Economic Crisis Is Largely a Problem of Confidence

Observers of this economic crisis are well aware of falling home prices impairing derivative values impairing bank balance sheets impairing lending capacity impairing economic activity- further impairing home prices. And home sales remain depressed as homeowners and bankers are loathe to sell at a loss. As Vikram Pandit stated before the House Financial Services Committee on Wednesday, you can always "sell a $100 bill for $1", but that would not be consistent with his duty to protect the interest of his shareholders.

This is reminiscent of the classic "chicken and egg" problem - which is first, recovered home prices/derivatives or recovered bank balance sheets/economy? The answer is the farmer, who must decide how many chickens he wants and plan appropriately. And the farmer, in this case, is Mr. Obama's Treasury Secretary Geithner, whose announcement Tuesday showed he has a way to go to come up with a plan. This is a bit disconcerting, as he can determine the level of home values, derivatives, et. al., and investors are wondering where these levels are going to be set.

The deflationary outcome, kicked off by 18 Fed rate increases between 2004 and 2006, would have been widespread foreclosures, defaults, and bank insolvencies, and market clearing at pennies on the dollar. 50% would be optimistic. The hyperinflationary outcome would have involved quantitative easing, with a relatively quick recovery to near previous values, perhaps with $5/gallon gas. This has not yet occurred, as the trillions injected, and perhaps to be injected, have been sterilized. It is clear this Fed and government have settled on seeking moderate valuations, or as Mr. Geithner put it Tuesday, "fair and realistic" - a happy medium that prevents the economy from losing supply power yet punishes the most grievous offenders who lied to get loans, made loans without concern for risk, and created insurance transactions without concern for the ability for that to be made good in a worst case scenario.

So, what is "fair and realistic"? Certainly not $1 on $100. And not $100 (or $110) on $100. 80%, 90%, 50%? And how soon?

Somewhere in our past, 20% down evolved as a conservative requirement for a downpayment. Theoretically, if your loan was 80% of your home value, you were safe. Thus, it seems that recovery to values of at least 80%- where homes are actually selling at that level while inventory falls- is required to come close to building confidence, with intermediate steps to slow foreclosures and loosen regulatory mark to market repercussions. Given the regional disparities in losses, 85% would be a better target to build confidence on a wider scale. This will mean some regions will have healthy sales while some have slower sales, but if houses are selling at these values, the market can clear sooner than later. At that point, people can have confidence in the system again, and economic growth can resume. Many derivatives will still be under water, and consequences and punishment will need to be meted out to counterparties, rating agencies, and purchasers that profited from understating the risk. While it's reasonable for an insurance company to be unable to cover losses during wartime, it's not unreasonable to expect them to cover a 20% loss, is it?

Confidence will not come via cramdowns- confidence in contract law remains critical. Requiring Citi (C) to break its Citifield deal, in the absence of renegotiation or bankruptcy, would also be a bad step in this regard. Nor will confidence be created via artificial demand of a short term nature, especially if capacity to meet short term needs (say, in climate research or US steel) is created only to later turn to excess. Monetary stimulus would allow the invisible hand of the market to direct resources where best used. While inflation is a possibility, there's no reason that money should not have a half-life in addition to time value.

The current crisis is not just a financial problem to be solved by financial solutions, but more so a confidence problem that requires a confidence building plan. The American people voted to install Mr. Obama, and his appointment, Mr. Geithner as the farmers. They've told us they're working on a plan, we need to know how many chickens they want.

Disclosure: long DXO

Comments

[Ferdinand E...:]

Thanks for telling us that the American people voted for Senatorr Obama, which is the same as saying they thought that he could put together a plan to get the country out of the trouble hatched by President Bush, and to a certain extent President Clinton.. This is the same as saying that they voted against Mr McCain, and presumably the plan that he would have come up with. Those were the only two choices, and to my way of thinking the American people are to be congratulated for not installing in the White House the man who said "we are all Georgians", although admittedly Joseph Stalin might not have been an ideal representative of those good people.

Feb 12 09:32 AM

[kelm:]

No, this is not a confidence issue at all. At its root the crisis is brought on by a massive debt bubble. Once that bubble bursts as it has confidence is severely shaken. That confidence will be restored by closing the insolvent banks rapidly. Writing down the toxic assets rapidly is the way to go. The speed and determination to get through that process and fix the banking system is what inspires confidence. Instead we are "proceeding cautiously".

