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We don’t yet know how many trillions will be swallowed up by the
government’s rapidly breeding herd of stimulus-bailout-help!help! measures.
But additional bold steps are sure to come, some already in R&D and
others to be invented on the fly to answer each new wave of bad news. Expect
price tags suitable for proving how serious and determined the authors are.
The doubts that meet each new plan – does it really need to be that
big... hasn’t something like that been tried before... is it smart to
keep wrong-headed decision makers in high places... isn’t too much debt
at the heart of the problem... if you don’t know what causes inflation,
are you sure you know what causes babies – are all answered with the
same rhetorical question: “We can’t just do nothing, can
we?”
Yes, we can. But we won’t, because the decisions about our wealth and
our freedom are being made by career politicians, for whom stepping aside is
the only truly unacceptable plan. Nonetheless, even though the idea of
government doing nothing in the face of credit crisis, bank insolvencies, and
recession has been reduced to a hypothetical, such a policy deserves a little
exploring, since it can tell us something about where all the big-dollar
solutions coming out of Washington are likely to lead.
Background
It’s possible to train people to be crazy. If you’re acquainted
with a psychotherapist (socially, of course), ask him to explain how
it’s done. Training people to be crazy wasn’t what the U.S.
government set out to do when it ended the dollar’s convertibility to
gold in 1973. But it turned out to be one of the results.
Untethered from the gold standard, the Federal
Reserve was free to create new dollars whenever it saw fit. But the policy it
drifted into wasn’t steady inflation, day in and day out, it was rescue
inflation. The Fed would step up the expansion of the money supply whenever
it saw a risk of widespread defaults in credit markets. The unintended effect
was to train both lenders and borrowers, by repeatedly rescuing them from
damaging defaults, to appraise financial risk unrealistically and to regard
what is in fact a source of danger as a manageable nuisance. It made the
managers of financial institutions functionally crazy, and the longer rescue
inflation continued, the worse they got. (When you read about investment
bankers running a business with 30-to-1 leverage and tell yourself,
“Those people must be crazy,” you’ve got it about right.
But they weren’t born that way. They were trained.)
That’s how the credit crisis was nurtured. And here is what the
government has done about it so far.
August 2007. The credit crisis is just going public. Commercial banks,
investment banks, and other financial institutions are waking up to the
reason they were getting such great returns on junk paper – it really
is junk. To ease the shock, the Federal Reserve begins a vast and
unprecedented program of swapping out Treasury securities from its own
sizeable (nearly $1 trillion) investment portfolio in exchange for the
embarrassing and worrisome securities that seem to be paralyzing the lending
departments of the banks that own them. A novel approach, and not really
inflationary, since no new cash is produced.
September 2008. Lehman Brothers informs the Federal Reserve that the
novel approach, admirable though its inventiveness might be, isn’t
working and drops dead in front of Ben Bernanke’s desk. The Fed
abandons the hope of a non-inflationary remedy and begins a vast and
unprecedented program of expanding the monetary base (buying Treasury
securities and other IOUs in the open market with brand-new dollars).
October 2008. President Bush signs a vast ($700 billion) and
unprecedented bailout bill. It has been sold to Congress as a measure to help
banks survive and keep lending, but the details are vague in the extreme,
leaving the secretary of the Treasury with the authority to use the money for
almost anything, including, if he should find it advisable, “for
carrying on an undertaking of great advantage; but nobody to know what it
is.”
Other vast and unprecedented programs have followed, including tens of billions
for any car company willing to drive (not fly) to the teller window, hundreds
of billions to get messy home mortgages house-trained, and unspecified
mega-billions for Timothy Geithner’s proposal
to unburden banks of bad assets through a plan of great advantage but nobody
to know what it is.
And today, 21 months after the doctors started scribbling prescriptions, most
markets continue down, the economy is still shrinking, and worries are still
growing.
Now roll the tape back to August 2007. What would have happened if the U.S.
government had simply kept its long-standing commitments (in particular,
protecting FDIC-insured deposits and preventing the money supply from
shrinking) and otherwise had done nothing? No good-asset-for-bad-asset swaps,
no wild expansion in the monetary base, no bailouts, no arranged marriages
with taxpayer-financed dowries for failing institutions.
Nothing.
If that sounds extreme, perhaps you’ll find it a little more acceptable
if I put it this way: what would have happened if George Bush, Ben Bernanke,
Nancy Pelosi, Harry Reid, Barney Frank, and Barack Obama had done nothing?
