Japanimating the Crisis

First of all, I take the word "crisis" with a grain of salt.  I am reminded of a story from a former Marine, let's call him "Jamal," who was hired at an aerospace company that shall remain nameless.  He was given the title of safety officer, and received a call in his first months that went something like this:

Boss: "Jamal, you have to come down to work, we have an emergency!"
Jamal: "Is anyone dead?"
Boss: "Well... no..."
Jamal: "How many injuries?"
Boss: "None.  All right.  It's not an emergency.  But come to work anyway."

A "crisis" is when your town gets bombed, or when your son gets cancer, or maybe when all the electricity goes out forever or the money you earned a week ago is worth more in your furnace than in your wallet (stay tuned...).  So I think the current "credit crisis" is a form of Newspeak.  Kind of like saying "bailout" when you mean "PR stunt to look like you're doing something useful at staggering cost in order to get reelected."  Or: 

"The length of Japan’s asset deflation, recession and liquidity struggles has been blamed largely on the lack of political leadership and willingness to choose the hard but necessary policies—such as letting banks fail and letting the market reset itself. Politicians bent on retaining their power and showing the public that they are “doing something” took action that sought to solve the present-day concerns without regard to their long-term effects."

Reason.com published a terrific and sober white paper comparing the current causes and responses to the American credit bubble bursting.  Among the major points:

  • Central bank complicity.  The funds rate is a blunt tool that is exceptionally useful at wiping out all market information about interest rates.  In both crises, the national bank cut rates too deep and too long to respond to a previous problem whose severity they overestimated (remember the dot-com bubble)?  Then, after companies and individuals took advantage by making capital investments at a rate that overheated the economy, the bank quickly raised rates, which had the effect of crashing the wave and catching good investments that hadn't gottent to profitability yet along with all the bad investments made in the same period.   This is in contrast to a more gradual culling that a market-based interest rate would have caused.  Finally, the central bank showed up at a gunfight too late, and without bullets, and slashed the interest rates again.  This had the effect of erasing any possibility of banks finding a profitability optimum interest rate.  Worse yet, the nature of the bubble made this route meaningless, because there's no point having low interest rates without any liquidity in the first place.  In both crises, the doling out of loans became a political decision rather than an economic one, the final blow to the system ever fully recovering. 
  • Bailing out bad businesses.  Again, this happened writ large in both crashes, and it destroyed the ability of the market to correct itself.  We see today banks sitting on their hands due to the political uncertainty in the face of economic certainty:
"Just months after a $25 billion investment in Citigroup, and signaling its confidence in the firm by supporting its bid for defunct Wachovia (which was ultimately bought by Wells Fargo), the government had to step in with a second bailout of $20 billion after a negative analysis of Citigroup’s obligations. The analysis had caused the financial sector to lose whatever confidence it had left in the banking giant. Citigroup is now in the process of breaking up its holdings, though the process could have been started months ago if taxpayer dollars had not been used to feed the zombie firm."

The white paper makes two points that seem to be in opposition: one, that the government is not requiring failing companies to restructure, and two that the government is meddling in the affairs of the companies.  They're not in opposition.  The government is meddling for political gains in an economic game.  It's prescriptions are things like limits on CEO salaries, which is a terrific way to run off any competent leaders that a company might hire on or have left on staff.  On the other hand, we have a great system of laws for just this circumstance.  Bankruptcy law in the US is a safety net that limits the ripple effects of failed businesses and forces restructuring of unprofitable enterprises.  Or, as the white paper says more eloquently:

"While the debate over when and if government should act as the “lender of last resort” remains unresolved, a clear principle should be that government money—tax dollars—should never be used to “prop up” failing firms. Firms that have neither re-organized nor changed their management have not yet reached their “last resort”"

  • Spend, spend, spend!  With this the current government is playing a dangerous game, one to which it seems completely oblivious.  It is using the dollar as a bluff, but it seems to think that the borrowing can go on forever.  The assumption is that the dollar has been rock solid for a century, so how could it fail us now?  Of course, the mortgage industry was rock solid for 50 years before Autumn 2007.  That's one of the big problems with a planned economy.  You trade in little panics for big recessions and eventually system-breaking collapses.  This happened in Russia in 1991.  The problems are that 
a) you're slowing down long-term growth rate even if the booms feel like sex, cocaine, and double black jack all at once.  And to my liberal artist friends, this is not up for debate.  Even John Maynard Keynes, the planniest of central planners, had a name for it (dead weight loss) that was so ingrained in macroeconomics that it turned into an acronym to save time (DWL).  I know, it's all just math in a sea of semantics, god bless the US education system.  

And b) human memory, even of the smart people running the whole circus, is too short to remember how shitty it was last time all the things that never fail failed.  Actually, that's giving them too much credit.  It's more like human foresight for the smart people running the whole circus hasn't gotten to the point where they think the wall will come down while they're still holding the buck.  Will China start selling off it's $2T in dollar reserves tomorrow?  Probably not.  Could it?  Yes.  Are we doing things that make that more likely by the day?  Absolutely.

So, any good news?  Well, there are ways out of this.  

