24 August 2010

On Market Manipulation, and plastic surgery versus angioplasty

Hello Dear Reader,

And by that I mean, "Hello to the four of you who follow me, and who will know that I've posted."

So I often find myself posting things on the Book of Faces that I probably should write about here. But my distribution is so much bigger on FB, and it's so much easier to link an article to FB than to link it to the blog, and with Mercury in retrograde it's really not a very good time to be trying this stuff anyway...but I digress.

First, here's an article for you.

I was recently asked by a couple of friends to defend the free market, and also to justify the bank "bailouts" (I hate that term; it's reductive and simplistic, like calling the United States a "democracy"). I will address the latter, first.

First of all, a "bailout" is like GM or Fannie/Freddie--it's an unlimited and undefined government intervention/takeover of a business, usually for political ends ("job retention" or some such). Crucially, there is no repayment in a bailout, since the business would have theoretically died without government intervention and so it is unlikely to receive one's capital back, or to realize any gain. I wholeheartedly oppose bailouts. They create and enable market inefficiencies, and I'm not one for inefficiency (don't get me started on farming subsidies).

In contrast, the capital injections into the major banks at the peak of the crisis had a couple of things keeping them from being bailouts. Primarily, they were deliberately designed to be paid back. Most of the major banks HAVE paid them bank. JP Morgan, Wells Fargo, Goldman Sachs, etc. Citi and BofA have not, I believe. Second, they were compulsory, even for the healthy banks that would have survived without government action (like JP Morgan and Wells).

You can hardly call something a bailout when you don't need the money. If my parents came to me and forced me to take a bunch of cash because they were bailing out my brother, that hardly constitutes a bailout of ME. And that's exactly what occurred when the Treasury insisted that ALL banks be painted with the same foul brush as the bad actors.

As a philosophical ethic, I do not believe in government intervention in the market. Let me restate: I believe it is a moral hazard of the first order to interfere with the market, as the consequences of such action are routinely miscalculated, causing unintended consequences, and rewarding unjustly the people who caused the mess in the first place. Sometimes (often?) these consequences are worse than the original problem. This was Greenspan's problem coming out of the dot-com bubble, where he dropped rates so low that it created a private debt bubble--the consequences of which we are living with today, as we shift a private debt bubble into a public debt bubble.

Now let me make a distinction for those of my Readers who like absolutes better than nuances. I disliked the capital injections on philosophical terms. In the same manner, and to a greater degree, I dislike the ongoing manipulation (so called Quantitative Easing) that the Fed is engaged in to force rates lower. However, one of them is best likened to angioplasty, while the other is more like plastic surgery. One is life saving, the other is elective.

The Treasury's decision to make capital injections in the banking system was akin to angioplasty on a heart attack patient (I'm stretching my metaphors here, doctors, since I am a lowly investment manager, not a doctor). It was done in a surgical manner (specific amounts and with set terms of repayment). It was probably life-saving. Like all heart-attack patients, I'm sure we would love not to have eaten all those high-cholesterol foods. But that's done, and is a whole 'nuther post.

Again, most of the majors have repaid these mandatory funds, and those who have not (Citi? BofA?) probably should have failed. I have no problem with that. They would have been absorbed by other banks, creating even bigger banking behemoths of the survivors, but that would have been fine with me. I think it's something like 188 banks that HAVE failed during this crisis (another six or so were shut down just this last Friday) so let's not suggest that banks aren't getting shuttered--it's just not the top 5.

Quantitative easing, on the other hand, is plastic surgery. It's not necessary--it allows government to interfere with normal market behavior, disenfranchising authentic market participants (who would otherwise transact except for the market distortions). Here's my beef: rates should be higher, and prices lower, to reflect the actual conditions we're experiencing in the marketplace. Instead, the Fed is actively engaged in trying to get people to borrow (by manipulating rates) to spend more.

With consumer debt levels at 122% of incomes, that's like making alcohol cheaper for an alcoholic.

The corollary (screw the spelling if it's wrong) is that prices on debt-supported assets (some companies and most houses) are woefully (and willfully!) inflated. Since this effect is knowable, this has the effect of shutting down the market, as seen with the housing numbers today (inventory now stands at 12.5 months, where 6 months is a balanced market). No buyers, because sellers have unreasonable expectations of sales price. Why? Because the value of homes is being distorted by Fed action on interest rates. Why? For political ends because foreclosure is unpopular to elected politicians, and it turns out the Fed isn't so "independent" after all.

Here's the kicker, dear Reader: the market always wins against the government. That's just the way it goes.

It's late dear Reader, and I usually save you from reading my economic rants. But I had a commenter try to draw a connection between the bank bailouts and rate-manipulation and I needed to respond since I like him very much.

And since I'm defending capitalism...

Sticking one's head in the sand (socialism) is not a viable solution. Capitalism has brought us the greatest advances of mankind. And I'm not just referring to transportation, medical advances, standards of living, and networks of information. Capitalism and republican democracy go hand in hand. Why? Only because they're the two systems we have that respect the individual. The what? The individual, that Enlightenment age realization that each of us has intrinsic value beyond our use to the greater community. Socialism does not share such a belief. It is fundamentally anti-individual, and relies on the belief that each of us is entitled to the possessions of the other. Such thinking, as it might be called, goes something like this: "I'm entitled to your X because I deserve Y. My need is equal to your efforts." From such a bitter tree springs all the fruits of anti-individualism: unjust power (centralized or otherwise), "majority rule", stagnation and decline.

If capitalism has failed (itself an absurd assertion), then what of socialism? Let's ask the Soviets. What? The USSR collapsed? Then let's ask the Chinese people. What? They're censored by their centralized socialist government? Oh.

The naive fantasy of enlighted socialism is just that--a naive fantasy. No system is enlightened. We are human beings. We are dirty, mean, and short-sighted. How do you balance that? Well, I would start by admitting that I'd much rather have a neighbor who is intent on creating his own success than one who is intent on robbing me of the fruits of mine.

Ok! Whew! That's intense. Since it's so late, I will blame fatigue for the many lapses in logic that I've allowed in this piece. I've done my best, and I'm happy to keep plugging away to clarify things (or defend myself) as they come up. Now I'm going to bed, where I'll no doubt count sheep (or their market value) to settle myself to sleep.

Goodnight dear Reader.

Sable Crow


jason said...

I always enjoy your commentary, even when I disagree - which is rarely, by the way. This is one of those rare occassions...sort of.

Whether or not the money is to be paid back, the term bailout is quite appropriate. The banks were definitely bailed out by federal intervention regardless of their requirement to pay the loans back. This was not a loan - there was no credit check or security for repayment. After the feds stepped in and gave our money to these failed businessmen, they still could have failed. There would be no repayment if that were to have happened. The fact that most did not fail and have paid the debt back is great, yet that still doesn't change the fact at the time the government was intervening it had no reason to be sure they would get paid back. That is a bailout.

The banks that were compelled to take the money were also among the first to pay it back. Fannie, Freddie, and Citi...they are still having significant problems. What happens if they are unable to repay on the terms "offered?" Is that when it becomes a bailout?

My personal feeling is we have yet to see the worst of our government's officious intermeddling in the free market system. As I'm sure you know, I agree with your assessment of Capitalism and Socialism and I don't think Capitalism is dead. But as things get worse, and as our government leaders continues to blame the free market for the problems they have created, I sometimes worry that Capitalism will be scapegoated to death.

At the end of the day, I understand why the feds got involved. I just disagree with their involvement. Banks, like any other private business, need to fail if they make bad business decisions. By bailing them out of their troubles the government stalls any innovation or ingenuity that may have been created as a result of being forced to figure out a new means of business. We would have suffered - most likely quite severely - if they had been allowed to fail. But the market is funny that way...it would have adjusted itself accordingly and after a few rough years we would have worked it out. Instead, we've suffered a little bit less for a few years and will probably face significantly greater hurdles for a prolonged period of time thanks to the involvement of our government.

Sable Crow said...

Squawk!! This raggedy, wind-blown crow loves a Reader who comments at length!

Thanks Jason. True to your word, we agree more than disagree. Particularly your last few paragraphs.

It's too bad we agree on most things; it would be fun to argue with you. ;)