The stock market came back with a vengeance yesterday. On Friday’s episode of BloodhoundBlog Radio we noted that the market was vastly oversold from a fundamental perspective and suggested a rebound after the weekend. This was prescient enough that the Mortgage Cicerone made note of it, which is high regard indeed. So why am I not celebrating? Because yesterday’s reaction was as irrational as the sell-off. One thousand points?! Sure the correction was in there, but so was the exuberance of a seemingly ceaseless font of federal gifts. The markets like the latest ideas out of Washington and why shouldn’t they? Wall Street has done a good job creating an aura of representation – most people now believe that was is good for Wall Street is good for America. How else do you explain the frantic efforts our fearless leaders make each time the market drops? The rally cry lately seems to be: “If we make the Dow go up, we must be on to something.” This is nothing new. For years now the markets have taken a preeminent position in economics beyond their reach or relevance. One need look no further than earnings reports. You might report record earnings for your company, yet your stock is pummeled because the reported earnings did not equal what the market had already priced in to the stock. “You didn’t do as well as we thought you would do based on our self-serving judgment of what is best for you.” (Which is shareholder profits, of course.)
If you believe what you hear from the talking heads (and by virtue of the fact you are reading BHB, I doubt you do) the source problem for the economy is the toxic mortgage derivatives and their tentacle like reach. Everyone bought these things, even when they didn’t know they were buying them. Now (as the story goes) our problem is this: no one knows what this stuff is worth. Everyone is marking down their portfolios, no one wants to risk lending money and the initial bailout (bailout 1.0) didn’t phase anyone; all because we don’t know the real value of these default swaps and cdo’s.
I say that is a bunch of merde. It is not that we don’t know what they are worth. The problem is we don’t want to know what they are worth. It is so much easier to let sleeping dogs lie and guess at the best solution, just so long as every elected official looks busy and Wall Street does not have to account for their true portfolios. If we had to accurately price these investments rather than pawn them off on the government… as a great football coach once said about passing: “Three things can happen and two of them are bad.”
But the truth of the matter is we can know their value and more importantly we should. Bear Stearns discovered their value and so did Lehman Brothers. Countrywide, WaMu and Wachovia have all generated a value for their mortgage based holdings. The problem here is that Rotarian Socialists believe the government should alleviate the pain of a correction. Why actually put these toxic investments out on the open market (where, I might add, they would find a true value in short order) when you can hold on to them and refuse to lend money while hoping for a do-over courtesy of the government (which is to say: you and I). Think of this as a game of poker. There are, for simplicity’s sake, ten people sitting at the table. Everyone has chips in front of them but only six are going to honor those chips. The problem: you don’t know who those six are. So what happens? No one plays, that’s what happens. The game (or in our case the economy) comes to a quick halt. You cannot play in a game where the currency as well as others’ sense of obligation with regard to the currency are in question. The easy answer is to call the bluff. Everyone lay down their hands, (transparency in poker) and then everyone must color up and cash in. It is that simple. Sure, you might lose some money on that one hand where you didn’t get to play strategy. But at least you smoked out the players who had no money to back their chips; the one’s that were playing for salvation and using your money to do it.
When the government decides to bail everyone out and buy our mortgages to boot, they are taking over the deal and keeping us stocked with chips; but we are still playing in a game with people that won’t be able to honor their bets. All the new chips in the world won’t help us trust a game with players that can’t pay out. If you want to end the credit crisis it is easier than you think. No more bail-outs; let everyone get their bad debts out on the market. Some will survive and some will break but the game will once again have trust. One thousand points would have a lot more staying power in a game like that.
David Shafer says:
Great post. A couple of comments. Never use the short term gyrations of the stock market to describe any rational activity. Short term the stock market is irrational and emotional. Long term is a different story!
The value of these MBSs, like the value of stocks, are not so easily quantified in the short term. There has been an irrational aversion to them in the market. Beyond that, is the capital requirements of banks that hold them. There are real limits to the leverage both in federal rules and regulations and in the market, valuing securities, as we have found out. That fact, as much as anything else, is what has frozen the credit markets. The bailout was about giving confidence to folks to do business and to alleviate the irrational fear of these securities. Judgeing the veracity of these actions by the stock markets is simply using a wrong metric. Thinking that the credit markets would unfreeze overnight is again poor thinking (I am not accusing you of this!). Only time will tell if this was a good action or a bad action. Warren Buffett thought it was needed. For the time being I am convinced by Warren, although not without some reticence.
October 14, 2008 — 1:15 pm
Sean Purcell says:
David, you stand in good company. I was listening to Lawrence Kudlow on Monday and he had a team of experts. A number of them (Kudlow included) said exactly what you are saying: the government is making the right moves but it will take time for them to play out through the system. (I am paraphrasing.)
