Capitalism at Work

We made a brief trip back to France for a board meeting. Returning to London, people all seemed to be in mourning. Black is the color in London. Everyone wears black. Black pants, black skirts, black coats…

…the cabs are black…and so is the mood.

Last week, the Bank of England and European Central Bank announced new initiatives aimed at putting some brighter colors in the economy. Both banks are going to take up forms of QE – quantitative easing.

Whoa…don’t touch that dial! (A reminder for younger readers: TVs and radios used to have dials, which you turned to change the channel. Announcers would begin with ‘Don’t touch that dial’ when they had something important to say.)

We’re not going to discuss QE – promise!

On Friday, for the benefit of new readers, we were trying to explain The World According to The Daily Reckoning. Today, we continue our explanation – partly to bring new Dear Readers into the picture…and partly to remind ourselves what the hell we’re talking about.

On Friday, the Dow rose 164 points. The rally is still going on. Markets make opinions, say the old timers on Wall Street. After nine weeks of rising prices, people are beginning to see the world differently. To simplify: it doesn’t seem nearly as bad a place as it was a few months ago.

Oil has risen to $58 a barrel. The dollar has fallen to $1.35 per euro. And gold is at $914.

Even house prices – while not actually rising – are not falling as fast as they were before. And while people are still losing their jobs, not as many of them are losing their jobs each month as did earlier in the year.

This has led many commentators to believe that government’s expensive bailout/stimulus efforts are finally working.

Toward the end of last year, the days were getting shorter and shorter. Darkness covered the land – especially in Iceland where, even in the best of times, late December offers barely enough daylight to smoke a cigarette.

And then, the authorities got up to their usual antics. They bailed out some companies…lowered interest rates to zero…and shored up the financial sector – which just happened to have very good representation in the government and its central bank – and saved the bondholders from getting what they had coming. Meanwhile, the feds made sacrifices to the market gods too. Unable to find any virgins in the financial sector, they threw the taxpayers down the well. And then they went after the savers (admittedly, there weren’t many of them) and the next generation too.

At first, it seemed as if the feds had failed. Then, gradually, the light increased…the days grew longer.

And now, the mob screams: “The worst is over!” “We’ve seen the bottom.” “Hoorah for the feds!”

But it is not likely to be so…

Here we give you the first of four Daily Reckoning dicta:

People do not get what they want or what they expect from the markets; they get what they deserve.

Of course, people would like the downturn to be over. Many are counting on it. But Mr. Market doesn’t give a hoot. He’s got a “Capitalism at Work” t-shirt on and a sledgehammer in his hand.

What’s he up to? He’s demolishing a quarter century’s worth of mistakes. There are always mistakes made. Investments go bad. Businesses go under. People go broke. When many mistakes are corrected at once, it’s called a ‘recession.’ And when an entire economic model goes bad, it’s called a ‘depression.’

The economic model of the last quarter century caused more mistakes than usual. It encouraged people to spend, borrow, and speculate. And each time Mr. Market tried to make some corrections, the authorities came along with more money and easier credit. Businesses that should have gone under years ago kept digging themselves in deeper. Homeowners kept running up more debt. Speculators kept taking bigger and bigger gambles. Altogether, total debt – a measure of the bubble in the credit markets and all things associated with it – rose from only about 150% of GDP when the Pontiac GTO came out, to 370% during the Hummer and Prius years.

Fish gotta swim, birds gotta fly, and bubbles gotta blow. The bubble in the financial sector – including subprime debt, housing prices, bonuses on Wall Street and derivatives – hit the fan in 2007. And what a mess!

And why shouldn’t it be? Which brings us to the second of our dicta:

The force of a correction is equal and opposite to the deception that preceded it.

The delusions and absurdities of the Bubble Epoque were monstrous. Naturally, the correction must be huge too. World stock markets were nearly cut in half. Property prices too have been knocked down almost everywhere. The total loss of nominal wealth has been estimated as high as $50 trillion.

In today’s paper, we find that Buffett’s company, Berkshire Hathaway, made its first loss since 2001. Thirty-three banks have been shut down this year. America’s leading banks say they need another $75 billion to keep their doors open. And Fannie Mae said it lost $23 billion; it will need $19 billion more to continue jiving the housing market.

Could these losses have been prevented?

Ah…certainly many of them could. If the U.S. Congress had never created Fannie Mae, for example, it never would have distorted the mortgage market as much as it did. And if the feds hadn’t created the Federal Reserve Bank, it couldn’t have provided so much ready money for so many speculators and borrowers. And if the Fed under Alan Greenspan had done what it was supposed to do – that is, to “take away the punch bowl” before the party got out of control – the bubble in the financial sector probably would have been much more modest.

Of course, people drew all the wrong conclusions. They thought “capitalism failed.” They saw the car drive off the cliff…but didn’t notice how government had twisted the road signs. Instead of warning investors of the dangerous curve ahead, the Fed’s low lending rates said: ‘Step on the gas!’

We all know the story from there…

Dictum number 3: Capitalism doesn’t always take an economy where it wants to go; but it always takes an economy where it ought to be.

Whoever was responsible for the mistakes, capitalism went about correcting them with its customary élan. It hit imprudent investors with trillions in losses. It knocked down mismanaged corporations. It whacked homeowners…and pounded housing-based derivatives to dust.

Capitalism operates by a process that the great economist Joseph Schumpeter called “creative destruction.” It destroys mistakes to make room for new innovations and new businesses. Unfortunately, this puts it at odds with government…and what most people want. When people make mistakes, they maintain that they are blameless (“who could have seen this crisis coming?”) and that someone else should pay for the loss.

So today, the feds, who mismanaged their regulatory responsibilities during the Bubble Epoque, are bailing out mismanaged corporations in order to protect lenders who mismanaged their money. They are determined to prevent capitalism from making major changes – in the worst possible way. What’s the worst possible way? Simple. Leave the mismanagers in place. Keep the brain-dead companies alive – along with the zombie banks. Let the government take ownership of major sectors of the economy. And stick a debt-ridden society with even more debt! The feds are expected to borrow $2 trillion this year alone. From whom? And who will repay it?

And the fourth dicta: The severity of a depression is inversely correlated with government’s efforts to stop it.

The more the feds try to delay and distract the process of creative destruction, the longer it takes to get the job done. And the higher the eventual bill.

There are only two fairly clear examples in modern history. After the crash of ’29, the Hoover and Roosevelt administrations tried desperately to stop the correction. They could not make bad debts disappear, nor turn bad decisions into good ones. All they could do was to retard the necessary corrections – and cause new mistakes! It wasn’t until after WWII, 15 years later, when the New Deal was largely forgotten, that the United States got back to work. Similarly, when Japan was confronted with a major correction in 1990, its politicians followed the Hoover/Roosevelt model. Over the years, an amount equivalent to almost an entire year’s output was applied to recovery efforts. But all they did was to prevent and forestall the needed changes. Now, 19 years later, the Japanese economy is still in corrective mode.

Tomorrow…beware the suckers’ rally…

Uh oh…we might be next. The U.K. government has published a list of people it won’t allow in the country. The list includes some terrorists…but also conservative U.S. talk show host Michael Savage.

The idea, as near as we can make it out, is that Britain feels it can exclude people who nurture hatred.

So, let us make it perfectly clear: Here at The Daily Reckoning we do not hate bankers, politicians, lawyers, bureaucrats, tax collectors, gypsies, slow drivers, rich people, snitches, women, dwarfs, English twits or anyone else.

Nor do we advocate the use of violence in any form – unless it is necessary…and unless it is against small, defenseless little nations that can’t fight back.

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning