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Friday, February 18, 2011

The Only Thing We Have to Fear...

"The only thing we have to fear, is fear itself" - Franklin Delano Roosevelt

My wife's cousin Brian Kaller, in his cover story for American Conservative magazine, Wreck of the Irish, presents a grim picture of Ireland following the financial crisis of 2008.  He laments the wasted opportunities where their government failed to capitalize on economy, booming thanks to the tech and housing industries.  The chance to spend those tax dollars on roads and libraries is now gone, along with the good times.  But Kaller, who moved to Ireland a few years ago, relates how the Irish are coping with their crash.

...our Irish neighbors have an advantage, even if they don’t realize it. People here grew their own food, made and fixed their own belongings, and scraped by recently enough that older people remember how to do such things. Families are closer, literally and figuratively, and many of them include farmers. Some people here still know how to garden, forage, dig peat out of the bog for fuel, and handle animals—enough of a critical mass to teach others quickly. The lives of people here might stand up to more punishment than Americans can handle, in the same way that the stone bridges near our house still take daily traffic after 250 years and will continue to do so long after today’s shopping-mall infrastructure has crumbled. Transition to a post-crash life will not be pleasant, but here, more so than in America, it will be possible.

As Kaller recounts the resilience of his neighbors, who like a mourner leaving the gravesite vows to push on, an American fatalism surfaces.  He senses that the same fate of the Irish awaits us.
Serious crashes can happen, of course, and our technology does not make us immune to them. There is a reason Ireland has so much open country and so many ruins; in an earlier age of railroads and mass communications, one crop failed, and a third of the island’s eight million people died or fled. We Americans have lived for decades at the other extreme of prosperity. Most nations live somewhere in-between—which is where the U.S. is likely to find itself sooner rather than later.
While we can learn from the Irish experience, attempting to draw definitive answers for us will be difficult, just as the captain of a large Ocean vessel can only use so much information derived from the sinking of a sailboat.  This isn't to belittle Ireland, but the analogy adds perspective.  Americans do view this nation much like the Titanic - as an unsinkable ship; a very apt view.  Unlike Ireland and every other nation, America is uniquely positioned to handle whatever may come.

Much can be said about the nature of the boom/bust cycles that naturally occur in our economy.  President Obama has made it a point to speak out against it and seek changes in fiscal policy to end these cycles.  But what he calls a bug in our system, is in fact a feature.  It must be stated that our present troubles were not only aided and abetted, but initiated by the government, not the market.

Since the days of FDR, dabbling in the housing market has been a hobby of the Federal Government.  Under both Democrat and Republican leaders the urge to meddle has been persistent.  Fannie and Freddie Mac, the CRA and the mortgage interest deduction along with Fed manipulation of interest rates conspired together in our recent boom/bust cycle.  These along with Mark-to-Market accounting rules led to our banking crisis.

The Community Reinvestment Act was signed by Jimmy Carter and was designed to push banks to lend in primarily minority communities to increase property ownership.  Later, under Bill Clinton the Fed pushed banks to loosen qualifications in order to further increase housing for minorities.  This, along with the backing of Fannie May gave banks an incentive to offer loans as broadly as they wished.  Once the loan was in place with the backing of Fannie, they could sell it to without the worry of repayment from the borrower.  Low interest rates and the mortgage interest deduction allowed borrowers to purchase more home for the same monthly payment.  Lenders, with little risk and increased competition designed newer, sub-prime, hybrid/variable rate loans designed to give the once-upon-a-time unqualified borrowers increased buying power.  These sub-prime mortgages were then bundled together to be bought and sold on the derivative market.

The American people were quickly moving up the ladder in housing.  Construction was booming as demand for new housing increased.  It was all going well until the expected happened.  The sub-prime borrowers who overextended themselves in their purchase, could no longer make their mortgage payments when the adjustable rate kicked-in, increasing their payment amounts.  As an increasing percentage of borrowers began to default, the value of those derivatives held by the investment banks tumbled.  While the majority of the loans were solid, their packaging made it difficult to sort the good from the bad.  As the value of these loans declined, the Mark-to-Market rules forced banks to count these packaged loans at a loss.  This brought several banks to the brink of insolvency, caused a run on banks and saw several shuttered.  Banks became afraid to lend money and many businesses were on the brink of closing their doors without being able to acquire funds.