I agree with the idea that most of the efforts being made by the Fed and Treasury will take time to materialize. But (and this is where I get hung up), when they do materialize will we like what we see? Giving everyone more chips to get the game started does not alleviate the problem: some of these players no longer have the money to be at the table.
For instance, the banks are limited by capital requirements just as you say. They are also marking to the market which may cause their capital reserves to look worse than they are. But until an open market establishes real values we are just guessing and some institutions are being hurt by that while others are staying in the game longer than they merit.
October 14, 2008 — 3:20 pm
David Shafer says:
The government can put a value on the worth of these and by buying some a fair value, will establish a market price. Not perfect, put in theory should unfreeze the market for these and unfreeze the credit.
Right now, for example, there is no one willing to lend for municipal projects, which are now having to be put on hold until the credit frees up.
Interesting, anyway :-).
October 14, 2008 — 4:40 pm
Tom Vanderwell says:
Sean,
Can I repost this in it’s entirety on Straight Talk?
Very well said.
Tom
October 14, 2008 — 6:26 pm
Joe Hayden says:
Hi Sean…
Nice analysis…
I want to take it one step further and add that an economy founded upon a central banking system with the power to indiscriminately inflate and deflate the money supply, coupled with a fiat currency, is truly the root of all of our current financial troubles.
The cycle of failure / bailout will continue indefinitely with exponentially increasing numbers until the system collapses under the interest payments on the debt (this debt is the opposite of the credits we receive in the form of paper dollars from the Federal Reserve). We are getting closer and closer to this reality…
October 14, 2008 — 6:55 pm
Sean Purcell says:
Tom,
I am honored! Of course you can reprint it.
October 14, 2008 — 7:34 pm
Sean Purcell says:
Alright Joe, I’ll play along. What do we look like without a central bank? Fill in some details. Do we go back to gold? Do states print their own money? This is definitely more than one step further, I am curious if you can make it make sense.
October 14, 2008 — 7:38 pm
Greg Swann says:
> Do states print their own money?
Private banks of issue. The so-called “business cycle” is caused by inappropriate lending — bankers investing in the production of goods for which there is insufficient demand. Private banks of issue would not prevent this from happening, but they would tend to localize the consequences. Instead of national or global recessions, we would have small, local contractions. It seems plausible that these would be both less common and less consequential, too, because the relative value of one bank’s currency, with respect to other nearby banks, would serve as an early-warning system of malinvestment.
We have central banks — again going back to Alexander Hamilton — to empower Rotarian Socialists, not to promote economic health. A monopoly on money is just as perilous as a monopoly on water or food.
October 14, 2008 — 7:59 pm
Sean Purcell says:
Greg,
The cyclical nature of a marketplace, even a completely open marketplace, is inherent and reflects natural inefficiencies in the marketplace, which is, I suppose, what you are saying when you reference “the production of goods for which there is insufficient demand.” It seems a little disengenuous, however, to lay the blame solely on the bankers’ door step.
I understand and respect your dedication to decentralized power. I am almost as dedicated as you. But a unified nation requires some compromise in promotion of economic efficiency. Private bank issue is an example of a fine price discovery model that would lead to an inordinate amount of oversight.
As for “a monopoly on money being perilous,” I agree with you to the degree that a monopoly is made possible when currency has no relation to an underlying value.
October 14, 2008 — 10:01 pm
Greg Swann says:
> The cyclical nature of a marketplace, even a completely open marketplace, is inherent
As a metaphor? Purposive human behavior is not subject to cycles. That people make similar mistakes repetitively is not a necessary consequence. The business cycle as the term is tossed about is caused by the perverse incentives of central banking — exacerbated by other aspects of Rotarian Socialism.
> It seems a little disingenuous, however, to lay the blame solely on the bankers’ door step.
A market contraction results when investment in new production exceeds the demand for that production. This is the consequence of poor investment decisions. You can call the villains investors, if you like. In the U.S. since 1912, the sine qua non investors have been the central bankers, who, by issuing fiat money disconnected from either a benchmark good like gold or from a lockstep with GNP growth (Volckerism), have caused recession after recession.
> But a unified nation requires some compromise in promotion of economic efficiency.
That was Hamilton’s argument. How’s it working out?
Here’s another way of thinking about the same thing: If the designers of the internet had built one big computer in Washington, would that be better or worse than than the “inefficient” distributed system they built instead? How about one, single giant hospital, with one set of mandatory medical procedures?
