The biggest lesson from Europe

Six central banks -- the ECB, the US Fed, the Bank of England, the Bank of Japan, the Bank of Canada, and the Swiss National Bank -- rushed in to the European crisis today by taking steps to ensure liquidity for banks (essentially, lowering the cost of lending backstops that European banks can use as a source for short-term liquidity).

This was obviously a coordinated plan that had been prepared beforehand, probably for use in the event of real emergency (the collapse of a major European bank, for example, as Jim Cramer speculated this morning on CNBC). It is thus another example of "too big to fail" in all likelihood.

Before anyone explodes in anger at yet another example of those now-hated words (which have become so well-known that they are sometimes simply abbreviated TBTF without needing explanation), let's ask a few questions about why too big to fail has become the order of the day.

There is a line of argument which says that no bank should be "too big to fail," and that if banks make stupid loans, they should pay the price and go bankrupt if those loans don't pan out. After all, if those loans do work out, the banks get the profit, so why should they get the profit when their risky loans turn out well, but spread the cost of their failure to everyone who pays taxes, or to everyone who is forced to use a currency that is devalued over time?

However, there is a problem with this line of argument. For one thing, there is the moral problem that arises from the fact that the banks were often forced into making some of those risky loans in the first place (by governments, who have plenty of leverage over banks and can make life unbearable for them if they don't make loans to people or countries that the government wants the banks to loan to).

You can decide for yourself if it seems right for governments to coerce banks into making risky loans, and then to stand back when the loans go sour and shake their heads and say, "Well, I guess you never should have made those risky loans -- now you have to pay the price, by the laws of the free market!" We can look back in recent history and see plenty of examples that follow the same exact pattern.

Everyone in the US is angry that the government "bailed out" banks who held lots of subprime mortgage securities, but the citizens shouldn't be too angry, since they elected the government officials who passed laws forcing banks to loan to less-than-creditworthy borrowers (Congressman Barney Frank, who recently announced his retirement, was one of the primary culprits in pressuring the banks to loan to borrowers they would not otherwise loan to, and he will be replaced as the ranking member of the House Financial Services Committee by Representative Maxine Waters, who was just as aggressive).

Similarly, during the Latin American debt crisis of the 1980s, US banks had been told by the US government to lend at below-market rates to Latin American nations such as Mexico, Brazil and Argentina. When those countries found that their income (in the form of taxes, which come from the earning power of their businesses and the earning power of their citizens) was not enough to pay for the interest on the debt they had racked up, it would not have been right for the US government to simply let those banks swing as a penalty for lending to risky borrowers. They were forced to lend to those risky borrowers.

The same scenario is now playing out in Europe.

Further, while it does impress some people to talk tough and say, "I wouldn't lift a finger to help these banks -- they need to learn their lesson," the problem is that "teaching the banks a lesson" could entail collateral damage that goes far beyond the banks and causes severe harm to many innocent bystanders. Is "teaching the banks a lesson" worth the risk that ordinary citizens might be unable to access money that they have in money market funds for an unknown period of time, for example? If ordinary citizens can't access their money, it would cause all kinds of disastrous problems for families and small businesses. Is that a worthwhile price to pay in order to "teach those banks a lesson" about loaning to risky borrowers (especially when the government made those banks make a lot of those loans in the first place)?

To take this position is almost equivalent to saying, "If kids are playing with matches, you have to let them burn down the house sometimes -- it teaches them a lesson -- and that's just tough if they get burned to death in the process, along with a few of the neighbors."

The bottom line of all this is the fact that "you can't have just a little bit of socialism."

When governments interfere with banking, even if it's just a little bit, it eventually results in situations just like the one that is unfolding right now in Europe. First, the government meddling tends to result in expanded lending activity to borrowers who would not otherwise get loans (and at terms that those borrowers would never be able to get under a purely "free market" situation). This happens both because governments feel they can tell banks to whom they should loan and also because banks become more willing to lend to people or governments they would not otherwise lend to, as long as the government promises to pick up the tab if those loans don't work out (have a look at our previous post on the Solyndra debacle, for a recent example).

