Where Does the Economy Go From Here?

Okay, the massive cash infusion through both the bail out plan and the Fed's new lending programs and policies is a done deal. No sense saying it shouldn't be done. It's done. So what happens next?

Well, there's a whole lot more cash in play now. What happens to it depends on government policy. Bad business models and those who loaned money to people with bad business models or unsustainable cash flow situations are still going to fail. There's a lot of short-term pain yet to come. However, if the government simultaneously eases up on taxes and regulation and actually encourages risk taking by increasing potential profit margins, competition will set in for those extra dollars and they will eventually be converted to wealth; new, valuable goods and services. If the government tightens regulation, raises taxes and creates a more hostile business environment, inflation will set it and all that cash will just be devalued to match the available goods and services. As Dan Akroyd said during a Jimmy Carter sketch on Saturday Night Live, "We'll all be millionaires!" Of course the poverty line will be somewhere around $900,000.

It's true, "The only thing we have to fear is, fear itself". If the politicians trust the free market they give lip service to, this downturn will pass in short order. If they react out of panic, things could get ugly.

The health care solution. Are you pondering what I'm pondering?

Ladies and gentleman, I've asked you here today because opportunity is knocking once again. The public is clamoring for affordable health care and the politicians are pining to give to them. Everyone is looking for a system that will enable each participant to contribute $5 and draw out $500 and by golly we're going to give it to them.

First, we'll get legislation passed that requires everyone to purchase health insurance. We don't want to have the government provide the insurance directly. That would look too much like socialism. We've got to dress this thing up so it looks like a free market. We'll have private insurers sell the policies. They'll have to cover everyone, regardless of income or pre-existing condition. The government will provide subsidies to those who can't afford it. In order to reduce the risk to insurance companies we'll set up a Government Supported Private Entity, a Health Care Insurance Funding Authority. We'll give it a catchy name like Hannah Fay.

Hannah will buy up policies from the insurers. The insurers will simply sell policies and administer claims, which will paid by Hannah, through them, to the providers. Hannah will bundle the policies together and sell bonds backed by the premiums to raise operating capital to pay claims and subsidize more low income policies. We'll sell the bonds to a new kind of financial institution, which we will help create: Health Care Investment Banks. These HCIB's will bundle the bonds and sell shares in them. We'll call those Health Care Backed Securities or HCBS's. These HCBS's will be sold to other financial institutions, pension funds, sovereign wealth funds and the like. The risk will be spread so thin, it'll hardly be noticible.

Our roles? Advisors, consultants, investors. Keep away from the cameras. Stay out of the news. I know what you're thinking. This can't possibly work. Well, that depends on your definition of work. There will be Congressional oversight, but don't worry about that. Politicians are elected on emotion. Most of them wouldn't know a proper balance sheet from the supply side of a mule. Just make sure they get their due in contributions. As for the Wall Street boys, the important ones know the game. They'll get out in plenty of time. Their replacements will be lulled in by huge salaries and bonuses. It's kind of like executive hot potato. It'll be many years before anyone figures out the HCBS's aren't worth the paper their printed on and the health care system doesn't actually have any money. I'll have you out well before then.

Alright, we've got work to do. Set up meetings with your respective politicians, activists and friendly media and let's start leaking this idea out there. Remember, don't attach your name to anything. Present it as something you heard from someone else that you think could be worth looking into. Let the camera junkies do the rest. This meeting never took place. Good luck everyone. This could be the greatest thing since Cap and Trade!

How to Play this Market

Lessons from '29, The New Deal I and II and The Great Society

image from http://stockcharts.com

This is not intended to be a definitive answer to what causes recessions and depressions and what policy ought to be. It is an observation of what the government did and when in terms of spending and corresponding moves in the stock market.

Immediately following the stock market crash of '29, then President Herbert Hoover was of a mind to let the market sort it out for itself. Most believe this was a big mistake, but in his defense, the market had bottomed and begun to recover by the time he left office. Franklin Roosevelt implemented the first New Deal in 1933. This included short-term measures like jobs creation programs, spending on infrastructure, generally getting money in the hands of the masses. The market responded very well to this. The second new deal was implemented in 1935 and 36 and included support for labor unions, the Social Security Act and the Work Progress Administration (a continuation of the jobs programs from the first New Deal). The market responded positively at first, with a big spike in the DJIA, but that was followed on shortly by just as big a sell-off. While still up substantially from 1933, the net gain in the market from '35 - '38 was nil.