The moral is the practical. Freedom is never impractical. Slavery always is. If we can’t produce our way out this mess very quickly, we’re about to endure ten or more years of Hamiltonian efficiency.
October 14, 2008 — 11:25 pm
Joe Hayden says:
Hi Sean…
A complete answer I think is beyond the scope of this forum. I primarily mean to call attention to the elephant in the room (and our wallets), the central banking system…
Historically since 1913, there have been numerous bailouts used by the Federal Reserve to inflate the money supply and concentrate the Nation’s wealth into the hands of a few. In the 1970s, the Fed, along with the FDIC, began to make significantly larger bailouts of banks that had failed due to a mismanagement of their fractional-reserve and an over-extension of credit. Every few years the size of the bailouts has grown, the last major one prior to our current National Disgrace costing over 40 billion dollars in the mid-nineties.
The solution is basing the economic system of this country on a currency that carries a set value that can neither be inflated, nor deflated, and let the free market establish the exchange value for goods and services. It always seeks an equilibrium. This solution unfortunately requires other major economic powers in the World to follow suit…
The solution also requires a wholesale revamp of our education system to ensure succeeding generations understand and can implement sound economic policy. It requires a thorough cleaning of the halls of Congress and the White House. It requires a generations-long period of change, challenge, potential suffering, and complete paradigm shifts to enact.
We are going to continue this wash-rinse-repeat cycle of bailouts until we are deeply entrenched in a powerful economic socialism that will open the door to a broader political socialism in this Nation. The corresponding loss of freedom, reduction in personal wealth and ownership, and the destruction of the brilliant set of principals America stands upon follows soon after…
Sean, of all people, I think you would love the book “The Creature from Jekyll Island”. If you are not familiar, it’s worth your time. I have never read before such a concise, clear, simple explanation of all that currently dominates the economic news as I have found in this book. The meat of this literary work can do nothing less than raise serious questions about the ‘solutions’ proposed by our government…
October 15, 2008 — 5:41 am
Joe Hayden says:
One more thing to add to what Greg said in answer to your question Sean…
Private banks would be subject to the same free market forces as everyone else. The banks that were well-managed, were profitable for their investors, and provided exceptional service to their customers would prosper. The others would wallow and fail… No government intervention required…
I am not stating that I am against all regulation and reasonable governance, but I do believe the nature and letter of the regulation would be very different in absence of a central bank.
October 15, 2008 — 5:47 am
David Shafer says:
And for a opposing view:
http://www.washingtonpost.com/wp-dyn/content/article/2008/10/13/AR2008101302090_pf.html
October 15, 2008 — 6:23 am
Joe Hayden says:
Keynes would have seen in coming as he helped engineer the system that made it possible. He was integral to the development of the Federal Reserve policies that plague the system to this day… Keynes was a devote Fabian Socialist committed to implementing a world central banking system that would promote the same principals used in England to control and inflate / deflate the money supply against the free market.
Very interesting to read that article and see how cleverly it is worded to disguise this information.
October 15, 2008 — 6:49 am
Michael Cook says:
What a great debate. Recently I was reading about our banking system pre-Great Depression and even pre-Central Bank in the Wall Street Journal. Times were certainly no better then. I have a few questions for the non-central bankers out there.
One big problem with localized banking is the need for large scale investments. Imagine trying to building a national railroad, highway, steel factory, etc. with 400 localized banks with different regulations. The sheer scale necessary for these investments requires a system of banking to be much larger than any one (or even 100) small institutions. In Greg’s example above, it would be like requiring NASA to use 1 million computers across the country to research an extremely complex problem that require an immense amount of computer power vs. building one supercomputer.
Linking an economy to gold is as arbitrary as linking it to nothing at all. If we find more gold we print more money??? What does that have to do with how much production we need or how many goods we can produce? Nothing…Perhaps the GNP growth arguement has merit, but I fail to see how forcing that locally is better than a national system?
There is a reason why regulated monoplies are allowed in some industries. The shear amount of investment, economies of scale, and/or simple effeciecy. Pre-central banking, local banks were actually quite inefficient at providing banking needs of the community. Besides conflicting regulations, it was impossible to make any scale investments.
Additionally, failures were not localized as expected. With the concentration of business in several areas, many local banks were forced to go well outside of their scope and location to make money. This wound up leading to massive failures when the economy slowed. Because there was no central banks, there was no way to aid troubled local banks and there was really no hope. Its how JP Morgan made a big name for himself. He had enough money to act as a central bank, saving many local banks and their economy.
I think it is fair to argue that monetary policy should be examine much more closely, but I fail to see how localized banking would prevent crisis on a large scale. Localization only prevents aid and slows growth tremendously.