After the first result (expanded lending to people and/or governments who would otherwise not get loans, or who would otherwise have to pay a lot more for those loans), the second result is rather obvious. When all that artificially-expanded credit begins to go sour, the government sails in with other people's money in order to prevent the whole house from burning down. Once even a "little bit of socialism" gets added to banking, TBTF becomes an inevitable acronym of banking.

The sad fact of the matter is this: there is a market rate for borrowing that is based on creditworthiness, and if you want to subvert that rate, you will end up with inevitable losses. Loaning lots of money to people or nations with terrible credit histories will always mean that some of it is lost, and if you don't charge them high enough rates to cover those losses, you will have to get the money from someone else to cover those losses. The place that governments get that money is obviously from everybody else, either in the form of higher taxes or in the form of inflation and the slow loss of their purchasing power over time, or both. As Milton Friedman famously said numerous times, in economics there is no free lunch.

Yesterday we published a post about some other lessons from the current European crisis, but we believe the topic of this post is the biggest lesson out of the entire European situation. We have been talking about today's action which was probably taken to prevent a bank failure, but the question of government involvement in banking, lending, and bailing out is related to what we have called "the question of our time," because bloated spending by governments is directly connected to easy credit and borrowing, interference in banking, and ultimately the devaluation of currency. The pensions and other government entitlements that some Europeans have been enjoying on borrowed money are now going to be paid for by everyone else, but this should not come as a surprise.

Once people, through their elected leaders, decide to abandon the principles of free market capitalism, the socialization of losses and "too big to fail" become inevitable consequences. Everyone pays.

Another lesson from Europe

Over the Thanksgiving weekend, data for shopping activity in the US blew away the forecasts of most economic prognosticators. Sales for the full weekend (from Thursday to Sunday) were up 16.4% over the previous year -- an astonishing increase and an all-time record in terms of dollar value spent during the period.

This data should indicate that the US is not in the middle of a Great Depression, in spite of the constant pessimism on display throughout the financial media and the confident predictions by numerous pundits over the past six months that a double-dip recession was on the way. We have been on record opposing the pessimistic conventional wisdom about the economy for some time now see here and here for example), so we were not at all surprised by the strength of the numbers.

We'd like to go out on a limb a bit and suggest that the conventional wisdom over the European debt crisis may be overlooking some positive angles there as well.

One of the most consistent themes among commentators on the European debt crisis is the refrain that Europe is a preview of America's future -- that the US is resembling Europe more and more, and that if we're not careful, we will end up like Greece or Italy (in some cases, the argument is made that the US will end up like Europe no matter what -- it's too late to avoid the fate of Greece, and the only question is how long it will take).

For example, here is an article published earlier this month by Dan Mitchell of the Cato Institute and the Center for Freedom and Prosperity, entitled "US should learn from Europe's Welfare State Mistakes."

We agree with Dan Mitchell on just about everything he says or writes (you can see previous posts stretching back for many years in which we have cited his work or embedded his videos, for example here or here). We even agree with the arguments he makes in this article, to the degree that entitlement programs in the US (particularly Medicare but including a host of others as well) are unsustainable, and that planned entitlement program expansions will bankrupt the country if they are not fixed.

However, we do not agree that the only important lesson of the European debt crisis is that the US needs to learn from Europe's woes. In fact, we would be so bold as to suggest that this crisis has been beneficial in revealing that Europe needs to learn from the US, and that some of the early indications appear to show that Europe is learning from the US model and may be moving in the right direction! How's that for an opinion you aren't hearing in any other financial commentaries or analyses?

For starters, Europe created a common currency (the euro) in order to try to have the same kind of commonality enjoyed within the US (a worthy goal -- can you imagine how difficult and expensive business would be if California, Virginia and Alabama were each able to print their own money and pursued different monetary strategy regarding the strength or weakness of their currencies?).

However, they created that common currency without any sort of fiscal unity, so that member states were left to their own devices on questions of how much they could spend on welfare programs and other budget items, as well as on questions of how to raise taxes to pay for that spending. Predictably, some member states were more responsible than others, and they have started to get upset about the fact that they are now having to bail out the irresponsible parties without any mechanism for changing the profligate behavior of their more irresponsible neighbors.

