Only Shocking Fed Action Will Prevent True Catastrophe

I don’t usually write on macro topics; however, I do get lots of emails asking me about the economy, markets, etc. I try to respond to these emails. Here are some excerpts from an email response I sent out Monday night (some of the following has been edited):

The Fed is in a very tough position. This is a credit problem. It's serious. It's hard to say what the result will be - but it could potentially be very bad. You can have some pretty catastrophic things happen when people start to panic - as far as what happens with money and how all sorts of things can seize up at once. It's really a psychological problem - a spiral of negativity and panic that feeds on itself. People start to do irrational things and then others respond in irrational ways to their irrational actions and so on and so forth.

The possibility of terrible outsized effects from the kinds of problems we're seeing with Bear Stearns (BSC) etc. is real. The housing problem is real. The economy can deal with a lot of things clogging up the system, but credit is probably the toughest.

This is the most serious threat the economy has faced in a long, long time - much more serious (to the economy) than the September 11th attacks. People always want to see just one catastrophic event - point to that - and explain away horrible problems. It doesn't happen that way. You have a whole climate of negativity, fear, panic, etc. that feeds on itself and causes real problems. It really does come down to psychology. And it's amazing how fast it can happen.

It's something that either achieves a sort of critical mass or it doesn't. It's like a riot. Either it never really gets out of control and we all forget about it, or it builds on itself and it gets bigger and uglier faster than anyone could imagine.

I don't worry about single issues. The price of oil alone means next to nothing. Housing alone means something, but it's really how housing indirectly influences everybody's behavior where you get problems. A stock market crash means next to nothing to the economy. But the totality of some combination of these things - the climate created - that means everything.

We are on the brink. We haven't seen such potentially perilous economic times in a long, long time. But if the peril passes no one remembers it. People remember 1929 because the peril didn't pass - because that climate of depression fed on itself in so many horrible ways that things got worse and worse, not better. It seems almost inevitable in the past - but there was a point (no one knows when at the time) where you were on the brink, where terrible things lasting a long, long time could have happened (and eventually did) where you could have broken a downward spiral.

People always want to look at just one "black" day and say that was the day when "it" happened. It doesn’t work that way. What you really have is a series of unfortunate events; if people made different decisions at a lot of different points, things could have been better. But – like in a riot – everything around you is encouraging stupid, irrational behavior. The climate starts to drive the bad decisions that create the climate that drive the bad decisions that create the climate.

Has the Fed been too slow? Yes. It should have cut to below where we are now months ago. People would have said that was drastic. And it would have been drastic prevention.

I know you can prevent an economic disease. I'm not sure you can cure one.

Eventually the ravages of the disease create the right environment for a cure - actors start to act rationally and positively because it's so obviously profitable to do so – their greed overcomes their fear.

I'm someone who really believes the Fed and anyone else who thinks they can/should influence the economy has to "shock" the system before the spiral takes hold. There's always talk of "order", "prudence", and "measured" action. Psychologically, that stuff doesn't work. Only shocking action prevents true catastrophe.

I've always been skeptical of the Fed's ability to manage the economy. But, if and when it does something drastically unexpected and unexpectedly drastic it can potentially prevent a fearful spiral.

Is it too late for that now?

Maybe.

But that's the one thing I think the Fed can do - the one place where it can really make a difference. In a perfect world we would have rates well below where they are now months ago. In the fall, you could have cut a lot deeper. That would have been a good bet to make, because the one thing - above all else - the Fed must do is try to prevent the truly catastrophic from happening.

All the rest - the careful managing of unemployment, inflation, growth - and expectations is basically BS. You either get luckier with the climate you have or you don't. But avoiding the super spirals - the truly catastrophic events - you can do something about that in the embryonic stages and you can still try to do that now.

They'll probably be too prudent though. Even a full percentage point cut now won't be shocking.

We might manage to get out of this fine. I don't know. But it's the riskiest position we've been in for decades. While the probabilities may not be tilted toward catastrophe, it's a possibility, and the right bet is to throw everything against that possibility, because the cost of failing to do so is too high.

I think it's still probable we'll have problems that are relatively short-lived (in history's eyes, not ours) and can be overcome. But we are currently in a high risk situation. Although the odds of catastrophe may be small, they are real.

Regardless, the principles of value investing remain the same.

The best thing to do when you can't understand the world is to try to better understand yourself.

Invest in yourself during times like these. It'll pay off at some point.

Comments

[Willem D.Okkerse MBACEOOK--RATINGINSTITUTE]

When will be the end of the subprime crises and how big will be its damages ?

This is to-day’s issue. In view of the recent developments such as the $2.00 bidding for Bear Stearn as well as the blank cheques produced by the FED only further disturbances can be expected.

However, we must try hard to remain academic and not to follow the day’s illusion by sorting out and establishing the real facts and figures. A small attempt.

Firstly the size of the subprime crises. Under the flag “better roughly right than exactly wrong” we might try to estimate its maximum size. Only if we know the size of the problem we can calculate when it will be over.

Starting from the US GNP of 13,500 billion we estimate that the extra monetary volume that was created and not covered will be approx. 5% of the GNP, which means 650 Billion. It is beyond this small article to explain the underlying algorithm, however it is bases on adequate assumptions.

These 650 billion is the size of the balloon that has to be absorbed by the GNP’s growth. Since this growth is only happening in time, it is evident that the subprime problem will only be resolved in time. Since the FED is now distributing blank cheques the related banks will firstly go for their survival instead of helping the economy to grow, an aspect that Bernanke could have missed.

Facing the fact that the crises started end 2006 and in respect of the GNP growth figures of 4,3% in 2007 and 2008 we need 28 months to digest the bubble. Calculated from November 2006 we might encounter that position somewhere in February 2009. It is time to have some patience with the patient.

Willem D. Okkerse MBA
CEO OK-RATING INSTITUTE

[gordon]

Have you calculated the REAL GDP , not using the corrupt CPI inflation deflater imput the gov't uses? If you imput the REAL-ACTUAL inflation imput, the GDP has been flat to negative for at least 2 quarters. That means your absorption time will roughly double?
As an example, did you know the cost of oil as computed by the CPI manages to be sampled on the LOWEST PRICE OF THE MONTH? Did you know it's either back-dated or indeed, manipulated down on the exact day of the sample date? (source: financialsense.com)
Use a 4% or 4.5% CPI and tell me what the GDP has been.

[the finalhorseman]

My parents were teens in '29. Their parents almost lost their homes. I learned not to spend what I didn't have.

Apparently few listened or learned. Now, 'Let them eat cake.' As for me, I'm trying to save up enough for bread. What does this say about benny and the jets?

Will anyone listen to Ben Franklin? I think it's time someone listened to something other then the lies our beloved government vomits.

And some of the presidential wannabe's want to raise taxes? In the middle of this mess? The Apocalypse sounded. I guess they all turned the volume up on their campaign songs to drown out reality.