Monday, November 1, 2010

"Don't Fire Until You See the Whites of Their Eyes"

In many ways this single quotation sums up much of what makes America great. At Bunker Hill, a group of American soldiers facing a much better armed and trained British force, rather than doing the easy thing – panicking, firing haphazardly, and scattering in the wind - braved their challenge, inflicting 3 times the casualties on the ‘superior’ British force and helping set the stage to win the war! They faced adversity, didn't ask to be coddled, didn't need things to be easy, and ultimately after much hardship, emerged from the war victorious.

What does this have to do with the economic situation of today? We have become a land that does not believe in adversity or in suffering through pain. We want our politicians and central bank to do everything they can to make problems go away – and go away NOW. Do we really care about the long-term consequences? We all say we do, but the reality is we are unwilling to accept anything bad right now to reduce adverse long-term results. If we had been on Bunker Hill, maybe instead of having midterm elections this week, we would be arguing whether the Tories or Whigs are better representing us in parliament.

Mr. Bernanke is a scholar and expert on the Great Depression. But what does that really mean? That is he has analyzed what was done, and of that, what did and did not seem to work as expected. The problem is that although economics has a lot of parallels with hard sciences (math, statistics, data), it is simply not like physics or chemistry. Hard sciences are based on making detailed theoretical predictions that can be tested in the real world. Soft sciences use a “control” group concept. In economics, neither concept is possible. It is impossible to know what the real cause and effect are. You cannot know that one action led to one result and that another would have led to a different result. You can theorize, and make intelligent arguments, but it is not provable. There were never two identical economies in similar amounts of distress where stimulus was supplied in one but not the other. Or where trade barriers went up in one but not the other. Nor where currency was recklessly devalued in one but not the other. The best one can manage in studying economics is to analyze what occurred and make conjectures as to why things happened. But those conjectures cannot be tested nor even compared to something similar. This means that to some extent we are just guessing at what could have been done differently and what the results would have been.

The consensus seems to be that in the Great Depression not enough was done soon enough. That seems plausible enough, and it is a hypothesis that fits well psychologically with the “feel no pain” culture we currently enjoy. It is also arguable that the problems were so deep that nothing done during the Great Depression had the desired impact, and only World War II dragged the economies out of the morass. But it is also possible, maybe even equally plausible, that had money been thrown at the problem hand over fist in the beginning of the Great Depression, its initial stages would not have been as bad, but that it also would have dragged on longer as the early stimulus masked the symptoms of the disease? Or that stimulus could not be applied effectively until time had done a lot of the work to correct many of the problems by stabilizing the economy at a new lower balance. Or that trying to keep the economy at an artificially high level early in the crisis would make later interventions ineffective.

Doctors know that you can't give morphine to every patient for every type of pain. They know that over time the efficacy diminishes (and it is addictive), so they reserve it for extreme emergencies. Even something as simple as antibiotics needs to be rationed out of concern of encouraging the development of resistant strains. Why is there so little fear that we are wasting our ammunition early in a long, and sadly normal, phase of deleveraging during which we have to learn to live within our means and also within the context of how the rest of the planet lives?

Clearly early government intervention helped in the current crisis. The economy undoubtedly would have hit a lower level had the government not spent so much money and implemented so many policies. But the early intervention might well have been a Pyrrhic victory – the economy did not collapse as much as it would have but it might well have forced resolution of problems that are still there and that are preventing a healthy recovery accompanied by real reduction of unemployment. Maybe we would have that money to use now, and maybe we would have more faith that government intervention accomplishes its stated goals and that politicians are acting to promote better lives for us rather than their own careers. Maybe with more time to plan and think, we would have implemented far better policies that gave a much bigger bang for the buck. So yes, the economy could have been worse than it got, but it is possible that today it would have been in much better shape for it.

Traders have stop losses, at least in part, to deal with the fact that when you are losing money you often do not and cannot think clearly and thus make bad decisions. So you force yourself out of the position and hopefully into clearer thinking. The government works in the exact opposite way. It only rushes in to get things done when things are bad and when no one is left thinking straight. For instance, there seems to be universal agreement that letting Lehman fail was bad, but at the time there was strong agreement that it was right to save Bear Sterns. Bear was much smaller than Lehman. It would have been ugly to let Bear go, no doubt, but not as ugly as Lehman, and possibly the decision to let Lehman fail might never have had to come up if everyone learned the lesson from Bear. With the relief after the Bear bail-out, everything went back to business as usual without anyone trying to use the “bought time” to fix the problems of the other investment banks.

Poverty has always existed in the US, and for many people life has become much worse than it was before the housing bubble burst and years of living beyond their means came crashing down on them. But sometimes it seems that we have more people with 40-inch flat screen TVs whining about how unfair the system is than China has people with 40-inch TVs. In a larger context, life in the US is not so bad, and maybe we need to establish a new baseline. It is hard to admit, and particularly hard for a politician to get re-elected admitting, that we have a lot of pain to endure as a result of consuming so much for so long. TV personalities can snicker at how the French are striking because the retirement age is increasing to 62 from 60, but turn red in the face with self righteous anger at thoughts that the Bush tax cuts to people making over $250,000 won't be extended.

Every proposal to spend NOW is accompanied by talking about how we will fix our problems LATER, when times get better. What if we have not yet hit the lows? What if the new normal is not going to allow that? Even Basel III gives the banks 5 years to fix things! Are we so worried about bank stock prices that we do not want them to recapitalize as needed before then next crisis hits? Why do we assume that we have 5 years to fix that? We are not out of the woods, and blithely assuming that at some point in the future things will be better and we can pay for what we are doing seems naive and even dangerous. Just keep doubling down, eventually you'll win, right? We all know that the doubling down, when it doesn’t work, is far far far worse than having just fought through a losing position.

Maybe all these points are moot, as we are in expert hands after all. But, as already stated, economics is not like the other sciences. There are no experiments that can test a hypothesis and then be replicated. There is no way to know what would DEFINITIVELY work, what would not have worked, and whether what was done was harmful or actually optimal in the long run! It is as much about individual and group psychology as it is about data and statistics and rigorous sounding pronouncements. In what other “science” is there one M.M. who was awarded a Nobel Prize for ‘proving’ capital structure does not matter, while another M.M. built two substantial fortunes, at least in part, on the presumption that capital structure DOES matter! It is not clear that anyone knows the right thing to do, but it is clear that spending all your ammunition up front with nothing left in reserve is the wrong approach.

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