustainable as long as it was in continuing expansion.  This game could go on. Only as long as it wasn’t recognized as just one more bubble,

 

VAPOR PAPER AND LEVERAGED FRAUD

 

The transition to credit-financed economic growth floated to the top of the economic lake, supported by two radically simple, and radically beguiling concepts:  paper assets based on the notion that money manipulation could create wealth, and asset leveraging which became the clever financial instrument by which all things were possible. 

 

Or so it seemed at the time.

 

Most of our grandparents would laugh at the notion of paper assets, the transparently fanciful notion that real wealth can be measured by a set of fleeting volatile numbers the connection of which to “real stuff”, food, transportation and the like, is a matter of blind faith.  The jailed billionaire con-man, Bernard Madoff and his thousands of duped victims, many of whom have been driven from paper wealth into real poverty, are the perfect metaphor for paper assets. 

 

We’ve been there before.  Recall the buzz-word of the dot com boom?  Many of those promising startups were selling software products that had about the same solidity as the balance sheets of Freddy Mack and Fanny May.  Remember the term vaporware?

 

The term “leveraged assets” is particularly revealing because it refers to a loan and its security as an asset class that can be multiplied like one’s expected winnings at the gaming tables of Las Vegas.  In this fantasy construct, where all loans are actually paid, a lender’s balance sheet, a loan balance on paper, is as good as gold.  Inflated American real estate used as security for increasingly unpayable loans gradually became the gold standard of world commerce from about 1980 until the great crash of 2008. 

 

In this context, leveraging meant this:  You (the clever trader and financial manipulator) used assets (like California residential real estate) to support the value of unpaid loans.  This enabled you to sell these loans in large packages designed to conceal and disguise the inherent weakness of their constituent elements.  As this world-wide scheme started to unravel, the ratio of real assets to loan value in the conservative lending institutions was revealed to be ten-to-one.  In other words, the paper value of the real estate security was, say 10 million, but the aggregate loan value was 100 million. 

 

But a mere ten-to-one leveraging ratio was child’s-play in the larger market.  Many of the big players were leveraged thirty-to-one, forty-to-one, even fifty to one.  You come away with the impression that the more audacious the risk, the larger the stakes, the less critical were the investors.  Again, Mr. Madoff and friends are the metaphor.

 

THE TITANIC LESSON

 

But the picture was actually worse.  These bundled, under-secured loan packages became the security of additional loans.  We’ve heard the bromide, “too big to fail”.  Recall the Titanic?  The lesson here is: too big to bail out.

 

The brutal fact is this:  The sheer size of the inflated credit market now dwarfs the fiscal activities (defined as appropriated, tax-supported spending) of all governments by a huge number.  This is why our leaders seem to be stumbling, dissembling and concealing.  They have seen the truth and they are frightened out of their frigging minds by the staggering scale of the problem.  They are particularly fearful because they still cling to the illusion that failure is not an option. 

 

Here’s the dirty little secret:  The failure of the imprudent financial institutions is the only option.  We can afford to let this happen because not all of the lenders were idiots or criminals.  The end game here is to stand ready to shore up the smaller, well-run ships that could be swamped in the wake of the sinking behemoths. 

 

This article is part of a series that began on “The Human Conspiracy Blog” with “The Collapse of the Optional Economy”.  The other articles remain posted there.

 

In the next post, I’ll sketch out a practical, but challenging recovery path.  Stay tuned for “Climbing Out of the Crater”

 

JBG

March 09, 2009

THE FALSE BOTTOMED BOAT

Welcome to the Policy Think Site: http://www.jaygaskill.com    
As Posted On
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All contents, unless otherwise indicated are --
Copyright © 2003, 2004, 2005, 2006, 2007, 2008 & 2009 by Jay B. Gaskill
Permission to publish, distribute or print all or part of this article - except for personal use - is needed. Forwarded links welcomed.
Contact Jay B. Gaskill, attorney at law, via e mail at law@jaygaskill.com
Link to printable version:
http://jaygaskill.com/FalseBottomedBoat.htm

 

The False Bottomed Boat

 

During a fire sale, most prices are well below their natural market levels.  The credit meltdown crisis of 2008-9 is a fire sale on a biblical scale, but the principle still holds.  Fire sale prices are below the bottom.  I’m not qualified to make “buy recommendations” but it doesn’t take a genius to notice that GE stocks are so low and the company is so well positioned for an eventual robust recovery that its current stock price is well below the bottom.  The price is a panic-driven number and most shareholders know it.  They ain’t selling.