October 15, 2008 — 7:50 am
Michael Cook says:
On another note, great article Sean. I think the challenge will be trying to get ahead of the game. For all intensive purposes, this game is over. There is so much money out there now, it is only a matter of time before banks get comfortable lending again. Additionally, now that bankruptcy is off the table for the major banks, its also only a matter of time before they start trading the troubled assets and all is forgotten. But then what?
Eventually we have to face the music. The question of inflation should be looming and the question of what will the taking $2 trillion dollars out of the stock market and placing that money into the hands of banks do to the dollar, euro, etc. I think its obvoius that the money will not reappear in housing because of tighter lending regulations and the need for incomes to catch up to prices or prices to drop to income. A very slow process…
With so much money out there, it seems like there will be another bubble sooner rather than later.
October 15, 2008 — 8:02 am
David Shafer says:
Michael,
Great comments. As I was reading along I was thinking of old JP Morgan too! Yes, there is still much capital out there looking for a home. Much of it has ended up in large scale real estate investments pushing down capitalization rates and keeping prices relatively high. Some of it has gone to international real estate development in Asia and other growth areas. Although I agree with you about the US residential market (in general) I think real estate investments will still attract the capital. Real estate is fundamental to the economies of the world, always has been and always will be! Interestingly in my part of the world, in the middle of the biggest real estate slump of the last two generations, two upscale downtown condominium projects are reaching completion and mostly sold (70% on one and 90% on the other). Price range from $700,000- $4.5M!
October 15, 2008 — 9:02 am
Joe Hayden says:
Hi Michael…
You wrote so much that I don’t think I can begin to respond to it all…;)
In general though you didn’t express it openly, you wrote from the premise that a fiat monetary system was in place. With fiat money, it is easy and expected that the producer of such a medium of exchange would use said production power to “shore up” failing institutions. It is exactly what is happening today… Without that assumption, several of your examples no longer hold merit.
For example, most major railroad systems were built in the time period between the end of the Civil War and 1913. This period in finance is marked by the lack of a central banking system in the US, though many were attempting to organize one. How were these railroads financed? By businessmen who drew on a number of available resources and investors to raise the necessary capital. This included the sale of bonds…
Bank failures in this time period mostly came from loose fiscal policies at the individual banks as opposed to the overall economy. Investors trusted their money to the banks, demand money really, with the understanding that the money would be let for a profit (interest). Banks would get greedy and attempt to increase profits by increasing the amount of loans without increasing deposits. Risky behavior. This led to legitimate depositors finding it challenging or impossible to withdraw their demand deposits, and of course the potential for the bank to fail ensued. I simplified this example due to space and a lack of detailed knowledge of monetary science, but essentially the market put the poorly managed banks out of business.
The gold issue is a little tougher to tackle without extensive development. Essentially, as the supply of gold increases, the amount of available money backed by the gold would increase and prices would accordingly adjust. In other words, an equilibrium would be established over time that would still be based on a tangible medium. This adjustment would begin the moment someone bought the gold from the company that mined it.
I cannot say that gold itself is the best medium of exchange, but whatever the choice it must be a medium that is traded at a fixed price without allowing any entity to inflate or deflate the supply, or change the price, at will without a free (as in not coerced) exchange. Something must serve as a monetary constant. There are lots of good books on this topic that explain it far better than I am able.
You definitely should research how J.P. Morgan was able to “act” as a central bank. Mountains of evidence show he was funded by a central banking system already established in Europe to concentrate significant amounts of wealth and bring about a permanent change to the economic system in America… Very interesting reading…
October 15, 2008 — 5:49 pm
Michael Cook says:
Joe,
I spent quite a bit of time studying the gold standard in my many economics classes and it still makes no sense to me. The monetary system has to be tied to production. When that method becomes unhinged then you get rampant swings in valuations (inflation or deflation). Additionally, there is also times of simple irrationalism. Internet boom and bust, housing, etc. and these are times that you need a central bank to prevent total calmity.
Banks, like any other industry are not immune from this boom or bust cycle. Having a central bank should prevent this, if it acted more like Volker and less like Greenspan. Production is so broad and vast, the only way to tie a currency would be to a basket of goods (i.e. CPI). This simply takes your gold standard to the next level, by tieing currency to gold, bread, gas, etc.
I can sympathize and agree that our monetary policy has gotten off track, but I have not seen a strong argument here against a central bank system. Without having a master on/off switch, unique times like the Great Depression or even now could persist and become far worse. Perhaps that is true capitalism, but I personally feel that government does have a place and free markets are not perfectly effecient.
October 16, 2008 — 8:27 am