It would have been spectacular, a mass die-off of the incautious. Bear
Stearns, Morgan Stanley, and other practitioners of ultra leverage, including
perhaps Merrill Lynch, would have folded. When you borrow to carry $30 of
investments for each $1 of company capital, it only takes a 3.4% drop in the
prices of your assets to put you under water. And when you’re getting
that 30-to-1 leverage through overnight borrowing, even a whiff of doubt can
make it impossible to roll over your financing from one day to the next.
Either way, you’re out of business.
From there, the trouble would have fanned out. The firms just pronounced dead
were counterparties to trillions of dollars in derivatives. The investors on
the other side of all those deals (largely banks, insurance companies, and
other brokers) would have been left holding the bag. Some of them would have
failed, and all that survived would have been left weakened and living in
fear.
Growing mortgage losses would have forced Fannie and Freddie (and also
Countrywide Financial) into bankruptcy, which would have turned their
trillions in outstanding bonds into junk debt, doing great injury to the
banks, insurance companies, and other investors that held them. Citibank and
Wachovia would have gone under. And with Fannie, Freddie, and Countrywide
gone, the biggest sources of mortgage money would be unavailable, which would
have turned the housing market from a corpse into a mutilated corpse. AIG,
which had turned itself into a sink of follies by insuring other companies
against losses on junk debt, would also have joined the departed – and
the companies that had been depending on AIG credit insurance would have
gotten sorted out between the failed and the merely damaged.
Bank of America, having been spared the irresistible invitations to acquire
Countrywide and Merrill Lynch, might be in much better shape than it is
today.
With a hundred-car pile-up in the financial sector, lending to businesses and
consumers would have shriveled, and the rest of the economy would have
slipped into a depression. No more General Motors. No more Chrysler. Ford
maybe.
And those are just the big names. Tens of thousands of other companies would
have gone out of business. Most others would have laid
off workers. The unemployment rate would have moved deep into double digits.
With so many companies cutting inventories to raise cash for survival, the
wholesale price index would have gone off a cliff, and the consumer price
index also would have slumped.
It’s an ugly picture, with pain and hardship for millions of people and
grave worries for the rest. But before you start preparing thank-you notes
for the good people in Washington who’ve acted so boldly, consider this:
If they had done nothing, the whole sorry business might be over by now.
Without the promise of rescue and blow-softening, events would have moved
quickly. The collapse of the overleveraged financial companies would have
started soon after credit market jitters began in August 2007. (Leverage
built on overnight borrowing invites swift justice.) The disaster in the
financial sector might have been over by the end of that year or soon after.
The year 2008 would have seen the wave of layoffs and bankruptcies in
operating companies and the fall in wholesale and consumer prices.
A simple process would have brought the contraction to an end. With the
prices of most things falling, the real value of the money in
everyone’s pocket would be rising. That would continue until large
segments of the population came to feel cash rich and started spending.
Dollars appreciated in value, not dollars newly printed, would finance the
recovery.
And it would be a thoroughly healthy recovery, because the bankruptcy
proceedings that came before it would remove the billion-dollar bunglers of
recent years from positions where they can make expensive mistakes. Decision
making about the allocation of capital would fall to the survivors, who, by
their survival, had proven their ability and readiness to decide wisely.
There is precedent for this. In the depression of 1920-1921, for example,
wholesale prices fell by nearly one half, and most of that fall occurred in a
period of just six months. It was a violent experience, with widespread
bankruptcies, but it was over in a year and a half. It ran fast because the
government did so little to try to stop it. Nancy Pelosi hadn’t been
born yet.
So much for the hypothetical. Instead, with all the government efforts to
make things right, we have:
- An economy that continues to contract;
- A continuing mystery as to which banks are
solvent and which are not;
- Financial institutions still under the control
of individuals who’ve proven they should be doing something else;
- Car companies on apparently permanent
life-support at taxpayer expense;
- A retarded decline in housing prices that is
extending, by years, uncertainty as to how severe mortgage losses are
going to be;
- A flock of new government programs that will continue
to soak up billions of dollars per year long after the recession is
over;
- A vast and unprecedented (that again) increase
in the basic money supply, which is jet fuel for price inflation;
- A vast and unprecedented increase in peacetime
government borrowing, which, when the recovery begins, will trap the
government in a choice between letting interest rates rise (and risk
choking off the recovery) and continuing to inflate the money supply
(and kiss runaway price inflation on the mouth).
Yes, it does seem cruel to do nothing when disaster is unfolding. But
consider the likely consequences of the alternative.
Doing nothing might be appropriate for Washington at this point in
time… but it is not what you should do as an investor. Making the trend
your friend is the strategy that will get you through tough economic times
like this and provide you double- and triple-digit returns.
Terry Coxon
Caseyresearch.com
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