Let the System Reset

Good cultures balance short and long-term goals. Focusing too much on the long-term can lead to overinvestment, and problems like Japan still faces. Focusing on the short-run can lead governments and companies to focus on manipulating budget and earnings numbers to fulfill their own selfish ends.

At present, we have no surplus of long-termism, but a surfeit of short-termism. Many economic players have decided that it is in their interest to play for time — make things look good in the short run, and maybe a magical fix will appear for long run problems.

It seems that the EU thinks that if they can make Greece behave, that all will be right. Well, tell that to those that protest in Greece. Let each EU nation rather take a step back and ask, “What is cheaper in the long-run, bailing out Greece, or bailing out my banks with Greece exposure?” The latter is probably cheaper, but not certainly so. Given the lack of unanimity, the situation would lean toward bailing out domestic banks, because bailing out Greece requires the cooperation of separate nations, many of which have electorates that strongly oppose a bailout of Greece.

But, that could mean a virtual dissolution of the Eurozone. Not necessarily. You could end up with a lot of nations in default, and shut out of the bond markets (the PIIGS), while the rest do seemingly fine, as they quietly bail out their banks.

In that situation, the Euro would still exist, and might continue to be the currency of nations that are in default. They just could not borrow any more at any rate in Euros, and perhaps not in any currency.

But the Eurozone itself would be in tatters, at least from a marketing standpoint. What is good about being in the Eurozone? Free trade? Well Britain has that, even though they are a basket case, at least they control their own destiny, sort of. The veneer that being in the Eurozone means that you are a high quality borrower is shattered. Credit spreads over the German Euro benchmark will be high indeed for nations that have been undisciplined in their finances.

People and governments like stasis. No change. Why? It makes policy simple. If something is in trouble, give it aid. But — what if the trouble is an indication that people don’t want what is being produced by the one that is in trouble? Capitalism is wonderful because it is dynamic. It can quickly adjust to changing conditions, unlike socialist bureaucrats. Rather than volatility being a negative, with capitalism it is a positive. It shows that the economy needs to change, that losses on prior bad investments should be recognized. Failure to see things like this lessens the flexibility of the economy, and makes the eventual adjustments much larger than they would have to be if we did not interfere in the economy.

Now, this applies all over the world. China is creating some of the biggest white elephants in history, so it seems. Like Japan in the late 80s, they are building up useless industrial capacity. Naive Keynesianism says that it does not matter what one spends money on, what matters is that the money gets spent, and quickly.

We may as well throw bricks at every window we see with that logic, knowing that GDP will record that glassman’s wages, but will not record the loss from a broken window.

Alas, we have too much automotive capacity, so we support automotive firms in the US. We have too many bankers and too much capacity to build homes, so we support that as well. Far better that we let firms fail, and let the assets be released to better uses. Why waste your life or capital in an industry where there is not enough demand?

In one sense, my claim of cultural failure boils down to not being willing to recognize losses. In another sense, it is using the political process to invalidate economics. Why should the government bail out company A and not company B?

The present political climate in the US could be summarized as a question of fairness. Why should some benefit from bailouts, and not others? There should be some answer here that doesn’t sound lame. Lame answer: we were protecting the whole economy by protecting banks. Better answer: we goofed in protecting the banks. We should have let them fail, and bailed out depositors. Don’t bail out anyone; let housing prices drop until ordinary people can afford them. But if you must bail out, go down to the lowest level, and bail out those with mortgages, which will benefit not only them, but everyone above them.

This leaves aside moral hazard — all bailouts are a mistake. Far better to let all fail, and let the system reset. Run a hard culture where failure is punished. That will cause people to avoid failure with greater assiduousness.

I will have more on this in the likely final segment for this topic.

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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