At this point, the government stepped in to intervene with loan guarantees, TARP, increased FDIC backing and other measures.  The real estate bubble burst quickly and home values plunged.  Solid borrowers surprisingly found themselves underwater (owing more than the value of house), causing more defaults.  As the construction industry retracted, the ripple effects were felt through the economy.  As jobs losses piled up, the home defaults compounded.  This was definitely a boom and bust cycle, but it was not a natural cycle.  It was heavily influenced by government action at every turn.  It should be noted that in 2005, President Bush for a law to reign in Fanny and Freddy to no avail.

The boom/bust cycle exist in all areas of life.  In the mid-1980s any and every longhaired band wearing mascara and playing heavy metal music in LA was being signed to record contracts.  Motley Crue and Poison had begun a trend, but soon bands with little talent were being sold in the stores and on the radio.  Listeners turned off by this, found a new style of music being played in Seattle which became the next big thing.  The heavy metal boom in LA crashed as the Seattle boom began to build.  Radio and store sales didn’t suffer as they moved with the listeners.

In 1989 the Dallas Cowboys had a won-loss record of 1-15.  Three years later they won the first of three Super Bowl Championships that they would win over a four year period.  Following that final championship, their boom ended with a 6-10 record.  As the team aged, it became more expensive to maintain.  Their winning players became targets for other teams to pick up in free agency.  Yet the NFL carried on.

The larger truth is that success results in a tendency toward failure.  In other words, what goes up must come down.  But is this bad or good?  Are we better off maintaining slow and steady or allowing these boom/busts?

From 1963-1933 the stock market grew at an annual return of 11.83%.  But if you had missed the best 90 days during that span, your return would have been only 3.28%.  The stock market doesn’t grow in a steady and slow manner.  The majority of the gains come in large jumps.  To eliminate these would be to eliminate growth.  Unfortunately, this seems to be the path Obama has chosen. 
This cycle is not the enemy and it should not to be frowned upon.  It is simply a market response to our decisions.  I like apples. But if the price of apples is tripled, I would probably eat oranges instead.  As more people moved away from apples, demand for oranges would increase, which in turn would lead to price increases for oranges.  The Orange growers would bring in record profits from this new demand until either the price of oranges hit a point where people’s behavior would change or new orange growers would enter the market to drive the price back down.  Investment and innovation on the upswing drives the boom then as the market becomes oversaturated, a period of creative job destructions occurs on the downside of the boom, consolidating higher productivity rates.

A market that is large and well diversified, can sustain these cycles without any lasting harm.  The American economy can withstand the many market fluctuations that happen each and every day because of this.  Ireland, which could be mistaken in size for one of our states, is much less sturdy.  Just as the loss of one crop did its damage once before, the bursting real estate bubble waylaid their nation.

I can’t speak specifically for the Irish, but our problems here at home were brought about by the unintended consequences of dabbling by the government.  Mark-to-Market rules were ended by FDR in 1938 and implemented again in 2007 as a responsive action following the Enron scandal.  Correlation is not causation, but it is hard to ignore this.  Yet most people are not aware of how much our pain was caused by this rule.  

Many economist are still unsure whether the Fed chairmen’s (both Greenspan and Bernanke) actions have been correct.  I always felt that they were usually a step behind when making interest rate moves, but it is difficult to gauge.  But the real crime is still the government sponsored Fanny and Freddie Mac.  Using their government assurances allowed lenders to play fast and loose with the risks of lending.  Risk cannot be eliminated, it can only be transferred.  Either the individual players are at risk or the system itself is at risk.  Without a moral hazard, the boom/bust cycle becomes a net negative rather than a positive.   

On its own, our economy is highly resilient and able to weather the trade cycles.   If we can maintain an honest and open marketplace, and can prevent government from attempting to cajole and coerce the markets, we will escape a similar fate as that of Ireland.  When the government does choose to get involved, it should proceed with caution.  As our unsinkable Titanic weathers the storms, the government often applies its weight incorrectly and may just cause the boat to capsize.

"We have met the enemy…and he is us" - Pogo

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