Now take a look at the Great Society programs of 1964, introduced by Lyndon Johnson. This is where Medicaid and Medicare came from, as well as increased education funding. While the Vietnam War slowed down the implementation of these programs, spending on them ballooned under both Nixon and Ford. The market remained flatlined from 1964 until 1984 or so when deregulation seemed to finally spark the next big surge upward.

It seems as though putting money in the hands of individuals can actually have a positive effect. Companies must compete for this money and economic activity increases. When the government gives great big checks to specific industry groups, companies or bureaucracies, the numbers may be big, but the level of economic activity doesn't seem to be enhanced. It's essentially moving money from one account to the other and eliminating all the middle men. The problem is, all those middle men are what makes the wheels of this machine move.

Another way to look at it is in terms of something called the Marginal Propensity to Consume. Essentially, how much of each additional dollar of income is one likely to spend or invest? The answer is different depending on your circumstances. If you've gone without a working washing machine for six months and suddenly have a $500 windfall, you're probably going to go buy a new washing machine. If you're already well-to-do and see tough economic times ahead and get a $500 windfall, you'll probably tuck it away. In other words, if you give poor people money in tough economic times, they're more likely to spend it. If you give rich people money in tough economic times, they're more likely to hoard it. If your goal is to promote economic activity, it would seem to make more sense to give a little money to a lot of people than a lot of money to a few people.

The vast majority of new government spending so far is pegged for specific players in a specific industry. Don't look for a quick turnaround in the overall economy. There will no doubt be another round of "stimulus" out of Washington DC after the election. We're likely to have liberals controlling both the House, the Senate and the White House, with a mandate to spend as much as they want to "fix the economy". How this "stimulus" is doled out will be important. If it goes mainly to individuals to spend as they please, it may have a positive effect. If it goes to organizations and programs aimed at providing non-monetary assistance, it's likely to wind up in some big institutions' bank accounts and very little effect on the economy.

Of course I'd much prefer cutting taxes and spending to ballooning the money supply. Eventually, the hoarders will come out and spend. Why? Because for the real players it's not really about the money. It's about the game. If blowing a wad of cash on some crazy, labor intensive idea is what it takes to get the game going again, that's what they'll do. But it's not my call and that's not going to happen. Whichever way the government goes, the market in the short term should be very volatile. I'm going to bet on big swings up and down and try to have the discipline to periodically take some money off the table.

For the casual investor, I'd go with "dollar cost averaging". That is, put the same amount of money into a diversified fund each month over a long period of time. The only way you lose with that strategy is if the economy stays in the tank for decades, in which case your 401k will probably not be your biggest concern anyway.

Demand Side Economics

What went wrong with the U.S. economy? Was it corrupt politicians? Greedy speculator? Irresponsible consumers? I don't think so. All of those factors are with us all the time, in good times and in bad. I believe this was a major policy mistake. We did an about face from Supply Side policy and turned to Demand Side.

After 9/11 what did the administration appeal to people to do? Go shopping. Later, to increase home ownership, policies were implemented by Congress and the administration, not to decrease the cost of the home, but to make it easier and cheaper to get the money to buy one. When the economy continued to slow, we were all sent checks from the government and told once again, "go shopping". Now, the government has decided to give banks a massive injection of cash so they can more readily loan it to us so we can all...you guessed it, go shopping. All of these things were aimed at increasing consumer spending without any real market stimulus for doing so.

Ronald Reagan was an advocate of Supply Side economics. The idea is to reduce taxes and regulations on producers. Increased profit margins increased competition and spurred innovation. Consumers bought more because new and better products came on the market at lower prices. Demand went up naturally as the supply of things people actually wanted increased, as did value.

Today, the government will decide which businesses are worthy of a bail out and which aren't. The government will decide through subsidy and tax credits, which products it wants you to buy. The government will decide through regulation and mandate what those products will look like and how they will perform. This does not encourage innovation, it encourages compliance. Demand Side policy will only increase debt and decrease the value of the dollar. The federal government will never go broke. They'll just print more money. Interest rates will soar as lenders attempt to stay ahead of inflation. Prices will soar as retailers attempt to stay ahead of interest rates. We should have learned these lessons in the 70's, but obviously we didn't. Policy makers have gone back to the age old, tried and failed method of fixing problems by throwing cash at them.

The Zuckerman Alternative - to the Bailout

Mort Zuckerman, magazine editor, publisher, and real estate billionaire, suggested on CNBC today that essentially giving away $700 billion by buying securities nobody else wants, is not the only answer.