 

But there is one sector where the bottom has not yet been reached:  There is no bottom yet in sight for real estate prices in overheated markets like those California, the Las Vegas area of Nevada and, truth be told, most of the upper reaches of the urban-suburban realm...everywhere that the bidding wars in home prices have driven out the teachers and cops from all the desirable neighborhoods. 

 

As I said in an earlier post: It’s the incomes stupid! 

 

The entire sub-prime, toxic-finance mess grew out of the misguided attempt to marry overpriced homes with people whose incomes could never support any reasonable payback arrangement, based on the pie-in-the-sky notion that, in a rising market, they could refinance forever and ever. 

 

All of the efforts to shore up real estate prices are futile and ultimately harmful.  We may well have a housing surplus.  That means that prices must fall to unmanipulated market levels so that the properties can be resold to willing and able buyers.  In parts of California, that means another 20% on average, more than 35% in many cases and more than 45% in many others.  Why?  “It’s the incomes, stupid!”

 

Now here is the dirty little secret that everybody knows, but won’t fully acknowledge.  We would already be on the way to recovery if the damage had been confined to the banks and borrowers who went over the cliff (or should have been allowed to).  This notion is called the compartmentalization of risk -- apparently a novel idea for the current masters of finance and their political handlers.  [Or is it?  I suspect we’re talking about the masters of politics and their corrupt financial handlers.]  In any case, the compartment has leaked all over the place. 

 

Not all financial institutions were seriously compromised, but enough major players were badly damaged that two administrations in succession have panicked.  The exiting Bush and entering Obama administrations were so freaked by the condition of several well-placed major financial players that they were willing to hide the extent of leakage.  Their finance teams were and are apparently willing to bail out the incoming flood, endlessly it seems, so that we-the-people won’t lose confidence in our boat’s seaworthiness. 

 

Here’s the other dirty little secret.  The boat will not actually sink.  Many financial institutions are quite sound.  The Canadian banks, thanks to their traditionally conservative lending practices, are doing fine at the moment.  And I know of local banks that are equally untainted by toxic lending. 

 

A friend, a lawyer with an MBA who has made a number of astute real estate purchases over the years and is still doing quite well, thank you, recently wrote me in response to my last post, “Finding the Bottom.”

 

 

“The bottom in the real-estate market will be - When the rents, from a property, will cover the interest on the money invested in the property, plus the yearly Property Taxes, Plus the cost of maintaining the property.  With interest rates dropping in the 4 to 5 % range and other costs dropping there is still room to go down.  The other factor is the general lack of confidence in the government’s intrusion into the credit market, as when Obama also says, ‘I inherited this problem, things will get worse before they get better.’  No wonder investors take a wait-and-see attitude.  With the President’s cover-my ass comment he has prophesized things to come.  This can be a self-fulfilling prophesy, bringing on the ‘D’ word.”

 

 

 

THE BOTTOM FEEDING PANIC

Even normally restrained sources have succumbed to the panic atmosphere.  For example, this report:
US Stocks Losses Mount; DJIA Off 214; Nasdaq Off 36
By Peter A. McKay
The Dow Jones Industrial Average was recently off about 214 points at 6848. The benchmark slid under 7000 on an intraday basis for the first time since Oct. 28, 1997. The Dow last closed below 7000 on May 1, 1997.
... Industrial giants like Alcoa and Caterpillar also fell, as did shares of General Electric which dropped nearly 8% to slide below $8 a share.
... Friday, the Dow industrials fell nearly 120 points, leaving the benchmark down 11.7% for February - its worst performance for the month since 1933, when it fell 15.6%.
“It's like an unending nightmare,” said Kent Engelke, managing director at Capitol Securities Management in Glen Allen, VA.
http://www.marketwatch.com/news/story/US-Stocks-Losses-Mount-DJIA/story.aspx?guid={BA2F0D30-92A8-426C-BD1F-26D0C0B84E4C}
Nightmare?  No one was widely quoted using that word in the Carter recession...which was actually worse.
Many pundits are studying the Japanese experience, as we all should.  In the New York Times piece quoted below, Japan’s experience, an 18 year slump, presents an appalling prospect....

