There is a common error with contrarian investing. It is not a question of identifying things that people believe that are wrong, but finding things that people rely on that are wrong. Reliance is the critical component. I don’t care about what people think if they don’t have any skin in the game. When someone relies on a certain result happening (or not happening), then there will be series of behaviors that happen as what he believes in fails, from intensifying the bet in the early phases, to throwing in the towel in disgust at the end.
I’m going to take this idea and twist it a different way tonight. One thing that the Democrats and Republicans (except Ron Paul) agree and rely on is that they know how to avoid a repeat of the Great Depression. The textbook answer is:
- Easy Money
- Fiscal Stimulus
- Don’t Raise Trade Barriers
Ben Bernanke learned this as a young college student, and built it up in his Ph. D. dissertation. He has the same moral certainty about this that George Bush, Jr. does about fighting terrorism. And, I’m going suggest that Bernanke, and most of the political establishment (which hasn’t really changed in the last few days) are wrong.
What is a bubble? My definition: a bubble is a self-reinforcing cycle where monies invested obtain a negative return in aggregate over the long haul. It is characterized by significant borrowing at low rates to invest in already appreciated assets in order to profit from a momentum-driven market. When cash flow is insufficient to pay the interest to finance the bubble, the bubble pops, and a self-reinforcing bear market ensues. When that bear market encompasses most of the financial system, we call it a depression.
What is a depression? A severe recession where the banks are impaired. In an ordinary recession, lowering the Fed funds rate can stimulate the banks to lend. Not so now; the banks are licking their wounds, and letting profits grow by financing at lower rates, and sucking in bailout cash to shore up their balance sheets against future real estate lending losses.
The Great Depression ended when the Debt to GDP ratio dropped below 150%. When enough debts were extinguished by payoff or default, the system could once again be normal. Virtually none of the efforts of FDR focused on eliminating debts; in my opinion, he lengthened and intensified the Depression by not encouraging the liquidation of bad debts. And now we do the same thing. We perpetuate the misallocation of resources by trying to keep house prices high, by bailing out institutions that should go through the bankruptcy process. This fails to convert bad debts into equity in newly solvent businesses.
All the US government is doing is creating a bigger bubble. What will happen when the Treasury auctions fail, or, stretch the yield curve so wide that there is panic. We don’t want our financial institutions to fail, so we are willing to wager the creditworthiness of the nation in order to save them. I don’t like that bet. Many empires have died choking on debt. Is the US to be next?
When I wrote articles opposing the bailout, I did so because I did not think it would work, and that one-off conservations/liquidations would be preferable, but not optimal. Optimal to me would be using the bankruptcy code on a expedited basis, wiping out junior capital, and making senior capital take haircuts.
But in the present, we contemplate borrowing to bail out all manner of problems — bail out homeowners, automakers, banks, insurers, guarantors, etc. The end to this phase will come when the creditors of the US write off their prior lending, and decide not to throw good money after bad. I have no idea when that time will come, but the dreamy schemes of politicians aiming to solve every financial hurt will help to force such a time to happen.