If the goal is to sustain the system and inject cash flow, why not simply buy preferred shares in the companies that need it? Of course it would dilute the value of the company's stock. Preserving shareholder value isn't supposed to be the concern of the federal government. That's the company's job and they blew it. The taxpayers' interest is only in the infrastructure.

This is similar to what was done with Freddie, Fannie and AIG and similar to the deal Warren Buffet made with Goldman Sachs.

The companies could have the option to buy back the shares at a 10% premium, otherwise, the feds start selling them on the open market in five years (that bit was my idea).

Instead, the senate loaded up the bailout bill with an additional $150 Billion in special interest favors (who's going to notice a few extra hundred bil?). I hope the House kills this monstrosity so that better options, like Zuckerman's can be considered.

Bi-Partisan Robbery, Senate Passes Bail Out Bill

A parade of senators, Republican and Democrat are congratulating themselves and each other tonight for passing the $700 billion giveaway to "save the economy". They did throw the common folk a bone in the form of some tax relief. I guess that makes it all okay.

You may be unfamiliar with the meaning of some of the terms and phrases being tossed around in reference to this crisis. Let me clarify some.

"Sub-prime mortgage" - Loans made to people for more than they could possibly pay back, secured by assets that are now worth much less than the loan.

"Mortgage Backed Securities" (MBS) - Essentially, shares of the above mortgages, sold to banks and investment institutions in large bundles.

"The credit markets are clogged" - The banks have no cash. They spent it on these MBS's which had been carried on the balance sheet as "cash equivalents". The problem is, nobody wants to buy them so they aren't really cash equivalents.

"We must free up the credit markets" - We're going to buy these shares of subprime mortgages at a price pulled out of thin air by Henry Paulson.

"We will sell these MBS's back to the open market to redeem the taxpayers' investment" - We're going to sit on these things until the heat is off.

"Doing nothing is not an option" - Doing nothing would cause the markets to take their natural course, exposing the whole convoluted scheme that caused this mess. Politicians would be voted out. Lawsuits would be filed. Voters would be very angry if the truth were to come to light. Best to let it fester for as long as possible.

Yes, Republicans and Democrats have come together in an unprecedented manner to cover their collective behinds. Some voted against the bill, but only after its passage was assured. No member of either party made a serious effort to put a stop to this. I for one will no longer vote for the most competent stooge or the lesser of two evils.

Let me make this absolutely clear for those of you who haven't yet caught on. Your money will be given to banks, so that they can loan it back to you. You will pay your money back to the bank with interest. After the shareholders, employees and execs get their cut, some of the remaining net will be paid back, not to you, but to the government who brokered the transaction. They are, at this moment, on national television praising themselves in the highest terms for pulling this thing off (assuming it passes the House) because they are now 100% convinced that we are indeed, just as stupid as they've always hoped.

A Kinder Gentler Bailout - Why it's important that this one fail too

The argument among pundits, the administration and Wall Street is that if we do nothing, there will be dire consequences. Therefore, although they all say they hate to do it, they favor and insist on the government bail out. To make it a bit more palatable this time around, they've added increased FDIC insurance and some tax cuts. While the FDIC insurance and the tax cuts are good ideas on their own, the rest of the bill is still bunk.

The government argues that they'll make all their money back and then some. If that were true these securities would not be "toxic waste" on the banks balance sheets. The government is claiming that they, professional bureaucrats, are better suited to value these things than lifelong professional bankers. We have not been told the nature of the "mortgage backed securities". If they are backed by a random hodge-podge of mortgages, I'd say they're probably right. But if that were the case, there would be a market for them. They are obviously backed by mortgages that nobody expects to get paid. As for the underlying real estate, again: which real estate? I can tell you as someone who used to fix houses after people had been evicted, the cost of repossessing and fixing them when added to the loan balance can be far higher than the appraised value of the home, making the mortgage absolutely worthless.

The government also claims that credit will dry up if they don't "inject capital" (give away your money) to the system. In a sense that's true. A good portion of this economy has been built on people buying things they can't afford. That is in danger of coming to an end, or at least being severely curtailed. The economic growth figures aren't going to look so good for a while. People will have to work with their actual income instead of what they expect to earn over the next ten years.

It's important that we allow the market to play this one out for the simple reason that we have to see what happened. We have to unravel this thing so we can learn from the mistakes. It will not cause armageddon, we will not go back to the stone age. I've been flat broke before, it's not as bad as it's cracked up to be. Nobody takes you out back and shoots you for making honest financial bad calls. You just start again and try to be smarter about it going forward.

I don't know if Congress will have the courage to do the right thing. I hope they do. Sweeping the systemic problems under the rug just preserves the mess for another day.