Saturday, May 31, 2008

 

The Band Aid Removal Metaphor

Everyone knows that the best way to remove a band aid is to quickly rip it off which produces a sharp, short pain. Then you are done, the memory quickly fading. Slowly removing a band aid in order to minimize the pain never works. It only stretches out the process which is more traumatizing. After William gets a shot the nurse will put a band aid over the area. After a day I will take it off while we are changing him and if I do it fast enough he will barely flinch. Of course he is a really good baby. ;-)

I have been thinking about the Federal Reserves response to the credit crunch and it is clear to me that they have opted for slowing down the crisis and effectively spreading out the process so that the pain is not as sharp but it is no where close to being over. While listening to a local real estate show on the radio which has gone from a cheer leading squad to a wake I heard one of the mortgage professionals lament the fact that many banks are not letting sellers offthe hook to sell their homes when it was in the best interest of everyone else to just clear out the older inventory of homes right now rather than have sales stagnate for another year. (From their point of view it is better to let prices drop and then have a return of volume of sales because that is how they make their money.) He said the banks were slow to act because the regulators were not forcing them to write off the bad debt. The reason for this is you would see a sharp jump in banks going belly up. The Fed doesn't want to participate in a banking crisis among the smaller regional banks.

I was of two minds on the subject. The Suck It Up school has a point about fairness and the Let's avoid another Great Depression or Bailout school (for lack of a better name) points to the societal destabilization, which will affect guilty and innocent alike, of allowing a financial meltdown. The truth is that there is no right answer in that there will be pain no matter which course is taken.

There are real world examples which will help us to the correct course. Let's take two examples of depressions: the U.S. in the 1930s and Japan in the 1990s. Although it is difficult to separate out causes and effects in a real world laboratory of a social science experiment there are lessons we can draw without too much massaging of the facts. The U.S. experience was much more of a ripping off of the band aid- although FDR's policies attempted to mitigate this after 1933 and, arguably, stunting the rebound in the economy. Japan's depression has been much longer with low growth carrying on for more than 15 years. The U.S. was up and running at full strength after WW II, another apples and oranges problem, Japan still has a slight hangover. The Nikkei was near 40,000 at the beginning of 1990 and is currently 1/3 that level. The Dow was back to 50% of its 1929 value after 18 years. Yes, hardly a huge difference. And a very good reason to be owning Japanese stocks right now.


Japan continues to have sub 3.0% growth rates and with high oil prices and an aging economy that is likely to continue. The biggest difference between the two depressions has been the unemployment rates. The U.S. suffered through very high unemployment for a few years. The Japanese choice has been to freeze their capital markets to keep companies from laying off workers. These seems to be what the U.S. is doing right now. You can hardly blame the Fed for not wanting to return to 10% unemployment and all the suffering that would entail. But what is the cost? Below trend economic growth for the foreseeable future. What the Bailout school also offers is the risk that increased liquidity will be used to start another bubble. Perhaps a commodity bubble which would be a bubble which benefits a very small segment of the population and is very unpopular.

So the choice is low economic growth for a long time or a short period of high unemployment. Again, it's a no win situation. The Fed and Treasury and most of our gov't economic elites rather spread the pain over time. A muddle through economy is less likely to stir voter anger and that means politicians don't have to worry about revolutionary changes. I have gone back and forth on this but with time I am quite sure that this is a huge mistake. I don't want to see a massive recession but it would be better than decades of low growth that will mean a declining standard of living for all Americans. Better to tear off the band aid and let the most responsible suffer. In the long run it will mean higher growth and standards of living and a more prudent financial system that will take the rest of my life to unlearn the lessons of over-leverage and speculative folly that are a part of the character of the post Great Depression generation.

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