Sunday, November 30, 2008

The Economic Crisis: Trading on Expectations

Barack Obama's political skills were on full display over the last 10 days. Around 3:00 the afternoon of Friday, Nov. 21, 2008, someone (presumably from the Obama camp) leaked the nomination of Timothy Geitner, president of the NY Fed, as Treasury Secretary. In the last hour of trading, the stock market rose about 6%, a big jump even for these volatile days. The next week, the Obama team dropped names for economic appointments faster than Kobe drives to the hoop: along with Geitner, Lawrence Summers and Paul Volcker are the best known. Together with a Citigroup bailout that gave taxpayers plenty of risk and an unclear amount of reward, Obama's talk therapy boosted the market for five trading days in a row, by a total of 17%.

But talk therapy has its limitations. As applied to the economic crisis, it suffers from the basic problem as the Bush Administration's approach. The Bush Administration has viewed the economic crisis as fundamentally a problem with "confidence." In keeping with this outlook, it has acted primarily to keep the financial system on life support, even to the extent of putting $7 trillion plus of taxpayer money on the line. This blunderbuss approach, which included infusing capital into banks that didn't particularly want it, undermines a basic dynamic of markets: separating the winners from the losers. All financial institutions of any real size are to be saved; they have been federally transported to Lake Wobegon, U.S.A. It avoids confronting the biggest bogeyman in the financial regulators' closets: the still unbooked mortgage and other credit losses that America's financial institutions are carrying. These losses evidently will be carried until when? When the real estate market recovers? (Stop playing the laugh track.) When the banks raise enough private capital--from whom(?)--to write them off without becoming insolvent? (I said, stop playing the laugh track.) When investors--especially foreign investors like the central banks of China and Japan--that bought mortgage-backed investments from American financial institutions agree to take losses instead of trying to foist them back onto the firms that sold them the investments? (Well, all right, we really have only two options: laugh or cry; might as well laugh.) You can't really have confidence in American financial institutions because no one knows how much unbooked loss they're carrying, and the federal regulators aren't about to make them face the music, ahem, we mean provide greater transparency. Without transparency, investors are starved for information and capital markets cannot clear. Only the dole remains. That's why even once mighty Citigroup had to go to the feds, hat in hand, and ask for more porridge.

The gargantuan price tag of these bailouts might be worth it if they were working. But, there's the rub. Confidence is still lagging, and the economy is nosediving. President-elect Obama can't turn things around with just publicity and name dropping. The confidence-building game so vigorously played by the Bush administration has been a failure. While hope springs eternal, economic reality always wins over hope. And that reality is cracking mirrors.

The 17% rise in the stock market since Geitner's expected appointment was leaked on Friday, Nov. 21, reflects very high expectations of Barack Obama, expectations that he himself fueled. He must be cautious about fueling these expectations further. It would be easy for him to talk his way into hero status. But then, come January, the electorate would expect him to deliver, and that would be more easily said than done. At this point, a convoy of aircraft carriers would be easier to turn around than the economy.

We want Barack Obama to be a successful President. America badly needs a successful President. But he won't be successful if he builds up expectations beyond his ability to deliver, and last week's market jump indicates he might have done just that. Franklin Delano Roosevelt never promised a chicken in every pot. Indeed, he stay largely out of sight during the transition period, letting the Hoover Administration take its lumps. With today's hyperactive and hyperfast financial markets, President-elect Obama can't just passively wait things out until his inauguration. But he should avoid making things appear more rosy than they are, because the financial markets are merciless in punishing those that are thought to be less rosy than they appeared, say, two minutes ago. Consult with former Bear Stearns and Lehman Brothers personnel on this point, if it's unclear.

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