In the US, there is a governing body that is capable of imposing a unified tax-raising policy on all the member states -- it's called the federal government. The unified tax-raising policy may be inefficient and byzantine (as we have argued in other previous posts, such as this one and this one), but that is a very different problem than the one that the more financially responsible European states are currently facing as they prepare to bail out their less responsible neighbors.

Even more importantly, one of the most important lessons of the European crisis is the need to enable innovation and economic growth within an economy. The countries in Europe that are having the biggest problems paying their debts are those which make very little money, because they have built economic systems that stifle innovation and make business difficult. Those that are in better shape -- and Germany is in the best shape of all of them -- are the countries that have boosted production and economic growth by getting out of the way of businesses.

In other words, it is true that if you have too much credit card debt, one thing you should do is start spending less (and America certainly falls into this category). But the other solution is to start making more money, and the way to do that is to create an environment that allows for innovation and business growth.

In this regard, our assertion that Europe can learn from the US is perhaps most telling. Even Germany's economic growth is somewhat anemic by US standards. Even with the increased regulations and government intrusions that have blighted the US economic landscape over the past eleven years (starting with Sarbanes-Oxley and accelerating through Dodd-Frank), the US remains an easier place to start a business or pursue a new innovation than almost any one of the European nations. We may have compared California's self-inflicted economic woes to those of Greece in previous blog posts such as this one (and they are similar), but the difference is that Greece does not have a Silicon Valley that produces much of the world's most innovative technologies, nor does it have a Hollywood that produces much of the world's entertainment content, nor does it have a Great Central Valley that produces much of the world's food.

So, we would argue that the lessons of the current European crisis do include the warning that many have sounded, about the dangers of the US heading further in the European direction. But, we would also argue that an important lesson, and one that many appear to have overlooked, is that Europe really needs to move more in the direction of the US.

If Europe really wants to foster the kind of economic growth and innovation that it needs to get out from under the credit problems some of its member states have created, it should look at steps that will create a uniform business-friendly environment throughout the continent, with relatively lower levels of government spending, lower levels of regulation, lower barriers to the ability to start a company, and more fiscal unity providing methods to impose discipline on countries that don't play by the rules.

We realize that Europe is an incredibly complex region and that getting to such a state of affairs may be impossible, and would certainly be extremely difficult even if all the member states decided that it would be a good idea.

The good news is that some in Europe appear to have gotten this message, and are making some real steps in that direction.

This is a very big topic and cannot be completely addressed in a short blog post, so stay tuned for more discussion on the subject in future posts.

Happy Thanksgiving 2011

We would like to take this time to wish all of our readers a very warm and happy Thanksgiving. This of course includes our readers around the world, who can also share in the special message of this most American of annual holidays, wherever they may be.

As always, Thanksgiving is an opportunity to reflect upon and be thankful for the blessings in our lives.

In the United States, we certainly have an abundance of things to be thankful for, chief among them being a system which preserves human freedom and thus allows individuals to try to improve their situation by starting businesses, changing jobs, gaining new skills, and otherwise working to make things better. The byproduct of the free choices of individual Americans over the centuries has been a host of innovative products and services, new companies and new industries, medical cures and bounteous farm produce, all of which have enormously improved the world and created more wealth and prosperity than has ever been seen in human history.

Thanksgiving reminds us of this fact, and the humble origins of the holiday itself remind us that none of this was automatic: the first Thanksgiving on these shores, in 1621, was celebrated by a band of Plymouth Bay pilgrims who were not guaranteed of anything, including continued survival, and who would probably not have survived had it not been for the techniques taught to them by the Wampanoag Indians who were also present, and who brought the main course.

All of this is doubly pertinent this year, coming on the heels of nationwide protests by many who appear to be either misinformed about the freedoms that create such economic progress (and we would argue that the ability to start companies with limited liability, and the right to pay employees including CEOs as much as you want with privately-owned money fall into the category of "freedom"), or who are openly hostile to systems that give individuals and businesses such freedoms and who would rather have a system in which government bureaucrats or other dictocrats tell people what they can and cannot do instead.

We recently saw a video from a commentator named Bill Whittle, who with cutting insight suggests that the very prosperity that our system of freedom has created may in large part have led to the entitlement mentality so visible among many of the recent protestors. He proposes that some real exposure to the elements for just a few days each year might lead to a real change of views, and his arguments make some pretty good points about the benefits we often take for granted.