I do completely agree that cram downs whereby judges are allowed to rewrite mortgage terms seems like just another way of government interfering in the markets and an attack on the rue of law.

Feb 12 09:43 AM

[Dirk McCoy:]

The article was hardly about Senator Obama, rather the need for a reflationary plan that provides quick recovery of home values. And Senator McCain lost the election when he started talking about the "fundamental strength of the American economy" being "the American worker". Communists talk about workers.

Feb 12 09:45 AM

[antiquary:]

I agree this is at least in part a crisis of confidence. We see these things which have rarely or never happened before and suddenly we come to think anything is possible; that nothing can be counted upon. The one thing we can be sure of is that if we freeze like a deer in the headlights, dithering, uncertain and terrified of losing anything by making a move, we're gonna get hit, and lose everything. We have to keep moving.

Feb 12 10:43 AM

[Al-USA:]

Good article. I agree home values are a big part of the problem.

But, and I'm no communist, it seems to me that we are "seeing the trees but missing the forest". Take off your capitalist centric "blinders" for a minute, and consider that our economy was about 70% consumer driven. As such, the quote below from Economist Robert Reich makes alot of sense as to how we got to the present recession/depression:

robertreich.blogspot.c...

"
What's going on? Let me explain as clearly as I can.

American consumers are coming to the end of their ropes and don't have the buying power they need to absorb the goods and services the U.S. economy is capable of producing. This is likely to mean fewer jobs, which will force Americans to pull in their belts even tighter, leading to still fewer jobs – the classic recipe for recession. That recession may turn into a full-fledged Depression if fiscal and monetary policies can't make up for consumers' lack of buying power. And there's reason to worry they cannot because consumers are in a permanent bind. They're deep in debt, their homes are losing value, and their paychecks are shrinking.
"

"
Under these circumstances, the usual remedies won't work. Wall Street bailouts have no effect because housing prices continue to fall, and the Street is sitting on a giant pile of bad debt. Tax breaks for business won't generate more investment in factories or equipment because demand for their products what emerges from the factories is dropping. Temporary fixes like a stimulus package that give households a one-time cash infusion won't get consumers back to the malls because they know the assistance is temporary and their problems are permanent. They're likely to pocket the extra money instead of spending it. Additional Fed rate cuts might give consumers access to somewhat cheaper loans, but there's no going back to the easy money of a few years ago. Lenders and borrowers have been badly burned. The values of houses and other major assets are dropping even faster than interest rates can be lowered. Growing numbers of homeowners owe more on their mortgages than their homes are now worth on the market.
"

"
We're reaping the whirlwind of many years during which Americans have spent beyond their means and most of the benefits of an expanding economy have gone to a relatively small group at the very top. Adjusted for inflation, the median wage is below where it was in 1999. The nation's median hourly wage is barely higher than it was 35 thirty-five years ago. The income of a man in his 30s is now 12 percent below that of a man his age three decades ago. The rich, meanwhile, can't keep the economy going on their own because they devote a smaller percentage of their earnings to buying things than the rest of us: After all, they're rich, and they already have most of what they want. Instead of buying, they're more likely to invest their earnings wherever around the world they can get the highest return.
"

"
The debate over widening economic inequality of income and wealth in America usually pits fairness against growth. Conservative supply-siders contend that the people at the top not only deserve to be richly rewarded because such rewards encourage them to invest and innovate, and thereby benefit everyone else. Liberals concede that some inequality may be necessary to encourage growth but that we have long passed the point where it is either necessary or fair. But the reality we're now facing poses a different question: Can we have any growth at all when income and wealth are so unequal that most Americans can no longer buy what they produce?
"

'
The answer is likely to be no. Go back to the years just before the Great Depression and you see the same pattern. As I've noted before, Marriner S. Eccles, who served as Franklin D. Roosevelt's Chairman of the Federal Reserve from 1934 to 1948, noted this in his memoir "Beckoning Frontiers":
'

'
"As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped."

Is the game about to stop again?
'

And there you have it. I don't know about you, but it sure does seem like the game is on the verge of sputtering out, and yes, the home values need to stabilize and recover, but try to see the forest for the trees.

Feb 12 10:58 AM

[joes:]

The problem is not knowing what houses are worth, that is easy to discover, put it on the market and see what you get offered.

It is more the broader definition of wealth and what it means beyond a bank account. By making money "funny" over the past few decades it has created some interesting outcomes.

