The First Thing Is Character: How To Restore Confidence

by: Kevin Wilson


When asked what mattered in credit, banker J.P. Morgan said, "The first thing is character." Economist Walter Bagehot wrote in 1873 that "Credit means that a certain confidence is given."

Economist Stefan Ingves said, "The financial crisis was in essence a collapse in confidence;" Economists George Akerlof and Robert Shiller wrote that booms and busts are driven by "animal spirits."

Animal spirits that can support economic growth depend on people's animating ideas about confidence, fairness, corruption or bad faith, the money illusion, and economic stories.

If we are to restore confidence and faith in the system, and repair the broken social contract, we must embrace reforms in many areas: taxes, fiscal stimulus, Social Security, etc.

Assuming that real change results from the election, I like infrastructure (TOLIX, FGIYX, IGF), consumer discretionary stocks (XLY, XRT) and travel services (PEJ, JETS).

J.P. Morgan

Source: Wikipedia

Over a century ago, the great banker J.P. Morgan was asked by attorney Samuel Untermyer if commercial credit was based on money or property. Morgan's response was, "No sir. The first thing is character." Untermyer persisted: "Before money or property?" To which Morgan replied, "Before money or property or anything else. Money cannot buy it... because a man I do not trust could not get money from me on all the bonds in Christendom." Famous economist Walter Bagehot wrote in 1873 that, "Credit means that a certain confidence is given, and a certain trust reposed. Is the trust justified and is that confidence wise? These are the cardinal questions." Certainly, I remember from my own time in banking, the common phrase of commercial lenders, i.e., that a loan was approved on the five C's of credit: character, capacity (cash flow), collateral, capital, and (economic) conditions, with the first of these being perhaps the most important.

Economist Stefan Ingves, chairman of the Basel Committee on Banking Supervision, gave a talk in 2014 in which he said, "The financial crisis... was in essence a collapse in confidence." He stated further, "This crisis of confidence - which is what underlies a liquidity crunch - reflected uncertainty." But then he went on to propose that the new Basel III rules would greatly increase confidence by improving bank capital requirements. In contrast, the famous J.P. Morgan quote above was recently used by bank analyst Christopher Whalen to support his argument that the regulatory system is focusing on the wrong thing in the aftermath of the Great Financial Crisis. To wit, the increases in bank capital do not deal at all with the impact on liquidity of a general lack of trust. Whalen makes a good case for this lack of trust being the real cause of the 2008 financial sector meltdown. Indeed, in 2008, economist and Nobel Laureate Joseph Stiglitz wrote about a "crisis of confidence," and in 2009, famous investor Charles T. Munger wrote that "the public needs a restoration of confidence."

This difference of opinion is important, because now public confidence in banks is again eroding in Italy, Russia, China, and other countries, according to famed author and intelligence expert George Friedman of Mauldin Economics. There is also a sort of "crisis legacy" issue, according to the IMF's latest Global Financial Stability Report, that lingers on in the form of reduced confidence that may be effecting global economic activity. Americans seem to have lost trust in many kinds of institutions during the crisis and its aftermath, according to the Chicago Booth/Kellogg School Financial Trust Index, which showed that only 22% of Americans trusted the financial system in 2012. Gallup reported at that same time that a higher percentage of Americans believed in King George III of England during the Revolutionary War than believed in Congress in 2012.

There is a fair amount of evidence that investors and consumers are still dubious about the inner workings of major parts of the global financial system, especially in Europe, Japan, and China, but also to some degree in the US. This can be seen in a range of behaviors, including hoarding of cash consumers in Japan (Chart 1), banks in Europe, and consumers and businesses in the US (Chart 2); massive outflows of capital from Italy, Spain, Greece, and China (Charts 3 and 4); and massive capital outflows from US stocks over time (Chart 5).

Chart 1: The Japanese Are Hoarding Cash

(Source: Bloomberg)

Chart 2: The Americans Are Hoarding Cash

(Source: Calafia Beach Pundit blog)

Chart 3: Capital Outflows from Southern European Banks

(Source: MishTalk)

Chart 4: Chinese Private Capital Outflows

(Source: Pound Sterling Live)

Chart 5: Large Capital Outflows from US Equities

(Source: Business Insider)

We also see a long-term deleveraging trend in the non-financial private sectors in advanced economies (Chart 6), not exactly a sign of confidence in future growth. Another reason for a lack of confidence may be the well-known long-term decline in the relative net wealth share of the economy for the bottom 90% of American households (Chart 7). Still another issue is the increasing perception that corruption is a problem - not just in China, Greece, Italy, and Spain, but also in America to some degree (Chart 8).

