Tuesday, June 29, 2010

Preparing for Next Big One?

Before getting into my latest topic, a follow-up on my last comment. Mike Shedlock wasn't impressed, calling me "another Keynesian clown":
I am sick of Keynesian clowns who do not know the cart from the horse, who think debt is a free lunch, who think spending and debt are the ways to get out of debt problems and most of all never say how this debt is going to get paid back.

What causes depressions is an unsustainable run-up in credit and debt that precedes it, NOT a failure to go deeper in debt.

Anyone who understands 5th grade math should be able to figure that out. Unfortunately, Nobel prize winning economists can't.

"I listen to nonsense from some commentators claiming that if the US is not careful, it will suffer the same fate of Greece. Total rubbish." says Kolivakis.

Three Examples of Total Rubbish
  • People who think crack addicts can smoke crack to cure their addiction
  • Alcoholics who think they can drink their way out of alcoholism
  • Debt junkies (and Keynesian clowns) who think one can spend one's way out of a spending problem
In a sense all of the above ideas will "work".

In the first two cases the result is physical death, nature's way of solving the problem. In the third case, a bond revolt and economic death solves the problem.
Echoing Mish, an astute investor sent me this message:
I'm in the camp that believes its the unsustainable creation of credit during the boom phase that is ultimately responsible for the bust... a la Irving Fisher and Hyman Minsky. We've crossed the event horizon of sustainable debt and no amount of Keynesian economics will save us from the inevitable. We are now up against the simple math and exponential functions.

You are correct, fiscal austerity right now would kill the economy. Absolutely crush it. In the end, Keynesian economic theory and fiscal austerity all lead to the same outcome specifically because it is inevitable. Fiscal austerity just gets us there so much quicker.

For example, Japan. They bought themselves about 20 years to date. They have, despite their best efforts and with a very accommodating global economy failed to grow themselves out of a giant debt bubble that burst in 1989. Now what? A default now is inevitable. It was back in 1989 as well. They just played with the timeframe and in so doing increased the scale of the disaster.
I would like to respond to some of the criticism. First, it amazes me how ignorant people are on Keynes and Keynesian economics. Luckily, Lord Skidelsky, author of the most authoritative biography on Keynes, still writes his excellent columns with a genuine Keynesian twist.

Second, I never agreed with Krugman on the use of the word "Depression" or that we need more stimulus. I just think it's lunacy to start implementing aggressive austerity measures before private sector demand picks up convincingly.

Michael Hiltzik of the Los Angeles Times made this point in his article, Lawmakers are putting economic recovery at risk:
What is the source of the deficit panic that's fueling the pushback on economic stimulus? It's certainly not the public's conviction that government assistance is no longer needed. It's hard to identify a widespread perception that the economy has turned up, although Summers argues that such perception always lags behind reality.

"Recoveries are more like rheostats than light switches," he said. "People are gradually getting the sense of improvement. But it won't feel like everything is better all of a sudden. It will take time."

Is it bond investors fearful that deficit spending will drive up long-term interest rates, harming their portfolios, as the economist Paul Krugman posits? Or is it someone's Machiavellian effort to prove the correctness of Keynesian economics, which supports heavy government stimulus in periods when the private sector withdraws from investment, by imposing anti-Keynesian stimulus cuts while they're still needed?

John Maynard Keynes, it should be noted, was unafraid of government deficits. "At the present time, all governments have large deficits," he wrote in 1931, as his biographer Robert Skidelsky observed recently. "They are nature's remedy for preventing business losses from being ... so great as to bring production altogether to a standstill."

A few years later, Franklin D. Roosevelt bowed to his era's deficit hawks and cut back on federal programs to bring the federal budget more into balance. He got the recession of 1937 for his pains.

The deficit-cutting craze of the modern day threatens another such double dip. Its promoters say they're out to protect long-term economic prospects, but without a short-term recovery there may not be a long term to protect. If they get their way, we may not feel the consequences of their error before it's too late to fix.
One doesn't need to look too far to see how fragile this recovery is. Stocks plunged on Tuesday following a weak consumer confidence report.

And now we have New York Times columnist Andrew Ross Sorkin warning us to prepare for the Next Big One:

The next Great Crash is coming. Guaranteed.

Maybe not today and maybe not tomorrow. But, in all likelihood, sooner than we think.

How can I be so sure? Because the history of modern markets is a story of meltdowns. The stock market crashed in 1987, the bond market in 1994. Mexico tanked in 1994, East Asia in 1997. Long-Term Capital Management blew up in 1998, Russia that same year. Dot-coms dot-bombed in 2000. In 2007 — well, you know the rest.