It occurs to us that the message of Thanksgiving is nearly the exact opposite of the mentality of "entitlement." We hope that perhaps the annual observation of Thanksgiving will renew the wonder we should feel at the incredible bounty that the attempt (however imperfect) to institute a system based upon human freedom has unleashed since America was founded.

For readers who would like to revisit our previous four years of Thanksgiving messages on this blog, you can do so by following these links: 2010, 2009, 2008, 2007.

We wish you all a very wonderful Thanksgiving.

I'm glad I actually opened my account statement!

Anecdotally, we have now had more than one private client call us to say something along these lines:

"I was afraid to open my statement, knowing that things must certainly be going off a cliff, and when I finally did look at it, I was surprised to discover that things were far better than I imagined!"

Why would clients be so afraid to look and so sure that everything is "going off a cliff"? No doubt this feeling is due to the constant barrage of negative news coverage served up by the financial media for the past three months. Of course, the vicious market sell-off that accompanied the initial crescendo of fear during the month of September and into the first few days of October didn't help either. However, clients are surprised to learn that major market indices such as the S&P 500 are actually positive for the year right now (see this page for S&P data, for instance).

The financial media has a tremendous bias towards accentuating a perceived crisis -- any crisis -- because they know that such reporting drives viewers to stop what they are doing and hang on every word out of the media talking heads. This trend has been going on for some time -- since the dot-com crash, in fact. Before that (back in the 1990s), the financial media took almost the opposite tack and attracted viewers by reporting with wild optimism. We believe this trend is extremely dangerous for investors, because it gives them a false view of reality. The anecdotal comments we are hearing from clients, described above, appears to support this conclusion.

The economic data, as well as corporate earnings at many businesses, tell a very different story. All sorts of measures indicate that the economy is not going off a cliff but is in fact growing modestly (some businesses, of course, are not growing, while others are growing quite rapidly, particularly if they are involved in certain industries that are undergoing major paradigm shifts).

We have been cautioning investors on the pages of this blog for some time now that the dire predictions of many media pundits and market commentators are overblown and overly pessimistic (see here and here for some examples). Pessimism is in vogue right now, and optimism is out of fashion. However, we believe it is very important for investors to tune out the financial media and focus on actual business measurements. In fact, we have always said that trying to time economic ups and downs is folly anyway and that investors should focus on business fundamentals rather than economic predictions.

Certainly economic growth could be much better than it has been in the almost three years since the 2008-2009 recession began to turn around, and growth has been hampered by a host of government intrusions and mis-steps that have hurt everyone. However, the constant flood of financial negativity that has been hitting citizens from virtually every angle lately has created a perception in most people's minds that is entirely different from reality.

This is a very important topic and deserves careful consideration.

Why you can't pay off your home loan with Monopoly money

First Trust Chief Economist Brian Wesbury recently published an outstanding one-page explanation of some of the underlying issues surrounding the ongoing eurozone debt crisis.

Entitled "The Drachma is Dead, and so is the Welfare State," it is an excellent primer on the topic of strong currencies versus weak currencies.

For those who might be wondering why Europe doesn't just kick certain countries out of the eurozone and let them go back to their old currencies (such as the drachma for Greece), Mr. Wesbury abundantly illustrates why that is not an option. Those who suggest such a remedy are implying that if Greece had their own currency, they could inflate it to help pay off their debts -- the reason Greece is in such a jam is that they cannot use this common method sovereign governments (including the USA) use to escape debt. The problem is that lenders to whom Greece owes money would not accept drachmas as payment for loans that were made in euros.

It's the same reason your bank won't let you pay back your home loan with some unreliable currency, such as Monopoly money: they don't have any way to be sure you won't go print out a bunch more of it, leaving them stuck with worthless dollars in return for the real dollars that they loaned to you. (Lenders wouldn't mind accepting Monopoly money -- or Greek drachma -- for debts, as long as they were tied to something that you can't print out at will, such as gold).

Mr. Wesbury's piece also gets to the deeper issue behind this whole drama: the question of whether the unsustainable costs of excessive welfare and government giveaways should be borne by everyone, or by those who depended on the government for guarantees and promises that proved to be too optimistic. For it is when governments inflate their currencies that their money-creating ways drive the cost of everything higher, slowly taxing everyone using those currencies. This approach especially hits hard those who save money only to find it worth less when they want to use it.