Chart 6: Deleveraging in the Private Sector of Advanced Economies (Red Dash) vs. Increasing Leverage in Emerging Economies (Black Line)

(Source: Claudio Borio; BIS; ZeroHedge)

Chart 7: Declining Household Wealth Share for the 90%

(Source: The Economist)

Chart 8: Corruption Is An Issue in Many Advanced Economies

(Source: PBS)

All of these things are issues because they affect the "animal spirits" that govern much of economic activity. This was explained in depth and with great clarity by economists and Nobel Laureates George A. Akerlof and Robert J. Shiller in their book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (2009; Princeton University Press, Princeton, NJ, 230p). The term "animal spirits" originates with Keynes, but is defined by Akerlof and Shiller as the noneconomic motives that animate people's ideas and feelings. As such, animal spirits, especially when they are powerfully irrational, can alternately paralyze us with fear or energize us to action with confidence. Indeed, this is the underlying explanation for the major booms and busts in the economic cycle. Akerlof and Shiller believe that changes in confidence and changes in income are linked, and that this link becomes critical when an economy is going into a downturn. Akerlof and Shiller describe five different aspects of animal spirits and how they affect economic decisions: 1) confidence; 2) fairness; 3) corruption and bad faith; 4) money illusion; and 5) stories.

Confidence has already been discussed; however, fairness is also an important factor because it affects the decisions people make, such as what to buy, when to buy, and whom to buy it from. Unfairness results in no sale, and on a large scale, can cause economic problems. Just think of how people reacted when they saw the biggest malefactors in the Financial Crisis get bailed out at taxpayer expense, then collect hefty bonuses. Corruption and bad faith are easily understood, especially now that we have all lost our innocence in the wake of the Financial Crisis. An obvious modern example would be the Bernie Madoff case, which has resulted in millions of people arbitrarily questioning the honesty of all financial advisors. But it is a spectacular example of caveat emptor. Before that, there was the equally spectacular fraud of the Enron scandal. Both of these, plus many other recent examples, have eroded people's faith in the system. It may take some doing to fully restore that faith.

The money illusion refers to people relying on nominal dollar amounts instead of real dollar amounts in making economic decisions. A classic example is workers demanding that wages stay stable in the face of massive deflation that cut wholesale prices by 18% or more during the Depression of 1893-1899. Finally, Akerlof and Shiller refer to stories that motivate people to act. People like stories, and in some cases, when the stories are compelling enough, instead of explaining the facts, the stories are the facts. A classic example of a compelling story arose when Mexico discovered major new oil fields in the late 1970s. Mexico's president, Jose Lopez Portillo, pushed the fabulous story of the country's newly found and enormous wealth to the limit. In the end, although Mexico found lots of oil and its GDP rose 55% in six years, it ended up with 100% inflation, higher unemployment, widespread corruption, and massive debt. A crisis followed in the 1980s.

The charts and discussion above have illustrated several of these factors affecting animal spirits, and the charts to follow will show some other potential factors. For example, perhaps one reason confidence in the US system is problematic of late is because there is often a sharp contrast between what the government reports and what people on Main Street perceive. Because of this, many people suspect that the government is acting in bad faith. For example, there is much confusion caused by the way the government reports employment data. All administrations of the last 50 years subscribe to the methods used, so it is not a question of politics. Yet, the full number of unemployed is never used to calculate the headline unemployment rate; thus, we hear that the headline number, U-3, has dropped to only 4.9% this year, but everyone knows that the participation rate is the lowest in over 35 years (Chart 9). Many people know there are over 13 million workers who are not counted in the headline numbers, but are still actually unemployed (Chart 10). Likewise, about 45.8 million people are on food stamps - almost double the number that was recorded in 1982 during a severe recession (Chart 11), and almost triple the number seen in the 2001 recession - yet, the government claims the recovery is progressing well. And of course, if the job story is as good as the government claims, why did student loan debt at least quintuple (to almost $1 trillion; Chart 12) during the recovery after 2009, and why are about 8% of these relatively new loans already in arrears?

Chart 9: US Labor Participation Rate Collapsing

(Source: Business Insider)

Chart 10: Actual Unemployment Rate is Much Higher Than the Headline Number

(Source: BLS; NBER; Center on Budget and Policy Priorities)

Chart 11: Soaring Using of Food Stamps for Support

(Source: Matt Trivisonno's blog)

Chart 12: Student Loan Debt Has At Least Quintupled Since 2009

(Source: Federal Reserve; APW)

Now, obviously, there are complex factors driving some of the trends shown in the above charts, so we can't necessarily say that there is some single, simple answer that would fix each of these problems. But my point in presenting them is to show that there are reasons why we may suppose that the trust J.P. Morgan was speaking of 100 years ago may not be enjoyed by government or the financial system right now. Indeed, given all of the above charts, only a supreme optimist or a politician would think that large numbers of people in the US would be willing to take much risk right now. But in my opinion, based on economic data, quite probably neither investment risk nor business risk would be appealing to many, as shown by market outflows and weak business investment. The data supports a general pullback on risk, in that compared to 2000 (before either the Tech wreck or the Financial Crisis), there are fewer IPOs, rising outflows from equities, rising inflows to bonds, rising cash hoarding, weak income growth, relatively poor housing sales (Chart 13), and rising credit spreads. And just from a common sense point of view, the rise of Bernie Sanders and Donald Trump into political prominence, and the massive sales of guns in recent years do not suggest a lot of trust in the system as it is now structured.

