Shoveling Dollars Into A Bottomless Pit

By Colin Twiggs
February 26, 2009 9:00 p.m. ET (1:00 p.m. AET)

Thank you for the feedback on the new format. Roughly 9 out of 10 are in favor of the shorter newsletters. I will endeavor to keep the more comprehensive stock market overview in a single letter at the start of the week. Hopefully that will meet everyone's needs.

These extracts from my trading diary are for educational purposes and should not be interpreted as investment or trading advice. Full terms and conditions can be found at Terms of Use.

Crisis Of Confidence

Consumer faith in the very fabric of the economy has been shaken.

House prices are not supposed to fall; at least not nationally. But they have. Big banks are not supposed to fail. And if they do get into trouble, the Fed is supposed to bail them out. But big banks are failing — and the Fed seems powerless to stop it. Federal government is supposed to step in and clean up the mess. But despite all the activity and bold pronouncements, the lingering doubt remains: can they pull it off? Many consumers have already made up their minds on this score. Which is why they are saving for a re-run of the Great Depression.


"Just add a little inflation" is the advice from economists — forcing consumers to start spending by eroding the value of their money if they hold onto cash for too long. But running up further deficits or firing up the printing presses is unlikely to restore coinfidence. Merely breed greater uncertainty.

This is not a monetary problem and there is no monetary solution. We are dealing with the psychology of the consumer. Governments could spend trillions of dollars and have nothing to show for it — shoveling money into a bottomless pit.

Japan In The 1990s

The Japanese government attempted to revive consumer spending in the early 1990s, but met with stubborn resistance. Resistance that lasted almost two decades — and will continue unless their government liquidates the zombie banks whose problems precipitated the collapse in the first place.

Rational Behavior

Consumers are rational decision makers. What may seem irrational to an economist is perfectly rational to the man in the street. When the economic outlook appears uncertain and you are unsure whether you will have a job next year — or if you are a small businessman, whether you will have any customers — the rational response is to curtail your discretionary spending: pay down your debt and start saving for lean times. You are also likely to resist any efforts to manipulate you into reckless behavior — whether increasing discretionary spending, making new capital purchases, or running up debt. At least until the economic outlook is stable.

Confidence is not going to be restored overnight. Nor will it be restored by tentative action, vague policy or indecision on the part of government. What consumers want is stability. And that is what they are holding out for. When stability is restored normal spending patterns will resume. Until then: don't hold your breath.

The man in the street may be slow to catch on, but when he does, it takes a long time to change his mind.

Restoring Stability

Legendary former Fed chairman Paul Volcker recently set out a game plan that makes a lot of sense and, most importantly, will be understood by the man in the street.

  • Limit commercial banks to their traditional role: taking deposits and granting mortgages.
  • Restrict off-balance sheet activities. No SIVs, CDOs and MBS.
  • Restrict capital market trading. No proprietary trading divisions taking massive exposures in capital, equity or currency markets.
  • Restrict holdings in hedge funds and equity funds.
  • And limit involvement in equity markets to vanilla-style broking.
Basically, a return to the old, boring, bricks-and-mortar bank, with slow growth and no million dollar bonuses.

The reason Canadian and Australian banks have fared better than their US and European counterparts is because they bear a closer resemblance to this traditional model. Their risk profile is far lower despite having been seduced into borrowing cheap money in international capital markets — then finding it difficult to roll over without government backing.

Lose The Zombie Banks

John Hussman points out that the largest bank failure in US history, Washington Mutual, was resolved at no cost to the taxpayer and with no loss to depositors. All the $350 billion Treasury rescue plan has succeeded in doing is protect bank bond-holders at the taxpayer's expense.

Rationalize or Nationalize

What we are currently witnessing is nationalization by instalment, with Treasury forced to continually expand their involvement. Bankers have a saying: "the first loss is the cheapest/sweetest". Take the bad medicine up front and then focus on the recovery — rather than become embroiled in a downward spiral as the situation unravels. Attempting to avoid painful losses ends up costing far more in the long run.

The Fed is already conducting stress tests to gain a clear picture of which banks are capable of surviving. Banks that are strong enough should then be required to rationalize operations to conform to the traditional commercial bank model. And weaker players temporarily nationalized, broken up into viable business units after giving bond-holders a haircut, and then privatized.

The Bottom Line

Unfortunately politicians thrive on good news and attempt to convey everything with a positive spin. Like pronouncing a recovery before it has started. What consumers want is the bottom line. How bad is it? And how do we get out of it? But this message seems to get lost in the spin. So they imagine the worst.

Unless confidence is restored, all the financial and fiscal manipulation won't make an ounce of difference. The economy will continue to spiral downwards. Consumers are prepared to accept bad news. But what is needed is leadership. Someone who will give them the bottom line. And then show some sense of direction as to how to get out of the hole that we are in. Globally.

This is not an ordinary recession. I have never in my lifetime, seen a financial problem of this sort................ The ordinary recession does not bring into question the stability and solidity of the whole financial system.

~ Paul Volcker