Defenestrating Thoughts from the Bivouac

All the headlines are talking about how the stock market has dropped to levels we haven’t seen since 1996. This is obviously a really big deal: if you invested money in 1996, you haven’t made any money. That’s 13 years of no returns.

But it turns out it’s much worse than that. According to the Bureau of Labor Statistics, we’ve had 35% inflation since 1996. So $1 in 1996 is now worth $1.35.

Adding in inflation, we’re actually 26% lower than we were back in 1996.

[Note: 26% = 100% - ($1/$1.35)]

This video explaining how we got into this economic mess has been circulating around the “interwebs” for a week or so now and I thought I’d mention it in case you haven’t seen it. It’s pretty good and worth the 10 minutes to watch.

Continuing on the theme of “Do we really have a free market economy?“, there are couple of things in the video worth pointing out. First, one of the reasons we’re in this mess is the Federal Reserve unilaterally dropped interest rates really, really low. This, in turn, encouraged bankers to create more mortgage-backed securities. Second, the bonds (AAA, AA, etc) are rated by agencies that have a government mandated monopoly and thus they have little incentive to be good (as we can see from their past performance).

(The Crisis of Credit Visualized from Jonathan Jarvis)

Lots of people have been saying that the current recession is a failure of the free market. But, do we really have a free market?

I think the answer is no. In our current system, the price and availability of money is controlled by a group of wealthy private bankers: the Federal Reserve.

The Federal Reserve isn’t a government agency. It’s a half private, half public organization which has full control over the supply and price of money by manipulating interest rates.

Why is this is big deal? It’s because money is involved in every single transaction on our economy. And if you control the money, you really can control everything.

In basic microeconomics we learn that if $10 are chasing 10 loaves of bread, the bread will be priced at $1 per loaf. If, now there are 20 loaves of bread being chased by $10, the price is roughly $0.50 per loaf.

So the supply of bread has a big impact on its price. Likewise, if demand changes, that will affect price as well.

But in these examples, demand is measured in dollars and, in our current system, dollars do not have a fixed value. Suppose, the Federal Reserve randomly decides to double the amount of money in the market. Now there are $20 chasing 10 loaves of bread and the cost is now $2 per loaf!

Some will argue that since money is just a unit of exchange, it doesn’t matter. If bread is more expensive because of inflation, then wages are higher and everything else is will just “reset”.

But it’s not that simple, because the value of money spans time.

Huh? :-)

For example, let’s pretend that the entirety of the world economy was $100 billion. If I loan $1 billion to a friend, that represents 1% of the wealth in the world. Now, if the Federal Reserve prints another $100 billion, when my friend pays me back that $1 billion, he’s only paying back 0.5% of the wealth in the world. So my friend is paying me back half of the real worth of my original loan!

So printing money discourages savings and encourage debt. Why would you save money if it’s worth less tomorrow? You may as well go into debt and pay it back with cheaper dollars later.

Now let’s consider interest rates.

The Fed manipulates interest rates by manipulating the money supply. Interest rates are an important price signal as they represent the aggregate time preference for money in the economy. In other words, if everyone wants money (i.e. they “prefer” it over goods, services, equities, etc), the interest rate goes up. If no one wants money (i.e. they “prefer” to have goods or services instead of money), the interest rate goes down.

Interest rates are “the price of money”. If I want to borrow money (i.e. “buy money”), the price is the interest rate.

The interest rate is the price of the most basic unit of exchange, yet it is controlled by a few wealthy and politically connected bankers. How can such a system be considered a “free market”?

Right after I posted about how government policy uncertainty is preventing a recovery, I came across an interesting article with recent comments from Fidelity’s Edward Johnson:

Johnson, sounding like he’s never been a big fan of the original New Dealers from the 1930s, warned of too much government involvement in the economy and indicated Fidelity is beefing up its government-affairs unit to fend off possibly burdensome new regulations.

Now there’s a money quote! With the market paralyzed with uncertainty about what the next random game-changing policy to come out of Washington will be, companies are hiring lobbyists in an attempt to protect themselves!

So, I guess Obama’s job creation plan is working; it’s creating all sorts of demand for lobbyists.

We’re not making it up,” Bernanke told the House Financial Services panel. “We’re working along a program that has been applied in various contexts,” he said. “We’re not completely in the dark.” (Source)

Sorry Ben, but the truth of the matter is that you are making it up as you go along and you are completely in the dark. And while you twiddle your thumbs trying to figure out what to do, the whole system is falling apart.

Let me explain. :-)

At the root of any healthy economy is the ability for the market to price and value assets. Market risk is an expected part of this and priced in. The riskier the endeavor, the higher upside. The safer it is, the less upside.

But what’s not expected is the amount of uncertainity coming out of Washington. Our policy makers’ inability to commit to something and stick with it is making it hard to price assets and, as a result, all the remaining money out there is sitting on the sidelines.

The policies being discussed are game-changing and as a result the spreads are now wide open. As an example, in a normal market, if the buyer thought something was worth $8 and the seller thought it was worth $10, they would probably settle on $9.

But in this market, the buyer thinks the asset is worth $1 and the seller thinks it is worth $100. There’s no way that bid/ask gap will close. And as a result, no transaction occurs and the remaining capital we have sits on the sidelines.

Let’s look at some examples.

First at the micro-level: houses aren’t selling that well now. One of the reasons is that sellers expect a government policy that will reinflate all the prices. In fact, a home down the street from me just got listed at more than 20% of what a comparable house sold for a few weeks ago. Buyers, however, are seeing prices drop and expect them to continue to drop.

Since both parties are waiting for game-changing government policies or decisions, neither is moving from their position and no transaction occurs.

Now at a higher level: let’s look at bank paper. The banks think that the government will bail them out by buying the paper at above-market rates (again) and the buyer thinks that the government learned its lesson and will now shift to a policy of cramdowns. As a result, the buyer is looking for prices like 15 cents on the dollar while the bank is expecting a full dollar (or more).

Government shooting from the hip is keeping these spreads wide; which results in no transactions.

Finally, let’s look at a very high level: no one can really price any company stock right now by looking at their balance sheet. No one knows what the assets (inventory, bonds or every cash!) will be worth on the open market or how their business model will fair tomorrow. And it’s not because of the economic uncertainty, it’s the policy uncertainty. One bill signed into law could turn billions of dollars into nothing in a flash. There is no way to price in that sort of risk.

Now I could buy some bank stock, but tomorrow a major bank could be nationalized. So if I bought a stock in a big bank, I’m wiped out (common shares are worthless if a bank is nationalized). If I buy stock in a small, local, healthy bank, I lose since a weaker competitor just got a bailout.

Or I could buy some car stock. Of all the auto companies, Toyota and Honda are the most likely to appreciate, but their incompetent competitors could get even more handouts. Which would reduce the value of my investment. Or I could invest in GM. But they could be nationalized and I’d be wiped out.

Given all the governmental policy uncertainty, no one is making a move. And this is the core reason that equity and credit markets are deteriorating.

So far every time Obama talks, the market tanks. Here’s why: the market needs specifics on the plan. The time for vague promises of “pretty pink ponies for everyone” ended on the campaign trail. We need to rebuild the economy and that absolutely won’t happen until the rules of the game are made clear.

Remember, the capital we have left in the market is owned by people who were prudent and avoided the market crash. These people are smart and they certainly aren’t going to invest their money in anything if the stroke of the President’s pen could make their investment worthless in a blink of an eye.