Less bad is not good enough

According to Bloomberg: "Wall Street's largest bond-trading firms say the worst may be over for investors in Treasuries after government securities posted their biggest first-half losses in at least three decades.”

“Stocks will keep going up until 2010”, says money manager John Dorfman. “The ‘crisis management’ phase is behind us”, says Jeff Immelt.

This brings the history of 1930 into mind. Lets wake up the ghosts from then and say hallo to them!

"The spring, marks the end of a period of grave concern, American business is steadily coming back to a normal level of prosperity," wrote Julius Barnes, Head of Hoover's National Business Survey, on March 16, 1930.

"We are now near the end of the declining phase of the depression," wrote the Harvard Economic Review, on November 15, 1930

In 1930 as in 2009 the average man in the street thought the crisis had passed. "Well, the depression wasn't so bad," he said to himself.

How is it possible that the credit expansion that began after WWII and lasted until 2007, raking the debt-to-GDP ratio from about 150% to 360% has contracted in the space of 24 months? Have the mistakes of the Bubble Era been corrected already so quickly? Are household balance sheets back in balance?

One cannot correct financial mistakes by subsidizing them. You can't erase bad investments by putting more money in it. You can't turn bad businesses into good businesses by providing more money. And last but not least: borrowing more money cannot cure too much debt.

Instead of forcing people to correct the mistakes of the bubble era, the government is doing all it can to keep bad investments from getting worse, keep brain dead firms alive and keep zombie banks in business. The more money the feds put to this task, the less quickly the economy corrects errors, being able to adjust to new realities.

Every dollar that goes to prop up Wall Street, for example, must come from somewhere else. A recent headline reported that the "Rich Get Richer on Wall Street." Of course they do. Instead of going broke and getting fired - as they should have been - the government steps in with more money. Not only do the banks stay in business, they're able to pay their managers even bigger bonuses.

The government borrows from the private economy - money that might have been lent to a developer, or to a bakery, or to an oil explorer and is squandered away elsewhere. It's true that in a credit contraction, borrowing seems to go down, this is for a good reason, because the economy doesn’t function correctly. Lenders don't know what projects will work and which ones won't. Besides, asset prices that tend to support lending are falling. Who wants to take a chance on lending money when the collateral might be disappearing? So, new lending is frozen up until the period of shock, adjustment and restructuring is over.

The feds' theory is that they are merely putting idle resources to work, and getting the economy going again. What they are really doing is taking resources out of safe idleness, and wasting them on active projects that won't pay off. That is not the basis for a genuine new bull market. It is the basis for a very big disappointment.

Consumers have abruptly switched from living beyond their means to saving more and working down the debts they incurred during the bubble years.
Like all financial crises, the current crisis is a crisis of confidence and trust. Reassuring people that the financial system will be better controlled is critical to economic recovery.

Housing is wealth for consumer’s middle class. As long as housing is going down – or even NOT going up – the middle class is going to feel poor. It has the huge debts that were built up during the credit expansion, and it has to pay them, even though income and assets are falling.

Almost certainly this deflationary correction has further to go, much further.

“But against this natural, normal — and probably inevitable — market trend are the hopes and fantasies of an entire generation. The baby boomers have staked their futures on continuing EZ credit. So have their leaders. And so now, the feds and the voters are of one mind. Both want to stop the market correction AT ALL COST – especially if they can lay the bill onto the next generation.”

Meanwhile in order to bring matters back into balance, the economy continues to do its work, by correcting, stripping, cutting off bad pieces, removing the abundance from before while destroying the illusions of the bubble years in the process.

Housing and jobs are the two cornerstones of middle class wealth. If they can't hold the weight of the reconstruction of the economy, there is little chance of a broad recovery in the United States, Britain or in the rest of the western world including Japan.

“Many think that appropriate leadership will overcome the crisis. Madoff has been locked up; now it's just a question of beefing up those regulators so it doesn't happen again. The stimulus packages have been set up; now we just have to wait for them to do their work. The Fed has done its part too; it's just a matter of time until all that money and credit it put into the banking system turns up in the consumer economy.”

But Mr. Market is of a different opinion: "Gloomy US consumers clip housing recovery," begins a Reuter’s article. Another report, at MarketWatch, blamed the gloom on a "gloomier jobs view."

And still continues the talk of “green shoots”. A huge part of the public believes that the worst is over, and that the feds’ policies are working. They’re buying stocks in the belief that this is a recession just like any other recession of the post-war period. Ben Bernanke says, “it will be over by Christmas”; and people do believe him.

Meanwhile, there are some very smart people who think the feds’ efforts not only won’t work, but also will create an even bigger disaster. Those people are buying gold and commodities.

China and Russia, among other countries, are starting to look for alternatives to dollar-denominated instruments for their cash hoards. This could be troublesome news for the U.S. economy and Americans' standard of living.