Things are Different Today

In recent weeks I have read several reports which have been decidedly gloomy. The authors would probably concede that the pictures they are painting are not cheery, but do give some reasons for which to be hopeful. However, their reasons for having hope focus on the accommodative policies which have already been undertaken by the Fed and the future effects of government stimulus. Is it that some economists and strategists do not understand how and why the economy has declined to such a distressed state?



That is unlikely, it is more likely that economists have nothing else on which to fall back, but the hope that policies which have successfully stimulative in the past will once again be effective. That to me is disturbing. It is disturbing because the stimulative policies of the recent past focused on making borrowed capital more affordable. Such policies never solved the problem, they only masked the problem. This is akin to warding off a hangover by becoming drunk again at the onset of a headache. If one can stay drunk, one never has to experience a hangover. That is until either one runs out of alcohol or dies of alcohol poisoning. The economy has run out of alcohol.





Let’s go back to early 1980s. The economy was mired in a morass of no growth due to high taxes, inflexible labor laws and prohibitively high inflation. Then Fed Chairman Paul Volcker correctly identified high inflation pressures as the culprit for the stagnant economy. Contrary to recent Fed policy he raised interest rates to stimulate the economy. The plan was to combat inflation by making it prohibitively expensive to borrow. Mr. Volcker made it difficult to lever up. That the resulting recession was necessary as it reduced demand to the point where inflation was defeated. Once inflation was defeated, the economy began a long, steady march upward.



All was fine through remainder of the 1980s. Yes there was the 1987 market crash and a recession in the early 1990s (exacerbated by the First Gulf War), but the economy experienced steady growth with mild periodic corrections. However, after the 1980s rapid recovery from the malaise of the 1970s, the public expected strong growth all of the time. Slow growth and recessions were considered the result of failed policies and not of normal economic cycles. Thus, the Fed would lower rates aggressively to stimulate the economy. The culture of borrowing was born of affordable leverage.



To the delight of consumers, free trade policies, welfare reform and an explosion of technological advances combined to have a turbocharger affect on the economy. By late 1999 public perception that the tech bubble was the new reality. Every venture with “dot com” in its title was considered can’t-miss business idea. Actual earnings or business plans (many ventures had no business plans) were of little concern to the new dot-com investors. Newer financial advisers were also sucked in. Investors of all ages loaded up on tech.



Former Fed Chairman, Alan Greenspan’s warning about “irrational exuberance” went on heeded. When he saw the economy overheating due to preposterous investor expectations he increased interest rates. That removed leverage from the economy keeping many investors on the sidelines. Companies found venture capital more difficult to obtain. Without additional venture capital, many dot-coms failed as they were never able to generate a profit. This caused the markets to take a closer look at the tech sector. What they found was a sector littered with bad businesses. As should happen in a free market economy unviable businesses were permitted to fail. Of course the public saw the bursting of the tech bubble and the following recession as a failure of policy rather than what it really was irrational behavior on the part of investors. Business (and personal) failures are normal parts of life, except when people are told that they are not.



The recession of 2001 was blamed on the new president because it made for a good sound bite. Political pundits began telling the public that they deserved a return to a “healthy” economy like they had experienced in the late 1990s. People bought into the idea that double digit growth and windfall investments were normal!



As it had done since late in the Paul Volcker era, the Fed eased to stimulate the economy, stimulation via cheap borrowing. Fed Chairman Alan Greenspan became concerned that although business activity increased, job growth remained modest (the so-called jobless recovery). Modest job growth was due to productivity gains resulting from technological advances and globalization. Fewer workers were needed to produce the required goods and service for a given amount of economic growth. That answer was politically unacceptable.



The Fed began a strategy of supercharging the economy by bring the Fed Funds rate to 1.00% was, in affect, a negative interest rate as it was below the rate of inflation. Even investors who had to pay higher-than-typical interest rates were borrowing at historically low rates. Combine that with the banks’ ability to bury exotic and subprime loans into AAA-rated securities and the recipe for disaster was not only on the stove, it was coming to a boil.



We all know what happened next. We are living it right now. What many of us many not realize is that we are not experiencing a collapse of our capitalist system (take that George Soros), but a reversion to an economy based on fundamentals and prudent lending. The last to booms (bubbles) were unsustainable economic aberrations. Efforts to re-inflate the bubble via the traditional policies of easy money have proved unsuccessful. Some businesses (possibly some banks) may fail. Many homeowners will lose their homes. These are unfortunate, but necessary occurrences. The leverage binge is over. The sooner we deal with the headache and move on the better.