Wednesday, October 15, 2008

Enough for the Financial Crisis. Now Let's Focus on the Economic Crisis.

Easy come, easy go. The stock market dropped about 8% today, two days after leaders of all the major nations of the world pledged coordinated action to deal with financial crisis. The Dow Jones Industrial Average today finished just about 1% above where it closed last Friday, before the announcement of coordinated international action. The S&P 500 and the Nasdaq indexes are lower than where they closed last Friday. So much for the effectiveness of government action in stopping the stock market slide. As has happened so many times before, each announcement of a new government initiative produces a temporary sugar high, to be followed by a sickening drop.

The truth is that no government action will stabilize the stock markets now. The reasons for the credit crunch are too large and complex for a quick solution. The root cause--the largest morass ever in the mortgage markets--will require years for recovery. The derivatives market added layers of complexity to the mortgage problems, and the convoluted liabilities it created will take years to sort out. The Federal Reserve's and U.S. Treasury's tools for addressing the credit crunch don't, for the most part, fix the underlying problems. They are life support measures, meant to maintain some sort of pulse at the heart of the financial system until the underlying problems work themselves out. Fed Chairman Bernanke said today that the government has the tools it needs to address the credit crunch, and that now he needs time.

Time is what stock market investors don't want to risk. With the way things are going, stocks could drop how much more tomorrow? If it was 8% today, is there any limit for tomorrow? (Okay, the New York Stock Exchange closes if the market drops 3350 points, or 2200 points after 2:00 p.m., and you get a trading halt for an hour or maybe just a half hour if the market drops 1100 points before 2:30 p.m.; but how much comfort is all that?) Much of the selling today is driven by fear, and there is no way to know when that fear will subside. This is the fear of the unknown. The financial markets have become so complex that Wall Street executives and government regulators don't understand them. The average investor, who probably has trouble figuring out how to manage a 401(k), can be forgiven for viewing all this as little more than witchcraft. It's no wonder that so many of them prefer to sell stocks and hold cash than continue to dabble in witchcraft.

Even the smart money is taking a breather. Prominent hedge fund managers are reportedly selling their stockholdings and sitting on their cash. They can't understand what's going on, and choose not to invest when they can't invest intelligently. That point explains, among other things, why Secretary Paulson's decision to let Lehman Brothers go under created so much havoc. Paulson reportedly decided to not to save Lehman because its exposures to the rest of the financial markets were relatively limited, and he wanted to make a point about people--even senior executives on Wall Street--being held responsible for the risks they took. Abstractly speaking, that's a good reason for not bailing out Lehman. But the problem was that no one else in the world has the level of information that Secretary Paulson has. He knows enough about each major bank that he can decide which needs to be saved and which can be allowed to fail. No one else, though, knows what Paulson knows and is thinking. Therefore, it is logical that no one would want to lend to the large banks. Interbank lending today is sensible only if you can get inside Hank Paulson's head and see who will get a thumbs up and who will get a thumbs down. Otherwise, better to sit on your cash. The credit freeze is not based on fear or panic; it's actually quite understandable.

To get around this problem, the Treasury Department revived the Selective Service System and drafted a number of large banks for national service. They were told they would be receiving federal infusions of capital and would give the federal government preferred stock. They were told they would lend out the money they received and couldn't hoard it. They were informed that limitations on executive compensation would be imposed on them. They were told they all would participate; any resistance to induction was swiftly quashed (maybe after one or two were ordered to do some push-ups).

Oddly, perhaps, in this hour of financial socialism, we can see a way to softening the impact of the recession (the one we all know is coming but which the Federal Reserve resolutely avoids acknowledging). Federal capital infusions should be made in regional and local banks, the ones that finance small businesses, farmers and other independently employed persons. The small business sector is a vital part of the economy, employing about a third of all employees and typically creating more jobs than big business. Small businesses are vulnerable to credit crunches, often having fewer resources than large companies. Money pumped into the big, money center banks may not wend its way to Elm Drive in Middletown, U.S.A. Much has been done to protect Wall Street, and the Federal Reserve has all the tools it needs. More must be done now to protect the real economy. Regional and local banks are a good pipeline of funding for small business. They also make a fair number of mortgage loans (with real credit standards, so there's a chance the loans will be repaid). It would be prudent to diversify the bailouts and send some money to Main Street. Who knows: a recovery in the real economy could help revive the real estate market and lift some of the storm clouds over Wall Street.

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