The Humility of Realism
The Audacity of Hope
All we need to do is restore the confidence of investors, and everything will be fine.
We must take measures to make sure that the nominal value of assets that have been borrowed against do not fall further.
There is nothing to fear except fear itself.
There is nothing to fear except an aggressive government with idealists who think they know how to prevent a second depression, but really don’t.
Okay, the last one is what I think. I have new sympathy for the liquidationist philosophies of Andrew Mellon, Secretary of the Treasury for Harding, Coolidge and Hoover. Depressions occur because of economy-wide debt levels being too high, which leads to a self-reinforcing negative cycle when asset prices can no longer be supported by debt, because the cash flows from the assets become less than the cash flows needed to finance the debts.
There are two choices in such a situation. The government can interfere and cause a Japan-style malaise, not all that much different from the last depression, or we can liquidate, which is really, really hard. Think of what Poland went through with their “Big Bang” post-communism.
Most Americans, particularly Baby Boomers, do not like hard things (I would have loved to have written that article). Well, who does? But pain is a normal part of life, and mature people embrace it when it unavoidably comes their way.
In a depression, everything fights against the one trying to restrain it. Ask the Japanese how successful they have been in restoring normality to their financial system. Or, how good the economy was when the measures our government is applying today were tried during the last depression. Then consider:
- Our troubles with the auto industry, and why it might be better to not rescue Detroit.
- The level of historical equity volatility today versus the Great Depression.
- The deteriorating conditions at Fannie and Freddie. Oh, AIG, too.
- How the lure of cheap capital is luring all manners of institutions to become banks to line up for bailout capital. (American Express, CIT, various life insurers, etc.) Seemingly free money brings out the worst in all of us.
- That cities are applying to be covered by the TARP. (How will they offer ownership interests?)
- Modest efforts to stop home foreclosures may just delay the inevitable.
- The degree to which homes are underwater in the California Bay Area (among other places) is astounding.
- How overvalued housing remains in much of the developed world.
- In a depression everything fights against you at the same time. Consider seniors try to tap home equity using reverse mortgages. Sorry, door closed. Or consider trying to avoid bankruptcy when debts are high going into this slump.
- What it would take to go back to a gold standard. Not likely, but the price of gold could be 8-9x what it is now.
- And finally, my biggest bugaboo: can the US government continue to borrow aggressively without something significant going wrong. (I.e., dollar troubles, steep curve, or crowding out.)
Confidence exists because there is enough transparency and lack of overall leverage that people can have assurance that marginal institutions will not get pulled down in a self-reinforcing cycle of failure. We are nowhere near that now — if we can get the Debt/GDP down from 3.6x to 1.5x, we would have a chance. Until then, regardless of the confidence building measures attempted by the Treasury/Fed, we will not get to that level of transparency.
There are a few things different now versus the Great Depression. The US went into the Great Depression with a clean balance sheet. We come into this situation with a lot of debt, explicit and implicit (entitlement promises). On the other hand, we don’t have protectionism yet. We have an aggressive monetary policy, but one designed to stimulate hurting areas, and not the economy as a whole. The same is true of fiscal policy. It’s happening a lot faster than the government response during the Great Depression, so this will give a chance to see who was truly correct about what to do then versus now.
Are depressions caused by panics leading to a loss of confidence in the system because a few key areas have failed, and if we patch those up using government/central bank help, everything will go back to normal? That’s the view of the political powers that be, both now and before the Great Depression. Or, are they caused by Debt/GDP levels being too high, such that asset values get pushed significantly above their market clearing levels, and incremental new debt is not capable of financing those asset prices anymore? That’s my view, the view of Mellon, many pre-Great Depression economists, and a number of others today that argue that the problem is not that the markets have failed. Yes, the markets have failed because we let the credit creation inherent in a fiat money system run out of control. For the last 20 years, the Fed would never let a recession be severe enough that it would bring debt levels down, as the Fed did from the forties to the mid-eighties. So the debt levels grew and grew without bounds, because no discipline was imposed in the interests of permanent prosperity. Congress and the Presidency went along with it happily. Who wants to get in the way of a perma-boom?
Now the payment for this folly has come due, and the question sits before us: do we take it short and sharp, a Big Bang? Or, do we eat the elephant one bite at a time, a la Japan, which is still not quite out of its bubble woes after almost 20 years? I say Big Bang, but that’s not the nature of our culture, so be humble, be realistic, and be ready for a long slump or series of slumps as we enter the not-so-great depression.
November 16th, 20087:58 am at
With respect to protectionism, Michael Pettis has pointed out that China today is much like the US was in the late 1920’s, with huge foreign currency reserves and manufacturing overcapacity. As such, China may be the one to go protectionist, either explicitly, or by monetary manipulation. See his last two posts:
http://mpettis.com/
November 16th, 20088:44 am at
David, my continuing thanks to you for such clear-eyed analysis. I think part of the mix as well is the demographic one, namely that the leading edge of the boomers is rapidly becoming a Lost Generation financially, with the twin impacts of the housing depression and the loss of value in financial markets, and not enough time left to recoup losses or compound what value remains. (The article you linked to discusses some of the ill-preparedness of the Boomers, and this largely before the loss of value in the market.) I think you’re struggling with the same question I am does one go with one’s own and client investment dollars?
