Sunday, February 22, 2009

Are Experts to Blame?

I was discussing the financial crisis with some people tonight when someone asked why things are different now in previous crises, such as during the 19th century. My immediate answer was that the banking industry was much less centralized then. The country at large was susceptible to gold outflows, but there was no unified bond market, securitization or national real-estate market.

I also suspect the gold standard helped in the past. If you had real bullion, you were ok no matter what happened in New York. Now, you might hold your savings in stocks or mortgage bonds. When they fall for one person, they fall for everyone. Because money is no longer rooted in real gold, it seems to follow trends in the financial markets, which themselves have none of the safety of gold. Many people complain about derivatives, but they forget that common stock is also a derivative -- especially when a company has a lot of debt.

Just now, I thought of an even better explanation about why events like the Great Depression or the Second Great Depression (i.e. Bernanke/Obama/Geithner Depression) seem so much worse than events in the 19th century. It's precisely because people like Bernanke, Obama and Geithner are "in charge." Just by offering to "help," they are prolonging the crisis. This marks a change from the 1800s, when hundreds of settlements sprung up across the frontier only to fail and wind up as ghost towns. If that happened today, people would be asking for bailouts and rescue packages instead of moving on to other endeavors.

I suspect that the presence of policymakers to "fix things" has caused an entirely new kind of problem because it makes people hope for someone else to solve their problems. Instead of just abandoning the ghost town and moving on, people stay, asking for the authorities to subsidize the the local businesses and help them stay in their homes. This dynamic is most visible in Michigan, where millions of people have been trapped by the failing auto industry and the promises of organized labor. A century ago, they would have been long gone for greener pastures. But why should they do that when the union had arranged "job banks" to keep them on the payroll?

The cruelest irony of all is that the same people who have been paid not to work for the last 10 years could have spent that time establishing themselves in different professions. Now that the overall economy is collapsing, it's the worst possible time to seek a completely new career path. The union, intended to protect, wound up a prison.

I think another problem that has yet to be seriously addressed by anyone other than myself is the country's unhealthy education bubble. During my entire life I have watched universities create "degrees" in subjects like "restaurant management" and "criminal justice." I have seen certification programs like the CFA grow exponentially. Few people question the value of this designation, even after its disciples led the credit system over the cliff -- guided by their models.

The problem with academia is that it's a false environment. It exists in its own bubble, independent of the real world, untroubled by profits or managing costs. The government is to blame for much of this because it has subsidized the system for decades -- much as it has supported mortgage lending.

"Experts" emerge from this environment, supercharged with a shaman-like aura of power that was created in the false world of the seminar and classroom. The typical academic setting simply gives people grades on tests, but doesn't make them manage a portfolio, study technical analysis or tear into a company's balance sheet. The certification process gives them a bogus sense of confidence.

In my own experience as a reporter, I have been amazed at how many people ignore facts directly before their eyes in favor of "theories." They worship ideas like "fundamental analysis" of stocks, focusing on fictional concepts such as "earnings" in order to determine "proper valuations." (I personally believe in enterprise value and EBITDA over market cap and earnings.) They assume the market is like a football game where a referee is going to come out and say "you should be trading at a multiple of 15x, not 8x" and magically push it higher. They ignore the very clear reality that stocks go up when people buy them and down when they sell them. Many factors can cause people to buy or sell that has nothing whatever to do with intrinsic value.

I often think that having a "theory" to fall back on increases moral hazard and the pro-cyclicality of a crisis because it makes everyone do the same thing. For instance, one analyst said that U.S. banks should be buying AAA-rated German bunds rather than Treasuries. He might be right that they are safer, but I told him that's not how people think institutionally. If everyone in the world buys Treasuries and it winds up being a bad decision, no one is going to get fired for owning them. But if you buy Bunds and the trade goes against you, you're at risk of getting fired because you took such an outside-the-box move. Accepted theory/expertise herds people together... much as barbed wire and landmines are used on the field of battle to channel attackers into a narrow space to be cut down by machine gun fire...