He points out that the choice most governments take is pretty obvious -- in the second choice, governments would have to admit that they were wrong, and take the anger of those who trusted them, while in the choice of debasing the currency, governments can blame markets, bankers, and the financial institutions that seem to be raking in money while everyone else suffers.

This deeper question does not face those in Greece, Italy, or even Europe alone: the United States and just about every other western country is facing the same question in one form or another, as the costs of guaranteeing more and more payouts to more and more citizens are shown to be a weight that no government can bear.

Financial innovation is largely bunk

Here's a conceptual diagram of all the companies listed on the NYSE from September 2006, grouped by sector and sized according to market capitalization (value of the companies).

It is roughly based upon the excellent "map of the market" tool that is available to look at on a daily basis in the "Market Data Center" section of the Wall Street Journal. You can go over right now and see what it is doing today by following this link.

The point of showing the sector weightings from September 2006 is to illustrate the size to which the financial sector had swelled at that point in history -- in fact, to the point that it was the largest sector in the entire economy, by a large margin. In other words, at that particular point in time, the financial sector was 22% of the entire economy by market capitalization, meaning that an awful lot of capital was flowing into that sector -- not only monetary capital which can be measured on a chart of the market capitalization of different companies but also "human capital" in the form of individuals choosing to pursue careers related to finance, and students choosing to pursue degrees related to finance, etc.

As you might imagine based on the world events which have taken place since September 2006, the size of the financial sector has deflated somewhat since the days when its size dominated the rest of the economy by a wide margin. A simple visual inspection of the map of the market using the above link will verify that.

A visit to the data available at Standard & Poor's about the capitalization of the S&P 500 by sector (a slightly different group of companies) reveals that companies categorized as financial now make up only 14% of the economy (as of November 08, 2011). Financials are no longer the largest sector (that honor now belongs to companies categorized as "information technology"), although they are still the second biggest sector, and their relative footprint is now much closer to the third-place sector -- energy -- which used to make up only 9% to financial's 22% and which is now roughly the same size as the financial sector at close to 13%.

We would argue that this is a very revealing exercise, because we believe that the amount of capital (both monetary capital and human capital) that was pouring into the financial sector prior to the collapse of 2008-2009 illustrated a disastrous "over-valuing" of what we might call "innovative" financial products and services (more on that term in a moment). Even with the reduction that has taken place, this sector is probably still too much of the economy, although at least the trend seems to be moving in the right direction.

Now, as professional money managers and therefore members of the financial industry, the above commentary might seem confusing, especially as we just finished explaining how important the ability to buy and sell shares in a public market is to the economy in general, and defending the financial sector's valuable role of enabling pools of capital to become available to entrepreneurs and businesses who need it. We wrote that defense in light of some of the misguided attacks of the Occupy Wall Street movement, which appears to have banks, the exchanges, and the concept of legal personhood for corporations as its prime targets -- all institutions which play a valuable role in the critical allocation of accumulated capital to business.

The argument we are making when we say the financial sector's footprint became way too large and absorbed way too much human capital is the argument that financial companies moved far beyond the connection of capital with business and into all kinds of "financial innovation" and "financial engineering" of dubious value.

Much of this "innovative finance" was not only of dubious value but was harmful and played a role in creating the conditions that led to the financial implosion that followed. We have made this argument in numerous previous posts, including "The ideology of modern finance" and "Professor Amar Bhide and his praise of more primitive finance."

In fact, we think investors might be well served by considering the possibility that finance itself is pretty simple and straightforward, and that its job is to connect capital with innovation rather than try to be innovative itself.

In many ways, the confusion between the two is evident in the turmoil dominating the news of late, including the European crisis, where investors are mainly focused on the woes of the financial sector and are largely missing the root problem, which is the lack of innovation and business growth in the other nine sectors of the economy.

This confusion manifests itself in the breathless worrying over whether Europe's banking woes will cause an economic collapse in the US. The storyline goes something like this: Europe's banks go into a state of shock because loans they made to countries such as Greece and Italy were unwise loans and the borrowers default; US banks which have dealings with European banks are unable to lend because of the crisis in Europe; therefore, US businesses and consumers cannot borrow, and US business and economic growth suffers or goes into another 2008-2009 panic and recession (or worse).

