Monday, December 22, 2008

new thoughts for a new era

I have totally neglected this blog for various reasons, but feel the need to put some stuff in writing now...

First, I have been watching Larry Kudlow talk about how low gasoline prices will help the economy. This to me is unlikely because lower oil prices mean less money leaving our country in the form of trade, which means less money coming back in the form of capital-market flows. For the last 5-10 years our economy grew dependent on securitization as the spigot of credit for our economy. Evidence of this is massive in the data, which I don't have time to gather now... It's also apparent in the way the system broke down. We had a credit bubble because the underwriting and lending processes were separated... Fly-by-night mortgage brokers did the underwriting, and were essentially paid to manufacture mortgages, while Saudis, Chinese and Russians lent to us from the massive stockpiles of dollars they had accumulated selling us stuff.

Now that they're selling us less, they going to lend to us less.

People might say: great, Americans will now save. That's all well and good, and they have been saving largely by piling money into bank accounts. Twenty years ago, this would have been fine and dandy because banks actually lent money. Now, however, banks have simply become intermediaries between borrowers and the capital market. They have spent the last 5 years becoming less local and more massively corporate. While Meredith Whitney is brilliant, her recent recommendation that the country needs to go back to a local-banking model is economic suicide.

Now that securitization is moribund, banks have lost the ability to lend. This is why banks are sitting on vast piles of cash, uncapable of lending.

My expectation is that the Fed is going to keep spewing money into the economy, it's like putting gasoline into a diesel engine. Until securization returns, the economy is dead in the water.

This is remarkably similar to events in the 1920s and early 1930s... In 1925, for instance, Churchill (then Chancellor of the Exchequer) put Britain back on the gold standard, over the objections of John Maynard Keynes. The resulting deflation put the UK into the Great Depression five years before the rest of the world.

In the early 1930s, the Fed raised interest rates believing this would support lending in the economy. After all, that was the standard operating procedure during the gold-standard period in the 19th century. Even though the USA was still on the gold standard at that time, it was essentially dead because it had been abandoned by England, and almost every other country. Unlike Keynes, the Fed failed to recognize a new era had begun.

And in Germany about the same time, Heinrich Bruning tightened credit controls as the Great Depression began, following the belief that austerity would fix the economy. (This was apparently such a pervasive cultural value in the period that FDR actually ran on a small-government, budget-balancing ticket.) Bruning's policies proved even more disasterous in the long run than the Fed's, as history clearly showed. (Guess who soon succeeded him as Germany's leader?)

Just as balanced budgets and small government were the established beliefs in the early 1930s, allegedly Keynsian "stimulus" is the creed today. Just as most leaders failed to recognize the new economic realities of the post-WWI world, not a single policymaker today seems to understand how different the world is today from a few decades ago. (For more, read this posting.)

My contention is that we have entered a new world where established rules of monetary economics are breaking down. We had ample evidence of this in 2004-5 when the Fed's interest rate increases corresponded to an acceleration of mortgage lending. It was clear then that something wasn't working as it should. The rules never contemplated securization or the impact of unregulated borrowing mechanisms such as the yen carry trade.

The question is: will our policymakers ignore the new realities, just as Churchill, Bruning and the Fed of the 1930s did? So far, the answer appears to be yes.

My expectation is that credit will continue to contract and deflation will worsen. Home prices will keep falling, foreclosures will snap back in January and jobs will continue to disappear. The Fed's low interest rate policy will worsen the situation by harming repos and money-market funds, while doing nothing to spur lending. Securitization will remain close to non-existent and consumers will lose access to credit cards. State and local governments will run out of money and be forced to lay off workers, worsening the economic slump. (I am still not sure how anyone can be bullish on infrastructure stocks in this environment. If state and local governments can't afford to pay their workers, I'm not sure how they're going to pay for roads and asphalt.)

My recommendation remains the same: We need to stop thinking about the Fed funds rate and create a spectrum of spreads at which the government will buy various credit securities. (It should set the levels for different risk levels, and possibly nationalize the credit-ratings firms in the process.)

The evidence is overwhelming that capital markets have replaced banks as the source of credit in the economy. We can embrace this new reality -- this new market primacy -- or we can fight it. But we cannot change it.

No one doubts we're in a new era. It's time to starting thinking that way.

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