John Hussman: Applying Ockham's Razor to the Current Crisis

Excerpt from the Hussman Funds' Weekly Market Comment (1/26/09):

There is a time-honored principle called Ockham's Razor, which states that the explanation for any phenomenon should focus only on the essential and relevant elements, avoiding as many unnecessary “second-order” factors as possible. Albert Einstein put it this way: “A theory should be a simple as possible, but no simpler.”

There is certainly a wide range of important programs and objectives that the new Obama administration was elected to pursue, including investments in alternative energy, infrastructure, health care, and other programs. But from the standpoint of economic stimulus, Ockham's Razor suggests that we will fail as a nation to address the current economic crisis if we fail to address the source of that crisis. Again, this means focusing first on bank capital and mortgage foreclosures.

Although the troubled assets relief program (TARP) was originally based on an ill-considered idea to purchase distressed assets directly from financial institutions, the Treasury somewhat inadvertently discovered what we had strongly argued from the beginning – that providing capital directly to financial institutions was the most effective use of TARP funds. (see You Can't Rescue the Financial System if You Can't Read A Balance Sheet). Unfortunately, neither Treasury nor Congress has made an attempt to address foreclosure abatement. Without that, financial institutions will face a continued need to replenish capital, and far more Americans than necessary will lose their homes.

...

In short, the essential problem is not “insufficient aggregate demand” but rather risk-aversion and anticipatory saving triggered by fear of financial instability. Ockham's razor cuts straight to bank capital and foreclosure risk. We can address a much wider range of interests in the cause of economic stimulus, but if we fail to address the central cause of the present economic crisis, the attempt to increase “aggregate demand” will predictably fail.

Comments

[DaveW:]

Good point John, the K.I.S.S. priniciple comes back time and time again...

Jan 26 12:46 PM

[MarvinMBA:]

There are way too many financial institutions that are unnessasary in todays environment. Its going to be impossible to bail them all out!!!!

Let them go out of business or merge. Even having the government nationalize the Banking industry might not be such a bad idea and might be the only way to economically get rid of excessive baggage in this industry. MarvinMBA

Jan 26 01:07 PM

[Moon Kil Woong:]

I disagree Marvin, nationalizing banks is a terrible idea. The government will use these banks to fulfill their silly fantasies (cheap homes, money to their friends, financing briges to nowhere, etc.) And since it won't be on the governments books like TARP no one will know about these dirty little deals. It is funny how Paulson asked for no disclosure on TARP either. There is no surprise it went to AIG to pay CDS payments to his firm Goldman.

If you want a good example of government making financing horribly wrong look at Fannie Mae and Freddie Mac. They are still buying mortgage bonds from banks that will inevitably default. They were also at the crux of programs to direct banks to sell mortgages to low income families that turned into selling to people they knew couln't pay their mortgage in the long run. And they abused their tacit consent that the government would make good on all of their paper to grow out of control.

Sadly all those that took TARP money are in essence nationalized, because 1) the government won't let them go broke 2) they must do anything the government says now 3) they are all kissing Fed Treasury and Congressional butt to do anything for more free cash. Thus these banks are already becoming more like eunuchs chasing royalty around in a forbidden castle to see what they can steal than businesses considering the outside economic factors.

Jan 26 03:06 PM

[Socialism c...:]

The "Occam's Razor" solution of this economic mess would be across the board tax cuts -- business and personal taxes, and let those who have made bad decisions fail if they cannot rebound with the decreased tax load; meanwhile those who made good decisions have a bit more of their OWN capital to deal with -- whether their needs be for their mortgage payment, savings before future expenditure or whatever -- they will not spend until they are positioned and comfortable to do so.

Jan 26 05:05 PM

[Tony Petroski:]

When did it become legal under the U.S. Constitution for the government to "nationalize" banks or anything else. Does the present crisis justify "takings?" in which case there is supposed to be just compensation. Having the Treasury Secretary lose his nerve, panic the markets, cause runs on banks and then swoop in and nationalize banks without compensation because they are now all insolvent strikes me as impractical and illegal not to mention treasonous.

Jan 26 10:20 PM

[jgonion:]

John,
It's true that we need to address the cause of the problem and not merely the symptoms. The cause of the problem is not people's fear of financial instability. This is a relatively recent phenomenon, caused by layoffs and bank failures. The problem has been caused by the bank's failure to lend, which was caused by the opaque debt structures on their balance sheets.

As you point out, you can't fix the financial system if you can't read a balance sheet. This is precisely the problem: Financial institutions can't read their balance sheets because of the opaque and questionable securities that are on them.

Yet, you object to removing the offending organ:

> an ill-considered idea to purchase distressed assets directly from
> financial institutions, the Treasury somewhat inadvertently
> discovered what we had strongly argued from the beginning –
> that providing capital directly to financial institutions was the
> most effective use of TARP funds.

OK, so the banks can borrow money from the Fed, but they *still* don't know what's on their balance sheets, and are therefore have incentive to use the money to increase shareholder equity against the big unknowns on their balance sheet, rather than lend the money.

The cause of the problem is that the banks have stopped lending, pulling vast amounts of money out of the economy. A review of the economic data clearly shows this process beginning back in 2006 (you can check the Fed's G20 data), long before there was any fear of financial instability.

You're right, we need to fix the cause of the problem. It's not foreclosures which, while huge from an individual perspective, are a drop in the bucket of the larger economy. As long as the banks can't evaluate their own balance sheets due to the opaque debt on them, they can't lend in a fiscally responsible manner.

I assure you that getting the bad debt off of the books of the banks is not ill-considered, but was in fact thought through very carefully. The problem is that it was unpopular to a broader (and largely uneducated in economic matters) public that doesn't want to help the people that got us into this mess. But that's just rhetoric. We still need to clear-up the balance sheets off the banks so that they can be properly valued and begin lending again.

Resumption of lending will inject far more capital into the economy than the government (read taxpayers) can do on their own.

There is an well-written primer on the subject at:

seekingalpha.com/artic...

Jan 26 11:22 PM

[c smith:]

It will piss off all of the builders (the LAST thing we need is more new homes), but the solution to the problem is obvious: tax credits for people buying EXISTING homes. Avoids all the waste of a gigantic government-driven investments (i.e.; the vaunted "stimulus" package) and gets to the core of the issue.

Jan 27 09:38 AM

[Larry G:]

Providing capital to the banks was only HALF the solution to the problem. What good is it if you give money to banks and they horde it.

The other HALF that was forgotten was MARKET-MARKET accounting. Put yourself in the banks shoes. Why in the world would you loan out capital when you may need to market your assets down and need the very capital you just loaned out? You wouldn't and neither will the banks.

Moreover, if its hard enough to know whats on your books there is no way in the world your going to trust whats on another banks books. Hence, no lending.

If we had MARKET-MARKET accounting in the early 90's with the S & L
crisis not a single bank would have survived.How much capital has to be destroyed before someone somewhere realizes to either take a time out or eliminate MARKET-MARKET.

Jan 27 09:45 AM

[John Wake:]

"In short, the essential problem is... risk-aversion and anticipatory saving triggered by fear of financial instability."

The essential problem is that many banks are, in reality, insolvent.

Jan 27 04:16 PM