Our response is that, while it is true that finance touches every aspect of the economy because every business needs to use money and every business needs capital, the financial sector is not (or should not be) the dominant sector, and innovations in finance are not (or should not be) the innovations that drive an economy (see the discussion above). US businesses are generally flush with cash and many don't need to borrow a penny in order to grow and continue creating valuable goods and services for their customers. The 2008-2009 recession was not caused by businesses being unable to access capital, but rather by businesses picking up the phone and canceling all their purchasing orders for more inventory in the face of the implosion of Wall Street's financially-engineered innovations and in the face of a Rose-Garden speech from the President of the United States warning of a scenario that sounded like the end of the world (see this previous post for more on our view of the causes of 2008-2009).

There is actually quite a lot of real innovation going on in the US economy right now, innovation of the sort that adds real value and real economic growth, much as the computer innovation of the 80s and 90s added real value and real economic growth. We believe investors should understand the distinctions we are making in this post about the importance of connecting capital to real business innovation, and the dangers of pouring too much capital (monetary and human) into financial innovation.

We believe that over time, the problematic nature of much of what is called "financial innovation" will become more and more widely perceived, and capital will naturally flow towards real innovation and business growth. Investors who want to be there ahead of the crowd should be thinking about these things right now.

"Stop me before I ease again!"

Halloween is over, but that didn't stop markets worldwide from reacting in terror to the news that Greek leaders have decided to put their bailout up for a popular referendum, which is a little bit like asking a sick child to vote on whether he would like to take a bitter-tasting medicine or not.

The latest consternation arrives just in time for this week's meeting of the Federal Open Market Committee, which will announce its latest monetary policy decisions tomorrow. We hope that it will not encourage those at the Fed who want to introduce "QE3" or some other new form of monetary easing.

We believe the Fed's serial easing has already caused enough damage, and that more easing is uncalled-for.

Proponents of further easing argue that the stubbornly high unemployment rates, coupled with fears of another recession triggered by Europe's woes, necessitate pumping more money into the system in order to bolster consumer borrowing and spending, on things like homes and autos.

However, we have already explained in numerous previous posts that "the consumer" does not really drive the economy. If he did, the unprecedented amount of monetary stimulus that has been in place over the past two years might have been expected to have a lot more positive effect than it did.

On the contrary, we believe that production and producers drive economies. When producers increase their production, that prompts the hiring of more employees, which then stimulates the consumer much more effectively than artificial government stimulants can ever do. The Fed's excessive monetary easing has made life much harder for producers, by creating price instability and price uncertainty, which continues today (incidentally, this also ends up harming consumers because fewer of them get hired, and they also face higher prices for the goods and services they need to buy).

Noted Stanford economist John B. Taylor wrote an editorial in the Wall Street Journal today explaining the ways that the Fed's excessively easy policy has caused damage around the world. Some of them may surprise you because they are rarely explained by the consumer-centric media coverage that dominates the financial television shows. He explains:

Economic policies in America affect the world in ways that are often subtle. In the case of monetary policy, for example, decisions on interest rates by foreign central banks are influenced by interest-rate decisions at the Federal Reserve because of the large size of the U.S. economy. If the Fed holds its interest rate too low for too long, then central banks in other countries will have to hold rates low too, creating inflation risks. If they resist, capital flows into their countries seeking higher yields, thereby suddenly jacking up the value of their currencies and the prices of their exports.

While some might mistakenly believe that tilting the playing field in order to help one's own exports or harm another country's imports could be a good idea, we have explained in previous posts that such unstable business conditions make it very hard for producers to predict the future, lowering their willingness to hire employees and having a host of other negative side effects as well.

Further, with US GDP growth coming in at 2.5% for the third quarter, the argument that we are slipping into recession simply does not hold water, even though we believe that growth could and should have been a lot stronger at this point, if it were not for the misguided government policies that have been creating obstacles to business growth.

In sum, now that Halloween is over, we hope the serial "easer" that has been stalking the halls of American monetary policy for the past two years will not strike again.