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.