Sep 23, 2008
Below is an extract from a commentary originally posted at www.speculative-investor.com on 21st September, 2008.
The US economy has not been remotely close to a "free market" for a long time. Up until recently freedom was eroding at a gradual pace, but the pace of erosion has just accelerated in dramatic fashion.
In an effort to 'solve' the problems besetting the financial system, the US Government has just taken three momentous steps. First, it has decided to use taxpayers' money to purchase the bad mortgage-related investments made by banks during the inflation-fueled boom of 2003-2007. According to this Associated Press article: "The [government's] proposal is a mere three pages long, but it gives sweeping powers to the government to dispense gigantic sums of taxpayer dollars in a program that would be sheltered from court review." Second, it has decided to use the taxpayers' money to guarantee Money-Market Funds (MMFs). Third, it has temporarily banned the short-selling of financial stocks.
The above-mentioned policy moves are what we would expect from the governments of Venezuela, Pakistan or Russia; they are not what we would expect from the self-proclaimed "leader of the free world".
It is said that drastic times necessitate drastic measures, and some commentators have opined that such measures as those outlined late last week will help prevent a repeat of America's experience during the 1930s or Japan's experience during the 1990s. Well, the commentators expressing such opinions are ignorant of economic history because the sorts of policies now being put into effect are similar to the policies that were tried by the Roosevelt Administration during the 1930s and by various Japanese administrations during the 1990s. Moreover, such policies EXACERBATED and PROLONGED the major economic downturns experienced by the US during the 1930s and Japan during the 1990s. For example, after throwing phenomenal amounts of money into various schemes designed to boost the economy, Roosevelt found himself, in 1938, in the situation where the economy was just as moribund as it had been when he was first elected almost 6 years previously. In fact, things were so bad after 6 years of massive government-sponsored stimulus packages that Roosevelt all but gave up any hope of being re-elected. As it turned out, however, the war in Europe reinvigorated the Roosevelt presidency.
A definition of insanity is doing the same thing over and over again and expecting a different result each time. Advocating massive government spending and other forms of intervention to pull a country out of an economic slump is therefore a form of insanity.
As a means of restoring the health of the economy, the ramping-up of government spending and borrowing has never worked in practice because it doesn't work in theory. Inflation-fueled booms are ALWAYS followed by painful busts because the inflation distorts price signals, leading to the misallocation of investment and, inevitably, to a large mismatch between consumption and production (businesses, responding to distorted price signals, invest in production capacity that proves to be unsupported by sustainable demand). Once this situation arises the worst thing that can be done is to promote even more inflation in an effort to support the bad investment decisions of the past, because doing so further depletes the amount of real savings within the economy and thus guarantees additional weakness down the track. That's why there were as many unemployed US citizens in 1938 as there were in 1932 and why the 1990s are described as Japan's lost decade. And yet, here we go again.
Zeroing-in on the current plans, the thinking/hope is that by preventing speculators from short-selling financial companies and by taking the bad investments off the balance sheets of these companies, the financial companies will be able to raise enough new capital to stay in business. For the sake of argument, let's assume that this is true and that many financial companies that would otherwise have gone under in the near future are now able to attract enough new investment to stay afloat for while longer. How could the sucking of savings -- savings that could have been employed in more productive endeavours -- into failed companies possibly do anything other than REDUCE the economy's growth potential? And how could the transferring of bad investments from the books of failed companies to the book of the US taxpayer possibly help the taxpayer? By the way, regardless of whether the multi-hundred-billion-dollar pile of money that will be used by the government to purchase the bad investments of banks is obtained by borrowing existing money or by borrowing new money into existence, the result will be the forced transfer of real savings from potentially more productive endeavours to failed businesses. This is because the large-scale creation of new dollars would effectively take a bite out of every existing dollar.
Rather than helping the US economy avoid a depression, the policies that are about to be implemented will greatly INCREASE the probability of a depression. Furthermore, these policies all but eliminate the possibility of the US economy experiencing genuine deflation (a prolonged period of money-supply contraction). The probability of genuine deflation was already low, but we think it is now close to zero. In other words, if there is going to be a depression it will almost certainly be the inflationary kind.
A valid concern is that the draconian and economically-devastating measures just enacted will not be the end of it. Given that these measures were taken with the S&P500 Index 'only' down by around 20% from its all-time high and with the Bank Index well above its July low, what's going to happen if the S&P500 Index drops 30-40% below its all-time high (a probable outcome sometime next year) and the Bank Index breaks below its July low (also a probable outcome sometime next year)? We shudder to think! One possibility is that capital controls will be introduced. Up until last week we'd thought that the risk of the US Government imposing capital controls was low because of the adverse effect that such a move would have on foreign investment in the US, but our assessment of that particular risk has just changed for the worse.
By its recent actions the US Government has confirmed that it is prepared to violate property rights on a grand scale. This has disturbing consequences outside the financial world, but also has important investment implications. For one, it means that inflation risk has just increased a few notches and that there will now be greater uncertainty in the markets (speculators and investors will now be constantly wondering: what are these bozos going to do next?). The increased inflation risk and the greater uncertainty will, in turn, make the US financial markets less attractive to foreign investors. It also means that there is now more reason than ever for investors to spread their assets over multiple countries. Last week's events highlighted the risk of keeping all, or even the majority, of one's assets in the US, but similar risks will likely emerge in other 'free' countries if the economic backdrop continues to deteriorate.
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