"The American Economy is a Going Concern." Paul McCulley, PIMCO Investments
That is the conclusion of one of speakers at the investment conference I am currently attending. In light of today’s announcement from Treasury Secretary Tim Geithner, it is important to remember. Our economy, which is in trouble, is an ongoing, living thing. We need to attend to it like a sick patient. But we will make it thrive once again. We can take action (and by "we" I mean our government) or we can leave well enough alone. By broad measures, the majority of leading economists (from all political persuasions) agree that government has a role to play right now. Where intelligent minds may disagree is the scope and the magnitude of that intervention. Here is a primer on how we got here, and my thoughts about the quasi-socialistic (let’s call it what it is) moves our government is making right now to course correct.
Capitalism did some wrong things -- it is repairable.
Let that sink in a moment. We have a broken system right now, but it is repairable. We are suffering from two maladies at the moment: a) the Paradox of thrift, and b) the Paradox of de-leveraging. Let me explain.
The Paradox of thrift suggests that what is rational for the individual becomes irrational for the community. Take savings for example. If you have a desire to increase your savings rate (saving more from current income), then your own private actions are all you need. But if the community desires the same thing, that is, to save money, then ultimately there is less money circulating to buy things, demand for products and services fall, people get laid off, income falls and so does savings. The remedy for this is classic Keynesian economics: government spending to kick-start the deficiency of consumer spending.
The Paradox of de-leveraging is very similar: what is rational for the individual (or banks, or corporations) becomes a problem when everybody is doing it at the same time. There are only two ways to de-lever (i.e., reduce debt): a) sell assets to pay off debt, b) increase equity (or value of the asset). If everyone tries to sell assets at the same time, well, you know what happens. Price severely drops. As we say in my business, it’s all ask, no bid! The remedy for this: the government becomes the bid (buyer).
If you flash back to what feels like an eternity ago, (it was September of 2008) you may recall that Bear Sterns was about to go out of business due to its de-leveraging attempts finding no market. The government mandated that JPMorgan buy it for a song, and thus delayed recognition of the broad problem. The next investment bank to fail was Lehman Brothers. Essentially the government let it die. That was a mistake as the entire financial industry began to quickly unwind. The government, in trying to avoid another Lehman "oops" came up with the TARP (trouble assets relief program) to help rescue not the banks themselves, but the very system they operate on. And as politically incorrect as it may be to write (or read, depending on your perspective), the first half of the TARP was successful. It stopped the financial sector from getting worse (all, or many, banks conceivably could have collapsed). Sadly, it is like proving a negative to insist that TARP worked. But I believe that it did.
Continuing on with the subject of the paradox of de-leveraging, we must understand that, in troubled times, the role of the Fed and the role of the Treasury are very different. To put it simply, the Fed has a balance sheet in that it can print money, the Treasury has equity. Today, Treasury Secretary Geithner essentially announced a joint venture with the Fed. And what looks to be an end-around, the government is stepping around the banks...to become a bank! You can find articles and summaries of the current plan (for the second $350B and up to $1T....yes, that is a "t" as in trillion) in your newspapers and online. But my summary is that the government is getting into banking Big Time! The government is going to lever-up so banks can de-lever. The government is going to spend so that consumers can spend again in the future. I know it sounds odd, but that’s the deal.
Remember Colin Powell’s statement before Iraq: I don’t like war, but if you are going to war, you use overwhelming force." We are fixing capitalism’s bust with a huge socialistic replacement. I believe this is temporary (four or five years, perhaps?), but necessary to break the paradox of thrift (who is spending right now?) and the paradox of de-leveraging (many "too important to fail" banks need this badly).
Hyman Minsky, the late economist from Washington University, came up with the idea that stability begets instability. With apologies to Prof. Minsky for this elementary summary, but he basically said that the more markets are stable, the more risk people (or institutions) will be willing to take, which eventually leads to destabilization. Apply that basic knowledge to what you know of the mortgage crisis. Simple 30 year mortgages were good, but we could do more with interest only mortgages. That fueled more houses being sold and thus the "invention" of no-down payment, pay-what-you-can mortgages which lead to the subprime disaster which lead to the failing of the banks which has led to a recession where everybody who is still working is saving for fear of a rainy day when they lose their job. We are stuck.
We can disagree on the line-item bullet points of our government coming to the rescue, but I agree that given the mess we’re in right now, that it was necessary. Remember when former Treasury Secretary Paulson decided, instead of buying the bad debt from the banks with the TARP money, but to inject equity directly into the banks? That was a more palatable decision at the time because the country wasn’t ready for socialistic maneuvers like taking over the bad-debt from banks. It has taken awhile, but the ethos of the American psyche now permits a socialistic response. The second half of the TARP is going to all kinds of programs. With the help of the Fed, and a so-called limitless purse, AND the stimulus package that was passed today, our economy is getting the kick-start it needs. Once financial markets determine the dose of socialism it wants, you will see a return to capitalism and risk taking. The stock and other markets will resume.
As lousy as our economy is right now, I am bullish for the future. I believe if we all own this, we will persevere. Remember, our economy is a going concern. So let’s get going!