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.

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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.

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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.

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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.

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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.

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