The Gloom Talk from the Top Needs to Stop

Includes: AIG, C, FMCC, FNMA
by: Alhambra Investment Partners

The stock market is now back near its November lows and the pessimism is as thick as a copy of Keynes General Theory. The “stimulus” package has been deemed either insufficient or overkill depending on your political persuasion, but certainly not stimulating. The joy over the selection of Timothy Geithner as Treasury Secretary has faded to a fear that his creative abilities were exhausted in the preparation of his personal tax returns. The natives, or at least those at the Chicago Mercantile Exchange, are getting restless and the fear trade is the only thing that seems to work with gold and Treasury Notes the only assets that seem to catch a bid for more than day or two.

Amid the gloom and doom it is easy to overlook the good news in our midst, but it does exist. I have little confidence in the ability of government to fix our problems but I am ever the optimist about the capitalist system that so many seem intent on blaming for our economic problems. Despite the declaration of Newsweek that We Are All Socialists Now, the market, not knowing it has been declared obsolete, continues to do what it has always done. Prices rise and fall, the forces of supply and demand interact and the excesses of our recent past are purged.

Despite the determined efforts of politicians to prevent the inevitable, our economy is undergoing a much needed reallocation of resources. The home construction industry is being reduced to its former position of relative unimportance. The financial sector, which had become much too titanic for its trousers, is being put on a forced diet. A stomach staple may yet be needed, but the slimming is well underway. We’ll be hearing more from timid Tim this week about his plans for the banking sector, but the market waits for no man. The verdict on Citigroup (NYSE:C) and several other financial institutions has already been rendered; the only question at this point is whether they will get the death penalty or join the likes of AIG, Fannie Mae (FNM) and Freddie Mac (FRE) in the government gulag. Having watched Citigroup and its predecessors find its way into every financial debacle of the last three decades, I would prefer to put them out of our misery.

The housing market, which everyone believes must be healed before recovery can begin, is quietly healing itself. Home sales in California, the eye of the housing storm, are rising. Lower prices are attracting buyers at a rate 85% above last years pace. Indeed, even as the median price fell over 40%, the total dollar volume of sales in December was higher than the same month last year. Florida has seen existing home sales rise for four consecutive months, although the rise is more muted than California, up only 27% over last year in December. The government’s actions last week to limit foreclosures not only angers responsible homeowners, it slows the process of moving houses from those who can’t afford them to those who can.

The news of the credit markets’ death also seems to have been a bit premature. Those real estate sales in California and Florida weren’t all cash deals. While banks are certainly requiring more in the way of a downpayment and may actually call your employer to verify you are indeed gainfully employed, it is obvious that banks are lending. Contrary to news reports, banks are even extending financing for other consumer wants; consumer loans at commercial banks are still rising at a 10% rate. That doesn’t mean that lending as a whole is still rising; the securitization market is basically dead. As non bank lending has withdrawn from the market, banks have stepped up to fill the void. The total volume of lending may not be where it was, but is that something that should be lamented by anyone other than the Wall Street firms who benefitted from the easy profits in the boom years? I think not.

Leading economic indicators have risen two months in a row. Some have been quick to seize on the fact that the rising money supply is the biggest contributor to the rise. These pessimists assume that we are in a liquidity trap and that monetary policy has lost its effectiveness. If that is true then the rise in money supply means nothing and the LEI is rendered ineffective as an indicator, but based on the continued rise in bank lending, I remain unconvinced. Furthermore, in last month’s LEI report, five of the ten indicators were positive.

Productivity, which fell in the bad recession of 1981-82 and during the Great Depression, was up 3.2% in the fourth quarter. Incomes, adjusted for the recent deflation in the CPI, are rising. And while the Keynesians among us fret about the paradox of thrift, I find the rising savings rate comforting. Higher savings is exactly what we need to repair the damage done to our economy by excess consumption fueled by easy credit. And besides, retail sales were up in January.

Obviously, we are still in recession and there is more pain to come, but the gloomy mood that surrounds the Obama administration is either manufactured for some political purpose or completely unwarranted. The idea that only government can come to the rescue at this point is not only entirely too convenient for an administration determined not to waste a crisis, but also false. Whether one is speaking of the economic condition or the response to it, we are not experiencing unprecedented events right now.

In the panic of 1819, caused primarily by reckless lending and real estate speculation, Thomas Law advocated increasing the supply of money (from Murray Rothbard’s The Panic of 1819: Reactions and Policies which is available on line at the Mises Institute):

To advance his plan, Law attributed the depression mainly to a deficiency of currency, which caused shopkeepers to lose their markets and mechanics to lose their employment….To Law, domestic manufactures were distressed from “the want of money, for the home manufactures cannot afford to sell on long credits. They must have quick returns to pay workmen. I know of manufactures which have stopped, not because they were undersold by foreign goods, but solely because they could not get money. Money is the means to pay workmen, to set up machinery….”.