"Other policy changes, such as reducing the tax rate or eliminating the exclusivity clause in bankruptcy proceedings, would increase investor confidence and prompt private capital to flow back into the marketplace. Even the most toxic mortgage-backed securities aren’t worthless. With renewed private investment, a market in these assets could emerge, allowing banks to sell off the debt and begin repairing their balance sheets."
The first step is to create a market for the toxic securities banks own.  This will have a dual effect.  First, it will allow divestiture at a known price for over-leveraged banks, which will basically tell them how much baby has to go out with the bathwater.  In other words, it will allow successful bankruptcies instead of theatrical bankruptcies that only re-name the same bad businesses and destroy shareholder confidence.  Second, it will actually put a price on the toxic securities, which under the current accounting rules will instantly allow those securities to be counted towards an institution's assets.  This alone will give many borderline institutions the wiggle room they need to have some negotiating leverage and operating capital.  No bank is going to sell these assets right now because, while they are economic dead weight, they are political gold.  You can't get the government to pay for your toxic securities if you already sold them.  This was already happening before Washington stepped in, as healthier banks with some wiggle room in their reserve rates were vacuuming up toxic securities for pennies on the dollar from firms that had overextended.  That process has now ground to a complete halt.  Thank God the bailout saved us.

The other panacea being offered (at gunpoint) is the porculus bill.  
During the 1990s, Japan passed 10 fiscal stimulus packages, focused largely on public works, totaling more than ¥120 trillion ($1.4 trillion in today’s dollars)... Those plans did not succeed in reviving the economy, but they did saddle the nation with a mountain of debt that helped to postpone any recovery for years. Including “off-budget” debts, Japan’s debt was estimated to exceed 200 percent of GDP.
This was also tried, my Pepere surely remembers, in the Great Depression.  Sometimes a wash of government spending can reverse the ills of the recent past and snap an economy out of a recession.  This seems to work, although I have no citations for this besides a general intuition and some common sense, when several of the following are true:

1. The recession is localized.  If you get layed off, you may miss a few mortgage payments.  If it is a localized event - your company was in trouble but your skills are still in demand in the marketplace - it might make sense to get a loan from family and friends to cover a few months of payments.  If, on the other hand, your skills are worth less now in the job market, it's probably a good idea to find some more modest digs.  The dot-com bust was a localized crash.  This is not.

2. The underlying problems are identified and removed.    If you're a woman in the US who wants to improve her circumstances, it makes sense to spend up front on job training.  If you're a woman in Saudi Arabia, spending on job training probably won't help much if you're not allowed to hold a job.  Right now, the US regulatory and financial structure is rigged to fail by corporate welfare, over-regulation, political in-deals, and government micromanagement.  Spending on it will just dump more wealth into the pit.

3. The recession is likely to be short-term.  We saw in both Japan's lost decade and even more obviously in the New Deal, where spending ran out of steam when debts rose and taxes had to be raised after a couple years.  The life of a spending package is 12-18 months tops.  If the market isn't self-sustaining high growth by then, you're going to kill any progress when you raise taxes to pay for the previous stimulus.  
"There were two major tax cuts during the Lost Decade: a ¥5.8 trillion ($69 billion in today’s dollars) income tax cut in 1994 that lasted for one year, and a ¥4 trillion ($46 billion) income tax cut in 1998 spread over two years.17 The problem was that these tax cuts were not permanent and thus did not increase long-term aggregate consumption.

"From 1994 to 1995, the Japanese economy began experiencing modest growth, partially due to the first tax cut. Deflation in 1995 reduced government revenues. In an effort to stem surging debt, the consumption tax was increased from 3 percent to 5 percent in 1997, which slowed the economy again.
4. The collateral is a durable good.  There is a reason why there is no such thing as a car equity loan.   This ain't your daddy's dollar anymore.  By various estimations, we are on the hook for around $100T in entitlements already promised by the US government.  Our debt is right around 100% of our GDP.  Lending to the US government in 1960 was a bit like loaning money to a capital and equity-heavy company to build a factory.  You weren't really concerned about getting paid, because in the worst case the company went bankrupt and would be forced to liquidate some assets to pay you.  Lending to the US government today is a bit like taking part in a leveraged buyout.  You are extremely concerned about how things are run, because there is not enough wealth to pay off all the debts in front of you if the currency collapses.  Which makes China and all the other holders of large dollar reserves more like shareholders than creditors.  They rightfully have a huge stake in how our country runs, whether or not Trent Lott gets all up in a tizzy every time we launch a satellite on one of their rockets.  Strategically, this is a Bad Thing.

5.  Your investments are smart.  Contrary to what Obama thinks, a dollar spent is not a dollar earned.  If your job skills are out of date, it makes sense to take out a loan for education, but it does not make sense to take out a loan for a sports car.  The first law of investing is to look for value, but for some reason this shouldn't apply to government spending?  It goes without saying that this is not government stimulus's best trait.  Everybody looks at the interstate highway system, which accomplished great things like destroying the railroad industry.  
During the Great Depression, President Roosevelt’s massive spending program, which actually had its roots in the Hoover administration, did not work to “stimulate” the economy. Despite all that spending and employment programs, unemployment remained extremely high.
There aren't really any good government investments that don't involve physically defending the country, but what the hell, I'll take a shot:  how about investing in paying down our debt?  That's long-term and it tackles the real problem.  That, or if you're an optimist, you could give out vouchers for education.  But that would just destroy the school system, or so we're told.

But really, I just spent way too much print on that.  There is no excuse for all this spending.  I'm reminded of a particularly stirring chapter of Jarod Diamond's Collapse, which talks about the last wealthy Norse lords in Greenland, in the end, only buying the right to be the last ones to freeze/starve to death.  Milk it boys.  Milk it to death.

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