Some Unlikely Heroes To Guide Us Through The Crisis

by: Eric Parnell, CFA

Perhaps the time has finally come for a fresh approach in resolving the ongoing financial crisis. Instead of spending any more time trying to run away from the problems, perhaps we may be better served by turning around and facing the crisis head on. If this is indeed the case, the question is exactly what alternative path to follow. Fortunately, history provides us with selected examples, some of which may seem highly unlikely at first glance.

The events of this weekend highlight the sheer ridiculousness of our current circumstance. We are now five years removed from the beginning of the financial crisis and over three years on from its supposed resolution, yet the global economy and its investment markets are waiting with bated breath for election results in - wait for it - Greece. Yes, as we all well know, the supposed fate of the European Union and the global economy rests in the hands of a country that constitutes roughly 0.44% of worldwide GDP and counts tourism and agriculture among its leading industries. The fact alone highlights that we are scarcely in better shape than we were several years ago when risks such as these can potentially paralyze the global economy.

The policy approach since the early days of the financial crisis has been resolute.

The first, don't let any major financial institution fail, no matter what the costs. Better yet, don't even allow these institutions to incur losses in any meaningful way for fear of even possibly sparking disorderly asset sales.

The second tactic, provide as much monetary stimulus as needed at all times. And the moment financial markets show any signs of momentary stress, apply even more.

The third has been to provide as much fiscal support as possible. And once the markets will no longer tolerate any additional government spending from a particular sovereign, look to other more healthy nations to step in and foot the bill. And when absolutely needed, have the unhealthy nations paying up to help out other ailing countries, or maybe even turning the money right back to themselves.

The fourth has been to increase government regulations to prevent such a calamity from happening again. But we're several years on from the depths of the crisis and many are still uncertain about exactly what the rules are and how they might change going forward.

And lastly, threaten strongly with words of consequence for bad actors not taking the necessary steps to help resolve the crisis, but never follow through with action on these threats for fear of making matters even worse for everyone.

In summary, the response to the financial crisis since the beginning has been to throw money at the problem and then simply run away with the hope that it will somehow resolve itself along the way. Such strategies are how we end up holding our breath over an election in Greece so many years later.

With all of this in mind, one is left to wonder the following. Is there a better way to resolve the current problem than the approach we're currently pursuing?

Looking back over the last century, we've seen the end of three major secular bear phases for the economy and its investment markets. Yet the policy prescription that is doggedly followed in response to today's crisis is a derivative of the approach applied during the Great Depression in the 1930s. And it is still highly debatable today whether this underlying strategy was even what brought an end to the period of prolonged weakness at that time or if it wasn't instead the result of World War II. Thus, policy makers are applying what was potentially a flawed past solution to try to resolve the current crisis.

This raises some important questions. What of the other two secular bear market scenarios? What took place in the early 1920s that helped spark the end of that prolonged decline and brought on the dawn of the "roaring twenties"? What actions did policy makers take in the early 1980s to help herald in the start of the longest economic expansion in U.S. history? And what conclusions if any can be drawn from these scenarios that might finally bring us to a resolution to the current secular bear phase?

One distinctively key characteristic is true in both of the other scenarios introduced above. In both cases, policy makers turned directly into the fire and took the problems head on. They did not run away. Instead, they took their medicine. And by doing so, they allowed the economy to cleanse itself more quickly and efficiently without taking on even more excesses. And in the process, they set the stage for a new phase of sustained economic expansion.

Given the apparent effectiveness of these alternative approaches, it is worthwhile to examine both in more detail.

Early 1920s

Warren Harding was President during the first episode in the early 1920s. His brief term in office was much maligned for a variety of reasons including persistent problems with corruption and scandal within his administration. And in the historical assessments of U.S. Presidents, he often ranks toward the bottom of the list. But one aspect of his Presidency warrants much closer examination and discussion in the context of today's circumstances. And that was his administration's handling of the economy during a period of extreme stress.

President Harding assumed office in the midst of the Depression of 1920-1921, which was brought on by a massive deflationary collapse as the U.S. economy continued to adjust following the end of World War I. During this episode, unemployment skyrocketed, prices declined by double-digits, corporate profits collapsed, bankruptcy rates soared and the stock market plunged by nearly half.

But despite its severity, the Depression of 1920-1921 was generally short lived. Unlike the Great Depression that lasted for 11 years according to the National Bureau of Economic Research (NBER), the Depression of the early 1920s lasted only 18 months. So what actions did policy makers take at the time in response to the Depression at the time? On the fiscal side, they lowered personal income tax rates, slashed government spending and reduced the national debt. The stated philosophy behind this approach was "less government in business and more business in government". On the monetary side, the still fledgling Federal Reserve stood back and allowed the corrective process to largely play out before engaging in any expansionary policy. This, of course, is a stark contrast to the approach being pursued today of potentially higher taxes, vastly increased government spending, a yawning national debt and the most aggressively easy monetary policy actions in history. Yet the duration of the current crisis is now growing much longer than the 1920-1921 episode.

Now it is important to take this comparison with a healthy grain of salt. The Depression of 1920-1921 was not at its core a financial calamity. Instead, it was largely the by-product of a postwar adjustment to a peacetime economy. Moreover, opinions are widespread regarding the true efficacy of the policy prescriptions at the time. For those that are interested in exploring further, I have included links to several articles below that provide contrasting opinions from some familiar names that are worthy of review and consideration.