And that was just the last 20 years or so. The stagflation of the 1970s, the Depression of the 1930s, the panics in the 1900s ... and back and back and back it goes, all the way to the Dutch and their tulip bulbs.

In those giddy years before the Great Recession, it seemed as if we had grown accustomed to the wild ride. Wall Street certainly had. Jamie Dimon, the chairman and chief executive of JPMorgan Chase and Company, likes to say that when his daughter came home from school one day and asked what a financial crisis was, he told her: ‘It’s the kind of thing that happens every five to seven years.’ ”

No one should be surprised, Mr. Dimon insists, that booms go bust. That’s the way markets work. Most Americans probably find that answer unsatisfying, to put it politely. After all, millions have lost their homes, their jobs, their savings.

But now here comes the Dodd-Frank Act, which is supposed to ensure that we never repeat that 2008 finale of Wall Street Gone Wild. The bill, if signed into law, might help us avoid another sorry episode like that. But one thing it won’t do is prevent another crisis — if only because the next one probably won’t be like the last one.

So amid all the back-and-forth over this bill, keep in mind one of the most important aspects of the act: it would give Washington policy makers a powerful tool to mitigate the next too-big-to-fail blowup, however that blowup manifests itself. For the first time, Washington would have what is known as resolution authority, that is, the power to wind down a giant financial institution that runs into trouble. If policy makers had had that power during the tumultuous autumn of 2008, they might have averted the catastrophic failure of Lehman Brothers. They might have placed the teetering American International Group into conservatorship. And they might have taken over Bank of America and Citigroup, and possibly even Goldman Sachs and Morgan Stanley. Senior management would have been tossed out.

“We will have a financial crisis again — it’s just a question of the frequency,” said the economist Kenneth Rogoff, who, with Carmen M. Reinhart, wrote a terrific book titled “This Time Is Different: Eight Centuries of Financial Folly.” The title says it all. We’ve been through this before and will go through it again.

While Dodd-Frank might avert another crisis in the short term, Mr. Rogoff says the legislation itself is less important than how regulators act on it — and keep acting on it over the years.

Before World War II, “banking crises were epidemic,” Mr. Rogoff said. Then things settled down because “regulation had become pretty draconian” and laws were actually enforced.

But memories fade. “Having a deep financial crisis is the best vaccination for another right away,” Mr. Rogoff said. Down the road, a lot will depend on the regulators. Ten or 15 years after a crisis, and sometimes a lot less, the watchdogs start to doze. Political winds change. Regulators loosen up.

Many on Capitol Hill insist Dodd-Frank means the end of the “too big to fail” culture, period. Many on Wall Street insist it means the end of American finance. Bankers and their lobbyists argue that American businesses and consumers will ultimately suffer, since all these rules will end up throttling the vital flow of credit through the economy.

Neither side is entirely correct. Businesses in general, and Wall Street in particular, often overreach in search of profits. And regulators, however stringent the laws, often struggle to keep up. We haven’t found a way to legislate around that sober reality.

Consider the 2002 Sarbanes-Oxley law, which sought to reform corporate America after the Enron and WorldCom scandals. The Supreme Court upheld the constitutionality of Sarbanes-Oxley on Monday. It is a strong law that sought to hold executives accountable for accounting shenanigans. Many business people screamed that the law was too strict. Few experts ever argued that the law was too lax.

Have companies engaged in financial fraud since? You bet.

After the Exxon Valdez oil spill in 1989, the government enacted the Oil Pollution Act. Did that legislate away oil spills? Of course not.

Strong regulation is important. And Dodd-Frank goes a long way toward cracking down on some of the worst practices that led to this financial crisis. But my bet is that next time, the culprit won’t be C.D.O.’s or swaps, or shady subprime mortgages. No, the culprit will be some other financial instruments — something someone somewhere is probably dreaming up right now.

In his memoir, Henry M. Paulson Jr., the former Treasury secretary, recalled telling President George W. Bush in 2006 that it was impossible to spot a coming financial blowup.

“We can’t predict when the next crisis will come,” Mr. Paulson told the president. “But we need to be prepared.”

Dodd-Frank, whatever its pros and cons, helps prepare us for the next Big One — whatever that might be. But it won’t stop it.

No legislation will ever stop another financial crisis. Moreover, the financial reforms were just fluff — cosmetic changes that did not address deep structural issues, especially in the OTC derivatives market which remains totally non-transparent.

Finally, stocks moved down violently on Tuesday, but there is no fundamental reason for such a thrashing. Instead of preparing for the "Next Big One", market participants should prepare for a long period of wild market gyrations. What we've witnessed in the last few months may be a taste of things to come.

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