Thursday, November 20, 2008

The Continuing Collapse

As some of us have continued to say, it will continue to get worse until fundamentals are addressed. Money was given to banks, but balance sheets were not restructured. As such it is only a temporary delay in financial troubles. As long as financial markets are stopped up, demand freezes, and the longer that persists the more impact it has on actual demand. A general slow down ensues, and real firms, the worst run, and most at risk, begin to falter. Voila, autos slump; retailers are next.

The financial bail-out has failed. Primarily this is indicated by the precipitous drop in selected financial stocks after they were infused with cash. Bank of America, Citigroup, and Goldman Sachs are off more than 50%. There was no need to hide which banks were in trouble, since the bailout wouldn't work, we were bound to find out by watching their stocks.

Some suggest that this is not yet as bad as The Great Depression, pointing at the jobless rate as a key indicator. However, we must remember that in the Depression our economy was much more self-providing than it is now. Most of our manufacturing has been moved off shore to places like China. If you look at what's happening to factories, and unemployment there, it is not pretty.

Our government continues to throw money at the problem, and attempt to improve things by stimulating consumers to buy. However, this is attempting to change the cause by stimulating the effect. It is doomed to failure. What does the Federal Government risk through this policy? It already is close to lowering interest rates as much as it possibly can (to 0% effectively). But that is absolutely the wrong thing to do. Lower rates are what got us into this problem, and it only encourages poor investing. Capital has already been destroyed. What we need is higher rates to spur conservative investing and capital preservation, but this does not fit with the stimulatory policy of the monetarist Fed. While sound policy guarantees a protracted recession, doing the opposite is now almost sure to guarantee a depression. The Fed has thrown so much money at this, that it now threatens the viability of the dollar as a currency of standard. If dollar confidence erodes enough, expect massive dollar flight and a significant decline in dollar values, making the problem even worse. We're in a deflationary period now, but that is due to real demand destruction. If the Fed continues its stimulatory policy, expect the deflation cycle to turn to rapid inflation.

We also do not need industry bail-outs. This phenomenon is nothing more than poorly run company "pigs" to an ever widening trough. The other half of the US auto industry is fine. Why do we continue to reward failure? Every bail-out, the financial one included, has done nothing but reward those who have failed to manage their companies well, and punished those who have succeeded. While some advocates of a bail-out continue to think that it can be structured in such a way as to force Detroit to restructure, Megan McCardle points out that things have become so cynical back in Washington, the those who support the auto bailout there now nakedly see it for what it is, a cash grab, "Hail Mary" play. Yet, they advocate it anyway. My God, what have we become!

Citi begs for help, and Wells Fargo has "help" forced upon it. A free market would work in reverse. Wells would gobble up Citi, but as long as the govt is in play, Citi resists, holding out for a hand-out. When strong banks suggest that they will use bail-out funds to make acquisitions, the one rational, helpful action in this crisis, tax payers howl.

This crisis could have been avoided. If the government had only stayed out when the banking sector worsened, and let the natural course of bankruptcy restructure sick balance sheets.

There are letters being penned to my congressmen, and I'm planning a few LTE's as well. Now more than ever, there is only one thing to advocate, lasseiz faire!


Burgess Laughlin said...

Does "deflation" mean shrinkage in the money supply?

If so, what evidence is there that there is deflation?

Or does "deflation" simply mean "My investments are dropping in price?"

Kendall J said...

Sorry Burgess, you're right. By deflation I did not mean that the money supply is shrinking. Instead simply that price is nominally dropping. This is due to a drop in demand, and is usually seen in recessions.

The coming inflationary pressure will be because of an expansion in the money/credit supply.

Burgess Laughlin said...

So, we could be facing the worst of scenarios: an inflationary depression?

As an adult, I have lived through perhaps 10 recessions. I was fortunate enough to be laid off only once but that was because the company, rather than the economy as a whole, was shrinking.

In straight recessions, smart individuals who happened to get laid off can live off their savings and investments. In an inflationary depression, if such arises, there will be a wave of fear--which is the fertilizer in the garden of statism.

I stopped reading the news in August, but I notice that dramatic events have a way of making themselves known in other ways: in casual conversation about difficulties in finding a job, in the larger number of people in an apartment building doubling up to cut their rent, and my favorite discount grocery suddenly selling more rice and potatoes.

Kendall J said...

I think if the Federal govt continues to pump money into the economy as a stimulus, without addressing fundamental issues, then yes. That is the possibility.

Now, I'd like to hope that the monetarists see that some of this will happen on the continued course, and while they may not know what to do, they will decide not to continue down the path. But that is only a hope.

I think a Carter-like stagflation is a very real possibility, but not yet assured.

softwareNerd said...

I just read Rothbard's history of the Great Depression. It is about the Hoover years.

Many things from that time are uncannily similar. For instance, the government was trying to inflate, and complaining that the banks were not lending the money onward.

At the same time, some things that happened then have not yet transpired; and, they almost surely will. For instance, the massive public-works spending: I can see something like that being planned in the near future.

I don't think we're in for a Great Depression in real terms, simply because man has figured out how to produced food and clothing with far less real input than before. However, in relative terms (as a percent of the recent "peak") this period will surely compete with the 1930's.

One ideological position that played a big role in prolonging the Great Depression was the notion that wages rates ought to be kept high. If unemployment goes to 8% and above, and we hear calls to keep wages steady, we'll have one more similarity.

Jim May said...

There is one other difference, and it's a big one: our currency is fully fiat now.

Even after Roosevelt took gold away in 1933 and then devalued the dollar, they still set a value of the dollar in gold, even if only foreign governments were able to make the conversion. The last step was Nixon's closing of the "gold window" which allowed them to do that.

That factor is what will distinguish this depression from the last one; its character will be determined by how much money the government will print up. At one extreme is the German hyperinflation; at the other, the (First) Great Depression.

When you consider that the German hyperinflation was largely motivated by printing money for reparations payments owed to foreign governments under the Versailles Treaty, it should be clear which way our government will likely be leaning, given the trillions of dollars in US debt is held overseas, by such as the Chinese.

softwareNerd said...

The future of the economy is so hard to predict in a mixed economy, because the a range of possible things that government may do is wider than under near-socialism or near-capitalism.

Particularly at this stage, with the new President and Congress not yet started, we're all left guessing if they'll join to be the Hoover/Roosevelt team, or more of the Clinton run-to-the-middle team.

As Kendall indicated in his post, the U.S. controls the world's reserve currency. This is a dubious advantage: like being a spoilt brat of a princeling, who can get away with a whole lot, until the world revolts!

Inspector said...

Kendall, a small point about your aside about Honda. It's not that the Detroit 3 are "poorly run." It's actually much worse than that.

(there's a lot there that supports your other points as well. You're right - what have we become!?!)