For example, middle class income has stayed flat or dropped slightly over the last 30 years, but it is easy to see that middle class people have more stuff, maybe because of two incomes but also because 50: TV's are less than $1000. Education and health care are out of control, but they are most likely the next bubbles to go pop. Already Phoenix, EMC and Kaplan are taking a bite out of schools that these students would have gone to for the "traditional college experience" and Minute Clinics of various brands are reducing costs for the most frequent ailments that hospitals used to make the easy money on to support the transplant centers.

The entire world is undergoing an asset reset that will determine what scale wealth is to be measured by in the future, don't think that the answer is in one economics or history book, because it isn't.

Feb 12 12:11 PM

[pearl2k:]

We have seen this before, actually. This is the 2nd "hundred year storm" in a decade. LTCM. Huge leverage, complex and flawed models based on historical data, that, surprise, didn't include the conditions of the then current crisis(how could they?), potential systemic risk, "unprecedented" Fed intervention.... sound familiar?

The crisis of confidence is whether the government has any will to do something about it to prevent the 3rd "hundred year storm" in as many decades.

Don't these storms own a calendar?


On Feb 12 10:43 AM antiquary wrote:

> I agree this is at least in part a crisis of confidence. We see
> these things which have rarely or never happened before and suddenly
> we come to think anything is possible; that nothing can be counted
> upon. The one thing we can be sure of is that if we freeze like
> a deer in the headlights, dithering, uncertain and terrified of losing
> anything by making a move, we're gonna get hit, and lose everything.
> We have to keep moving.

Feb 12 12:12 PM

[axelrod608:]

Confidence ? NO. The term "confidence" in this topic of discussion should only be used in the framework of its meaning in "confidence game" or "con game".

kelm (above) has it spot on. This entire mess is the bursting of a debt bubble made possible only by decades of insane fiscal and monetary policy by the federal government and the Fed. Anyone who has "confidence" in their ability to fix what they broke is the victim of their con game.

Over the past couple decades, they've been stealing the golden eggs and giving them to the already rich elites. But what they're doing now is killing the goose that lays the golden eggs.

No person, family, company or government has ever spent its way to prosperity. Of that I am confident. People who refuse to learn history's lessons are doomed to repeat them. Of that I am also confident.

The half witted double down policy being manufactured by our leaders will make things worse. Of that I am confident.

That there is ZERO talk about how we'll pay for this next round of massive spending is the clue. The ONLY plan is to spend. No plan to pay. My world doesn't work that way. Nor does yours.

Feb 12 12:58 PM

[Dirk McCoy:]

Thank you for the comments.

A few observations:

As for Mr. Reich's comments, living standards in the US have doubled while increasing by a factor of 2-3X globally over the past 30 years. Rich people do invest, including internationally- creating jobs. I do agree that consumer debt and US debt has increased to maintain this increase in living standards, but there are many countries in more debt, so I'm not convinced that income inequity is the major problem.

The more important objective, I believe, is to produce, and in a world with 3 billion people living on less than $2.50/day, there is much to do. While the Indians and Chinese can do much of it (there's no reason a country with 4% of the world's population should have to produce 25% of world GDP), this does not need to be a zero sum game. We have significant advantages in many industries such as ag, pharma, IT, entertainment, aerospace, medical devices- and global corporations that can utilize cheap Chinese, Indian, and Vietnamese (China is high cost compared to them!) labor, so don't count us out.

I agree that reality dictates that retirements will be postponed, smaller houses will be built, a lower share of oil will be consumed, and pay relative to the rest of the world will be adjusted. To accomplish this, I'm convinced that inflation and a weaker US dollar (the same one that's weakened by 30%+ over the past few years) is the best way forward- as opposed to deflation, mass defaults, and cramdowns.

Feb 12 05:07 PM

[Ken Sherman:]

"And the farmer, in this case, is Mr. Obama's Treasury Secretary Geithner, whose announcement Tuesday showed he has a way to go to come up with a plan. This is a bit disconcerting, as he can determine the level of home values, derivatives, et. al., and investors are wondering where these levels are going to be set."
Disconcerting indeed. When the government has to tell us what assets are worth, we really are in deep trouble. By implication, they also tell us what a dollar is worth, which is not much, despite its recent, fleeting strength. When a government debases its currency, it prophecies its own demise. The only question is, when.

Feb 13 10:55 AM