Maybe Milton Friedman, who believed that the cause of the Great Depression was a lack of monetary expansion, wasn’t the original thinker we give him credit for. There were plenty who argued for exactly that monetary expansion during the 1819 crisis and while some states tried various inflation schemes, they were largely ineffective. Law also expounds an early, cruder version of Keynes theory:

Elaborating on the benefits from increased money, Law point to the great amount of internal improvements that could be effected with the new money. He decried the slow process of accumulating money for investments out of profits. After all, the benefit was derived simply from the money, so what difference would the origin of the money make? And it would be easy for the government to provide money, because the government “gives internal exchange value to anything it prefers”. All it needs to do , concluded Law, was spend five millions of newly issued currency per year on public works, and, in a pump priming effect, “the money thrown into circulating would, in the course of a year, enable individuals to make a number of improvements also.”

Maybe Mr. Keynes wasn’t the original thinker everyone makes him out to be. The debate also centered on whether relief should be provided to debtors:

The immediate and pressing problem for debtors was the legal judgments accumulating against them for payment of their debts. Consequently, they turned to state legislatures, which had jurisdiction over such contracts, to try and modify the provisions of payment. The proposed laws either postponed legal executions of property or prohibited the sales of debtors’ property below a certain minimum price. The moratoria were known as “stay laws” or “replevin laws”, which postponed execution of property when the debtor signed a pledge to make the payment at a certain date in the future. Minimum appraisal laws provided that no property could be sold for execution below a certain minimum price, the appraised value being generally set by a board of the debtors’ neighbors. Such laws had been an intermittent feature of American government since early colonial Virginia.

Those on the other side of the debate employed arguments quite similar to the ones we see today:

A report strongly in the negative was delivered by Representative Joseph Hopkinson, and this served to send the bill down to a two and a half to one defeat in the House. The arguments of the Hopkinson report were a well considered statement, typical of the opposition to debtors’ relief legislation, as well as to proposals to increase the money supply. The report began with assurances that the committee was deeply sensitive to the prevailing financial embarrassments, and that they had given due weight to the numerous petitions for relief legislation. While the proposed legislation , however, would perhaps alleviate the condition of the debtors temporarily, it would, in the long run, make their distress worse. The contention that relief legislation would eventually intensify the depression was a central argument for the opposition in all the states. The Hopkinson Committee used a familiar medical analogy noting that “palliatives which may suspend the pain for a season, but do not remove the disease, are not restoratives of health; it is worse than useless to lessen the present pressure by means which will finally plunge us deeper in distress.” They added that it was their duty to be truthful with the people and not delude them with promises that could not be kept - even at the expense of their “immediate displeasure”…The report remarked that suffering men were disposed to complain about their lot and look for rapid remedies rather than admit that the only cure was slow and gradual.

This sounds remarkably similar to the debate which rages today. Then, as today, one side argued for monetary expansion, debt relief and public spending. The other side argued for sound money (gold standard),thrift and industry as well as limited government intervention:

“Time and the laws of trade will restore things to an equilibrium, if legislators do not rashly interfere to the natural course of events.” The New York Evening Post

President Monroe basically ignored the depression, barely mentioning it in his annual addresses. Some states enacted debt relief measures and others enacted schemes to inflate the money supply (all of which failed), but basically the depression ran its course and ended by 1821.

The current crisis is not near the magnitude of some of the previous crises we’ve faced in the history of the US. We recovered from them all despite the ministrations of our perplexed pols. What stands out about the current difficulties is not its unique nature but how much it resembles all the others. The common characteristics of almost all past crises are fairly easy to identify: overlending by banks for some speculative activity, although real estate is the most common. The overlending was generally a result of some type of monetary inflation. The Great Depression stands out for its length and the depth of political interference in the market processes.

While I don’t believe the current administration’s actions will be helpful in the recovery, neither do I believe they have taken action nearly as drastic as that taken by FDR and his brain trust. The economy, and the stock market, will recover from their current malaise. The healing is already underway and unless the administration further impedes the workings of the market, it will become more obvious over the coming months. It is time for the debate to shift to longer term concerns. Given the banking system’s penchant for periodic self destruction, a rise in capital requirements would seem obvious. The tax code’s favorable treatment for real estate investment needs review. Monetary policy, which is the real source of our troubles, needs to be reduced once again to the role it is best equipped to fulfill - preserving the purchasing power of our money.

I am optimitic about America. We are the most productive nation the world has ever seen and there is no reason we shouldn’t stay that way. We need to end the bickering and do the heavy lifting required for recovery. I have every confidence in the ability of the American people to do exactly that. The gloom and doom talk, especially by President Obama, needs to end.

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