November 16th, 20089:32 am at
David – a question for you. I cannot claim a good grasp of macro, but my intuitive sense is that the key is your comment about the ratio of debt to GDP. Some of these claims must be wiped out by default – but the chief political characteristic of the system is an utter inability to inflict losses. Everyone must be bailed out.
So if we cannot allow piecemeal bankruptcies to clear the system, then what is the alternative except national bankruptcy — which takes the form of meeting all the claims in nominal terms and then hyper-inflating?
I have stayed with stock market investments on the theory that either the crisis will be brought under control and the stocks will recover, or that the efforts will fail and national bankruptcy will ensue, which means that money-equivalents are not a conservative investment. I do not think the Fed/Treasury will repeat the deflation scenario of the 1930s.
BTW – I heard James Grant speak last week, and he is bearish on money and bullish on high yielding corporate bonds, but I dunno — that looks like threading a needle.
Your thoughts (and I would be happy to be told that I am crazy)? (And I add my thanks Scott M’s).
November 16th, 20081:15 pm at
David: Would a reverse ETF such as the Proshares Ultrashort treasury funds be a good hedge against inflation or a failure of the Government to finance it’s obligations at current interest rates?
November 16th, 20081:28 pm at
Scott, David answered part of your question on where to invest in his November 12 article “What is a Depression?” Look toward the end of his article.
November 16th, 20084:28 pm at
First, I have a deep suspicion that people who advocate we take our medicine sharply, are generally in positions where the pain will not happen to fall sharply on them, but on other people. I suspect the author is one of these. I am pretty appalled at the indifference such people show to the enormous suffering real depression would bring to huge numbers of people.
Second, I do not know of strong agreement that the Great Depression cured itself; most seem to think the fortuitous enormous spending of World War II finished it off, not an automatic self-regulating process.
November 17th, 20088:26 am at
Has anyone tried to estimate what the economic situation would have been in the US had we not won the war? I know it sounds stupid, but I’m very dubious about this ‘WWII ended the depression theory’. Winning WWII was such a profound positive shock to the US economy that attempts to draw economic analogies and quantify an equivalent amount of peacetime stimulus seem stretched at best.
In terms of the question of how much stimulus we need, there must be many more examples of countries applying economic stimulus to study than the few people are bantering about at the moment. OK, so modern day Japan, Britain in the 70’s and the total experience of the New Deal are not encouraging for Keynesians. Where are the happy endings?
November 17th, 200811:49 am at
The claim that “this will give a chance to see who was truly correct about what to do then versus now…” is an exaggeration of the benefit of ex post outcomes of economic cause and effect.
The idea that a “Bling Standard” is somehow realistic, desirable, is wrong, Even the Swiss have dumped theirs. It makes you vulnerable to whomever buys up “all the” gold: SWFs, foreign central banks, Private equity, Hedge funds etc… The Fed may have had a hand in too much leverage, but the system self-corrects. The biggest problem after Reagan’s appointment of Greenspan was Bush’s administrative fiat: the 2004 leverage ruling and Congress’s post-Clinton budget busting.
One change we need is addressed correctly above: government policies need to be counter cyclical during boom times – no nation wants to be hamstrung by the pro-cyclical “Bling Standard” – government systems should be counter-cyclical.
At a minimum, the Fed needs to be allowed into VIP lounge where the punch bowl resides.
November 17th, 200812:11 pm at
Thanks. This is a discussion policy-makers should be having. I posted this on Roubini’s page:
Anybody else wondering about this: “One can thus only hope that this adjustment of consumption and savings rates occurs only slowly over time – four years rather than two.”
Is it better to have one year of disaster, mass unemployment and hit bottom fast or to have four years of drawn out misery?
I tend to think that the latter case will be worse for general economic confidence and thus harder to recover from. Thus, I vote for (i) putting in place a safety net for the unemployed and homeless, (ii) arranging for quick resolution bankruptcies for the likes of GM (I don’t see a problem with selling all of our car manufacturers to the Japanese and Germans for $1 each), (iii) forcing all financial institutions to mark their books down to nuclear winter levels, (if you assume those CDOs are worth nothing, you can be surprised on the upside if you’re wrong), (iv) recapitalizing the best of the financial institutions and liquidating the rest.
I would expect the economy to recover strongly once we reach a bottom. Of course, I could be wrong…
November 17th, 200812:14 pm at
….hmmm — “I say Big Bang…”…so you’re a financial analyst with a wife and eight children and you don’t mind being unemployed for a few years…or, alternatively, bagging groceries at Kroger (if it’s still in business)…you might want to ask the rest of your family for their opinion.
November 17th, 20084:01 pm at
Hello David, I have just recently begun to follow your blog and I’d like to thank you for all of the good reading.
Here is another article with a similar outlook as you have described, though it goes a bit far in places is worth the read either way. (And this blog is in no way affiliated with me and I have no personal gain from linking it)
http://pajamasmedia.com/blog/want-change-lets-try-truly-free-markets/
November 17th, 200811:35 pm at
JVDeLong wrote:
So if we cannot allow piecemeal bankruptcies to clear the system, then what is the alternative except national bankruptcy — which takes the form of meeting all the claims in nominal terms and then hyper-inflating?
The alternative lies in the denominator of the Debt/GDP ratio. We have to grow GDP as fast as possible. Unfortunately, no one wants to talk about creating incentives for growth. The only discussion is how to cushion everyone from slower growth.