How Austerity Cured A Depression

James Grant, Washington Post, January 20, 2012

1921 And All That
Paul Krugman, New York Times, April 1, 2011

The Forgotten Depression of 1920

Thomas E. Woods Jr., Mises Daily, November 27, 2009

The Anatomy Of A Slow Recovery

J. Bradford DeLong, Project Syndicate, March 31, 2011

At a minimum, the Harding administration and the Federal Reserve at the time applied a diametrically opposed policy approach from what we are seeing today to a severe economic contraction that was quickly followed by the end of a two decade long secular bear market for the economy and its investment markets. In short, the decision was made to turn into the problem and take the hit head on in order to put the crisis to rest.

Early 1980s

The previous secular bear market for the economy and investment markets ended in 1982. This took place under the Reagan administration, who also undertook a widely different approach than his predecessor upon taking office. At the end of the Carter administration, the U.S. inflation rate was running north of 14% and the unemployment rate was climbing toward 8%. Now it is worth noting as an interesting aside that President Reagan was an admirer of President Calvin Coolidge, who of course served as Vice President under President Harding and continued many of his same policies after taking office upon the death of Harding in 1923. And once he entered office in 1981, President Reagan also promoted lowering taxes and lessening the role of government in the private sector in order to stimulate the economy. What differentiated Reagan from Harding and Coolidge, however, was the inclination toward increased government spending and expanding the national debt, which does parallel to an extent part of the fiscal strategy being applied today even if the specifics of its application are different.

But what vastly differentiates the policy approach from the early 1980s to that of today was the monetary approach of the Federal Reserve. When Paul Volcker became Chairman of the Fed in August 1979, he inherited a massive inflation problem that was left to fester for years by the persistently easy policy approach applied by his predecessors in Arthur Burns and William Miller. The justification for keeping interest rates low was the idea that monetary policy should focus first on maintaining a low unemployment rate to support growth and that any resulting inflation problem would ultimately resolve itself as the economy adjusted. But by the time Volcker took over, the U.S. economy remained stuck in a stagflationary quagmire of low growth and rising inflation.

Under Chairman Volcker, the Fed raised interest rates swiftly and dramatically to completely stomp out the inflation problem. By 1981, the effective fed funds rate reached as high as nearly 20%. As would be expected, such a dramatic rise in interest rates placed tremendous pressure on a variety of industries and sent the U.S. economy tumbling back into recession. But as the economy progressed through 1982, the U.S. inflation rate was back down in the single-digits and falling fast. And with the inflation problem finally resolved and the economy cleansed through recession, the stage was set for what turned out to be the longest period of sustained economic growth in U.S. history.

Thus, Volcker's decision to turn monetary policy directly into the fire and absorb the pain instead of prolonging the agony brought a quick and decisive end to the stagflation scenario of the late 1970s. And although the decision to take this medicine was certainly painful for a time, our economy reaped the benefits of this short-term hardship for years to come.

So as we watch the election results unfold in Greece this weekend, we will be reminded once again of the perilous state we remain in the global economy. Until policy makers decide to stop running away from the festering problems and instead turn to face head on the underlying pain associated with the crisis, we are bound to continue through these ongoing cycles of fragile hope followed by unsettling insecurity.

In the meantime, keeping portfolio hedges in place remains prudent to protect against the variety of outcomes that could potentially unfold at any given point along the way. This includes assets that are negatively correlated to the stock market and can appreciate when the stock market is plunging such as Long-Term U.S. Treasuries (NYSEARCA:TLT). Holding securities that have demonstrated the ability to perform regardless of the direction of the stock market such as U.S. TIPS (NYSEARCA:TIP), Build America Bonds (NYSEARCA:BAB), Municipal Bonds (NYSEARCA:MUB) and Agency MBS (NYSEARCA:MBB) are also worthwhile, the last of which providing the added appeal given that this area of the market is likely to be the focus of any new stimulus program from the Fed. And maintaining positions in assets that provide a store of value to protect against persistently easy monetary policy such as Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) also has merit. Finally, the stock market (NYSEARCA:SPY) also continues to have a place in an overall hedged strategy, although it is worthwhile to concentrate positions in higher quality names such as McDonald's (NYSE:MCD) and Tootsie Roll (NYSE:TR) in order to control against downside risk.

Someday we will arrive at a breaking point. Either policy makers will arrive at a juncture where they decide to turn into the problem, or the festering problems will become so overwhelming that the market finally makes the decision for policy makers whether they like it or not. Hopefully at some point policy makers will begin realistically considering the former. Not only would facing the problem head on help put the crisis behind us sooner rather than later, but by controlling the way it is carried out will help ensure that the associated pain along the way is more orderly. And fortunately, history has provided us with examples other than John Maynard Keynes to help guide us through the process.

Who would have ever thought that a grouping of Warren Harding and Paul Volcker could potentially hold the keys to resolving today's ongoing crisis. At least it makes more sense than a Greek election potentially turning the global economy upside down. Interesting times indeed.

Disclosure: I am long MCD, TR, GLD, SLV, TLT, TIP, MBB, MUB, BAB, MBB.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.