That's why some portfolio managers kept buying Lehman Brothers all the way to zero, saying "it's really cheap on a valuation basis." They were following the same model as "experts" like Ben Bernanke, Tim Geithner and Larry Summers, who ignore that today's world is controlled by forces like capital markets and international money flows. Instead, they nostalgically pretend they're still the bank-dominated system of their youths. See this posting for more. And because they are men "of reputation" and "power," no one challenges them openly or seriously.

Anyone wanting to understand the proper place of academia should look no further than its origins in ancient Athens. It was an exclusive and closed environment where people like Plato sat around contemplating things. They had no deadlines or budgets to meet, nor many explicit responsibilities. It wasn't very different from the GM worker getting paid to sit and watch TV in the "jobs bank." Yet, we've given them control over our economy. This is why I called for the creation of a new power junta of established market professionals in this posting.

Because they're not in the real world, the academic mindset doesn't appreciate how things really work. They don't understand that economics is a bit like love or friendship. Things just work or don't work. (There is no General Theory, as Keynes tries to find.) Instead of people having chemistry between each other, companies and customers find each other and keep coming back out of their own free will. These relationships evolve organically over time, and are held together by everyone's individual sense of self-interest. (Friedrich Hayek won a Nobel Prize for arguing that the links are too complex and dynamic to be managed by a central authority.) Furthermore, places like ancient Rome had economic cycles, and they didn't have a Fed or M2. Keynes' ideas existed at one moment in time and are based upon an army of assumptions that may or may not be valid today. I am not sure even he would approve of how his theories are being used today. I say this because of his persipacious warning against the UK returning to the gold standard in the 1920s. I think unlike most of his alleged followers today, Keynes himself would appreciate that we now live in a capital-markets based world. He would know better than to do things like cutting interest rates close to 0%, which are like poison in the veins for the financial system. (See this posting for more.) He would probably also realize that a lot of this mess resulted from government policies that created the housing bubble (Fannie Mae/Freddie Mac, FHA, highway building, defense spending. For more on the role of military contracting, see pages 157-160 of this book). Unlike today's Keynesians, Sir John Maynard was able to think outside the box.

When the government gets involved in the economy, it can only use force. Occasionally this works. For instance during and after WWII, the government successfully expanded the country's industrial base and promoted a new kind of consumer-based growth model that lasted decades. (Until a few months ago.) This worked because companies like GM were eager to convert from military to civilian production, so it was like forcing a bunch of teenagers to go to a dance at gunpoint. Even if it's against their will at first, some will wind up making out before the night is through.

Unfortunately, it seldom turns out so well. At its most benign, the government resembles a scene in My Big Fat Greek Wedding when the father tries to match the main character with a series of unappealing men. At its worst, government "aid" resembles a forced marriage or a violent enslavement.

Compared to the 19th century, our fiat money system might prolong the crisis now. Since the government "can never run out of money," there is no limit on the stupid things it might do. This is just an idea I wish to record briefly. I am not sure how much it's worth dwelling upon.

One final criticism of the experts and academics: They all keep assuring us we're not in another Great Depression. (Their main explanation is that today we have "policy response." To me this makes as much sense as saying a patient with a bullet in his head will survive because he's been given antibiotics.) To me there are four big similarities between now and the early 1930s, but the academic mindset has blinded people from the stark reality:

1-The secular story today is broken. In the 1930s, it resulted from oversupply of steel, grain, oil and labor following WWI. Today, it results from an oversupply of houses and a lack of things consumers need.

2-We have a financial crisis. The Fed thinks it's easing credit when in reality they are squelching it. Determined not to repeat the exact same mistake of the Fed in the early 1930s, Ben Bernanke is making the same mistake of taking actions that reduce financial intermediation. Then, the culprit was higher rates. Today, it's falling home prices and artificially low interest rates.

3-We have an intellectual crisis. The paradigms that have brought us to this point have stopped working. Our leaders are mortgaging our futures trying to bring back the past. See point #2.

4-Deflation: Despite a gain in CPI last month, CPI fell by at least 1% the last three months of 2008. The last time that happened consecutively? December 1930 through February 1931.

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