Japan’s Slump Tests Faith in the Resilience of Stocks

By HIROKO TABUCHI
Published: March 5, 2009
TOKYO — When Japan’s stock market took a nose dive in 1990, analysts told Shizuko Kitamura to take the long view, just invest consistently and stoically and wait for share prices to recover...[BUT] she is still waiting...  20 years after Japan’s stock market peaked, share prices are still less than 25 percent of their top values.....
The longest [US] bear market in a major economy occurred after the Wall Street crash of 1929.  Stocks did not reach their pre-Depression levels until 1954.  ...Japan’s stock market has many problems that are particular to Japan. To name two: Japan took a decade to rid its banks of bad loans, hurting confidence in the market; and Japanese companies performed poorly on return on equity, a measure of how effectively shareholders’ money is used to develop a company or increase its profits.....
http://www.nytimes.com/2009/03/06/business/worldbusiness/06yen.html?_r=1&ref=todayspaper

THE SOLID FUNDAMENTALS

During the 08 campaign, when Senator McCain said that the fundamentals of the US economy were sound, he took flack because the financial sector’s fundamentals were like the late Aunt Tilly’s cancer-ridden body when metastases was discovered.  That America’s situation differs from a terminal cancer patient is clear enough:  Our underlying financial support infrastructure, however compromised, is well diversified. 
There are plenty of healthy banks and lending institutions to fund a robust recovery as long as the private enterprises that will do the heavy lifting can see a clear path to profitability. 
We are different than Japan in three important ways: 

  1. Americans still have the most robust, entrepreneurial capitalist culture in the world.
  2. We still have abundant real natural and human resources, food production capability, engineering and scientific talent, even huge energy and mineral resources.
  3. Americans are still the most optimistic culture on the planet.  These are the real fundamentals.  They will generate a true economic recovery the minute the financial conditions stabilize...provided government is part of the solution and not just another obstacle.

THE RECOVERY & ITS ENEMIES


MY PREDICTION: Within 90 days of today, the individual, well managed enterprises that make/sell/.move the “real stuff” on which day-to-day commerce depends will link up with the “better mousetrap’ ideas and the surviving sound financial sources.  This is where the real recovery will begin. 
And this is where a whole set of government impediments, tolerable in a boom, are fully capable, during a fragile recovery, of aborting the new stirrings of economic life in utero. 
What impediments, you ask?  Think of tariffs, business licenses, building permits, mindless approval loops, excise taxes, sales taxes, capital gains and income taxes, land use barriers, fees, more fees, hearings, slow-moving bureaucrats, all standing in line, blocking the path to economic growth....  You get the idea.  This is why successful businesses in the Third World have line-item budgets for bribes. 
Collectively I call this the “Political Commerce Load Factor” (or PCL). 
The existing PCL has been augmented by an environmental set.  NOTE: the even more oppressive “evil carbon” set that is now in the queue could take down a prosperous economy.  The PCL factors (extant and contemplated) are dangerous enough by themselves.  But when combined with price/cost instabilities induced by haphazard political market manipulation (the unintended consequences of non-productive subsidies, leading to artificial supply scarcities and-spot inflation), the effect is the same as putting a heavy foot on the national carotid.  Unchecked, political good intentions will consign us to Japan’s fate. 
All of the practical and effective economic models of robust recovery, however they might differ in particulars, have these four common elements in common: 
(1) Full transparency among lending institutions and borrowers. 
(2) Failures and successes are punished and rewarded by the market without political interference. 
(3) Credit liquidity. 
(4) A long term political commitment to a business-friendly regulatory and taxation environment.
Our path to economic recovery really is that simple:  I can make it even simpler:  You stabilize finance, clear the path to entrepreneurial private development and get out of the way.  I wish it could be made more complicated for the benefit of the policy wonks.  But that’s the trouble with radical common sense.
JBG
     
 
   
   
   
                                                   
       

March 05, 2009

The Obama Watch - Buyers' Remorse

A brilliant piece tracks the growing buyers' remorse among centrists, like Gergin, Brooks &  Peretz, whose campaign-engendered warmth for the Obama campaign has greatly chilled.  I refrain from gloating, but happily pass on the link:

http://pajamasmedia.com/blog/im-maureen-dowd-and-ive-been-had/   ***

Campaigns are poetry, but governance is prose.  The Obama of the grand gesture now confronts the most unrelenting critic of all - history.  As a fan of the late great Harry Truman, I prefer my poets and prophets to live and work on the protected sidelines and my policy makers to live and work in the real world....

JBG 

 ***  Copy & paste into your browser's finder.   Rubin's take on Maureen Dowd's Obama-regret is especially precious!


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