Chart 13: New Home Sales Have Never Recovered

(Source: Dent Research; Economy & Markets Daily)

So, assuming there is indeed a case of some sort supporting the proposition that people have been losing faith in the system and are not confident about the future, and that they question the fairness of the system and its tendency towards bad faith, it seems to me that policy makers have an almost insurmountable problem given their goals. For example, the Federal Reserve and the Administration want to stimulate consumer spending, but not only is that factor a bit weak lately, there is some risk that it will end up declining for some time to come. This is because global trade is falling sharply, prices are deflating worldwide, GDP growth is anemic, corporate profits have rolled over, and productivity growth has been falling as well. Certainly, the most massive Federal Reserve interventions in history have had little effect on demand, and credit is not really easy for the middle class, only for large corporations. Banks are sitting on enormous unused reserves, and economic growth has suffered because of it. After eight years of slow, weak recovery, the economy is still spluttering and appears to be stuck in a kind of stable disequilibrium, one that could easily be derailed by an economic shock of any size. How are we to proceed under these circumstances?

From all of the above, it would seem absolutely vital that we restore confidence and faith in the system before the next major downturn or financial crisis arrives. The problem is absolutely enormous, in part because in addition to all that I've already discussed, many people now believe the social contract is broken. By this I mean that the benefits of the welfare state cannot be paid for (and never could), and now people are beginning to realize it. Millennials scarcely waste any time thinking about Social Security, because they don't believe it will be there for them. Healthcare and education costs are squeezing the middle class mercilessly, with little prospect of a reprieve. Akerlof and Shiller suggest that we reform financial regulation, reform bankruptcy law to include large financial institutions, and raise taxes on the wealthy. The financial reforms under Dodd-Frank cover 1,700 pages, and have been followed with tens of thousands of pages of regulations; however, they did not get rid of too-big-to-fail firms or prevent further gaming of the system by major players, and there are signs that they are at it again.

I personally am a believer in supply-side economics, so I think supply-side measures are a better way to proceed than what has been done since 2009. As Akerlof and Shiller have concluded, supply-side decisions by the George W. Bush administration in the wake of the 2001 recession and the 9/11 tragedy appear to have worked, especially when considered in tandem with massive cuts to the Federal Reserve discount rate that occurred at around the same time. But now we are not able to lower rates dramatically, so we are left with fiscal policy alone. Elsewhere, I have written about the need for infrastructure spending, and I believe this should be one of our major projects going forward. Taxes on the middle class should be cut a bit, and it may make sense to consider major tax reform for corporations and individuals, including ideas like a VAT.

It would also help if government started talking openly about how to solve the high (actual) unemployment problem with bipartisan support, instead of dismissing it as an issue. Re-training programs for displaced workers should be expanded and well funded, and trade treaties should be examined by a bi-partisan commission to see what can be done to improve confidence in them. Social Security and Medicare reform to restore confidence should also be a priority. If healthcare could be tweaked to lower its inflation rate and cut costs, it should be done, again with bipartisan support. Grants should be made available to attract college students to careers in medicine, engineering, science, and math. There are no doubt many other things that could be done as well. For confidence to be restored, the government and business will have to work together to start solving our problems, rather than spending all of their time picking winners and losers. The American people want their faith and confidence restored, and want to renew the social contract if possible. I believe they will support reasonable efforts to get going again, whichever party is in power, and they will work hard to make it happen.

Assuming that real change will result from the coming election, and that a real effort will be made to address the issues presented here, I would favor certain ETF names like the iShares Global Infrastructure ETF (NYSEARCA:IGF). Unfortunately, there don't seem to be many publicly traded US-focused funds. Mutual funds focused on infrastructure include the Deutsche Global Infrastructure Fund Inst (MUTF:TOLIX), which holds 51% US assets, and the Nuveen Global Infrastructure Fund Inst (MUTF:FGIYX), which holds 35% of its assets in US stocks. Now, if the economy started to surge because of increased spending by a reinvigorated middle class, consumer discretionary stocks like the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA:XLY) and the SPDR S&P Retail ETF (NYSEARCA:XRT) might do very well. Travel services would probably surge as well, favoring the airlines, car rental outlets, and hotel chains (PowerShares Dynamic Leisure & Entertainment Portfolio ETF (NYSEARCA:PEJ) and the U.S. Global Jets ETF (NYSEARCA:JETS)).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.