Thursday, February 19, 2009

The Economic Crisis: Is the Government Bubble Bursting?

Since taking office, the Obama administration has expanded the scope of the bank bailout plan, secured passage of a $787 billion stimulus package, and announced a mortgage modification program designed to assist struggling homeowners keep their homes. The Dow Jones Industrial Average has dropped from a closing level of 7949 on Jan. 20, 2009, the day President Obama was inaugurated, to 7465 today, approximately 6%, in one month. That the market should drop after so much governmental action indicates that the government bubble in the stock market may be bursting.

From the fall of 2007, the stock market has been propped up by news of governmental interventions aimed at stemming the mortgage crisis, the credit crunch and the recession. Almost every announcement of a new program or measure precipitated a short term rally. Most recently, on Nov. 21, 2008, with the Dow languishing around 7500 in the middle of the afternoon, the Obama camp leaked its intention to nominate Timothy Geithner as Treasury Secretary. The market liked this news and rallied over 500 points in one hour to close at 8046 that day.

However, the problems in the financial system and the economy have overwhelmed every governmental measure, and the stock market has buckled under the pressure of the truth--that the U.S. and world economies are in deep trouble. Most recently, we've learned that Eastern Europe and former Soviet Union satellite republics are struggling to pay their sovereign debt. The possibility of another international debt crisis a la the 1997 Asian financial crisis looms. European banks, in particular, are exposed to these nations, and significant sovereign debt losses, piled on top of their current problems, may render them insolvent. The U.S. banking system, by all appearances, is insolvent. This is not to say that every U.S. bank is individually insolvent. But the system as a whole appears to be underwater. And it's taking the economy down with it.

The recent drop in the stock market indicates that even as the federal government is spending more than ever to combat the recession and the financial crisis, the efficacy of its spending is diminishing. This may, in part, be due to the way it's financing its spending. Hundreds of billions are being borrowed. The Federal Reserve's programs involve the printing of perhaps over $1 trillion. Printing money in our current circumstances amounts to a roll of the dice. If enough people have enough confidence in the dollar that they'll accept the printed money as valuable, and proceed to spend, invest and rebuild the real economy, the Fed's program may work. However, an objective economist from, say, Mars could easily conclude that the U.S. is debasing its currency and that each incremental dollar of government spending would have diminishing impact. Even though the stock market is subject to almost innumerable whimsies, fantasies, irrationalities and emotions, it ultimately must face up to hard, cold reality. The hard, cold reality is that the financial system is in extremis and the economy is sinking. All the government's horses and all the government's men can't put things back together again, at least not with an increasingly debased currency. The stock market has been propped up by a stream of government interventions. But the government is using increasingly questionable means to finance its programs, and the stock market could be starting to smell a rat.

The Federal Reserve has suggested that it might buy Treasury securities in the open market as a way to lower interest rates (or keep them from rising, as they have been recently). While this concept is presented as a means to assist the real estate market and corporate borrowers, it would further debase the dollar because the Fed would have to print more money to pay for these purchases. The Treasury Department is embarking on its biggest borrowing program since World War II. If the Fed buys up existing Treasury securities while the Treasury Department issues new ones, the effect would be for the Fed to print money and hand it over to the Treasury. Thankfully, the Fed hasn't embarked on its program of buying up Treasuries yet. But if it does, watch out. Stocks might prove to be even more of a losing investment, and the dollar could devalue through inflation (look at today's PPI numbers; inflation isn't dead yet). While gold and silver are, in truth, false financial deities, their disciples might gain credibility in ways detrimental to the dollar.

It's understandable why the government seeks to alleviate our economic problems; that's what the government is expected to do. But the worst case scenario would be for the government to go bankrupt while futilely combating economic problems with ineffectual weapons.

Lending without restraint bankrupted the banking system. Borrowing without restraint bankrupted the real estate markets. Printing money without restraint will bankrupt the government. With the economy spiralling downward, our resource base is getting awfully thin. Bankrupting the government would leave no line of defense. Perhaps the government bubble in the stock market is now bursting and stock prices will fall in the near term. The Obama administration and Federal Reserve should resist the impulse to artificially prop up stock prices with more spending financed with printed money. Stock prices ultimately derive from the value of underlying economic activity. That's where the hurt is the worst and the need for government assistance is the greatest. Focus on reviving the real economy and financial assets will join in the revival. But asset bubbles can't be maintained forever, and the government bubble is no exception.

P.S. To make things worse, another apparent massive investment fraud, the Stanford Financial Group case, has surfaced. As with the Madoff case, the Stanford Financial Group case raises questions whether the financial regulators missed the ball. With perhaps $8 or $9 billion at risk in the Stanford Financial case, investor confidence may now be further shaken, especially because the regulators were on the scene in the past two years without finding the big problems. As we noted when the Madoff scheme was exposed (see, a falling stock market reveals a multitude of sins. It is no surprise that the problems with Stanford Financial surfaced, and it wouldn't be a surprise if more such large cases emerge. If you have money in an opaque investment (i.e., for which you don't know the details of how your money is invested), strongly consider withdrawing it asap and putting it in something simple and transparent. A low-yielding bank account or money market fund is vastly better than being defrauded. There are reasons why some money managers keep their investments opaque and those reasons all too often aren't good ones.

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