Mc Cain Clings to the Solutions That Even Greenspan Says were Wrong

Today, in Florida, John McCain once again proved that he has no understanding of economics. He stated that the nation’s economic problems would pass. This is the same argument that classical economists made back during the depression. They said that markets are self correcting and that unemployment and recession are self correcting. This is the same as the specious argument that market discipline would prevent economic excesses. Keynes, much maligned by the Greenspan school of economists, proved that recession was not self correcting.

McCain has also hung his economic hat on the argument that giving businesses breaks to reduce the cost of investing will stimulate the economy. This is saying that supply creates its own demand. This was known, by economists, as “Say’s Law.” The problem is that the biggest boost to investment is demand for the product. If there is no demand, and/or there is excess capacity businesses are not going to invest in equipment, buildings, or inventory.

Another element of McCain’s economic program calls for the reduction of taxes at upper income levels. This will supposedly accomplish two things. Firstly, the rich will save thereby increasing funds available for investment lending. Secondly, these funds will thereby reduce interest rates. For this to work, there have to be banks that are willing to lend and businesses willing to borrow for investment purposes. In the absence of demand, we have already established that businesses are not willing to borrow for investment. In addition, this approach will work only if banks are willing to lend. Observation of current banking behavior indicates that they are not willing to lend. Even with bailout money from the government banks are too risk averse to lend.

Recently, Alan Greenspan has stated that he was mistaken in the belief that actors on the financial stage would act appropriately. What makes McCain thing that this will change?

The Crisis in Non-Financial Companies

As we look about the business landscape we find that many older, former blue-chip, firms are on the brink of financial collapse. Given the shrinkage of credit, many are asking if these firms have enough cash to survive a major recession. GM is looking to the possibility of using the Fed’s discount window and GE has already started marketing commercial paper to the Fed. Why are these firms so cash poor that they have to go to extremes to survive?

I blame the Wall Street analysts and the MBA programs of America. In the last 40 years there has been a growing emphasis on distributing cash to share-holders at the expense of a company’s future financial health. About eight years ago I spoke with the management of a firm which had recently moved from listing on the American Stock Exchange to listing on the New York Stock Exchange. Management was flabbergasted when the stock analysts assigned to their firm said that they could not recommend buying the company’s stock because they didn’t owe enough money. The company’s management had always pursued a program of internal financing. They believed that low leverage (borrowing) ratios meant lower costs to share holders and safety in the event of an economic turn-down. The analysts insisted that the company should do more borrowing and hand the excess cash over to the shareholders.

UPDATE 9/27/2011: THE FIRM IS NOW PRIVATELY HELD

Almost all publicly traded companies are faced with this dilemma: Do they look to the long term financial health of the company or do we put emphasis on maximizing short-term shareholder value? The fact is that that the two may be mutually exclusive. High cash distributions may enhance short-term shareholder value while undermining long term financial heath. It is similar to the kick an addict gets from cocaine. It feels good every time the addict gets a hit. However, the addict’s long-term physical health is at risk.

As a product of several of America’s business schools I am well aware of the financial analyses that are being taught. I also understand the economic theory underlying the analytic thought processes. The problem lies in the fact that most of the analysts are working from a strictly academic angle. Most have never worked outside of the financial sector and have no notion of how a firm producing real as opposed to financial worth operates. The crux of the problem is that they treat all wealth creation as if it were financial wealth. This leads to a casino mentality where the emphasis is on short-term results. We end up in a world where there are no investors. All we end up with is traders. If you don’t believe this, just look at the turn-over ratios of some of our largest pension plans. The ratios often indicate that the portfolios are being completely liquidated and repurchased more than once every year. This is not investing. It is gambling masquerading as an investment strategy.

If we want America’s firms to survive, we need to break this gambling mentality. We need to restructure the nature of business education. We need to realize that risk is more than the financial analysts’ notion of price variability. They believe that diversification will get rid of the specific risk of bankruptcy. What they fail to recognize is that the emphasis on leverage increases the bankruptcy risk of all firms. If all firms are under increased bankruptcy risk then specific risk becomes market risk and it is impossible to diversify it away.

Will Our Own Expectations Kill Us?

I just finished taking a CNN on line survey. Once I entered my response the results to date were listed. The outcome scared the hell out of me. The question was: “Are you confident world leaders can solve the financial crisis?” The result was that 70% of the respondents said no.

Normally, survey results do not have any effect upon me, especially ones that merely ask for opinions. Then why does this particular result scare me? The reason has to do with the effect people’s expectations have upon their economic behavior. Generally, people will either buy or save depending upon their expectations of their future economic health. If they believe the economy is slowing, they will cut their spending. If they believe the economy is healthy, they will continue to spend or even increase their spending. The current financial crisis has led to decreased expectations for the economy. This has led to a concurrent decrease in consumers’ economic activity. Consumers are the engine that drives the American, and subsequently the world, economy. This is where the survey result comes in.

The survey indicates that American consumers believe that world leaders will not be able to solve the financial crisis. Therefore, they believe that the economy will continue to decline. As a result, consumer spending will either stay low or decline. Either way this spells trouble for the economic future. A continued shrinkage in consumer confidence can turn what already looks like a severe recession into another great depression.

This weekend’s G-7 meeting must come out with solid plans that people believe will stop the financial decline. If this happens we can expect that people will begin to change their behavior. However, if the plans are tentative indecisive political obfuscations we can expect to see an economic disaster in our future. The Hoovervilles of our parents and grand-parents will become the Bushbergs of the 21st century.

THE COMING DEPRESSION

Now that congressional Republicans have decided that they want narrow political expediency to defeat the bailout package I am fearful for the future of our nation and the rest of the world, Although I did not believe that the proposed compromise was the best way of handling the problem I felt that an expedited poor plan was better than no plan at all.

People and markets are driven by expectations. If they believe that something will be done to alleviate a problem they will act as if the problem has been solved. On the other hand, if they see political divisiveness, they will act as if the problem will never be solved. This means that the financial markets will see a flight to quality. A flight to quality means dumping stocks and buying US Government Securities. The goods and services market will experience falling sales because people see their jobs as being in jeopardy, their 401k investments and savings shrinking while the value of their homes is falling. All of this will bring about further layoffs and a downward spiral in both consumer confidence and sales. I really don’t know a better description of the factors leading to a depression.

I know that many commentators believe that we now have the opportunity to do the job right. I do not believe that we will. The republicans believe that a total reliance on a market solution will solve the problem. In fact they are calling for market solutions devoid of regulation. This is what got us into the problem in the first place and the democrats would be dumb to go along with it.

On the other hand the democrats are calling for a “New Deal” type solution which might actually work. The problem here is that the republicans are so opposed to anything that smacks of the “New Deal” they’d rather sink the country than let it pass. They will throw procedural road blocks to the system that would prevent any solution that didn’t give the market reign.

We are still a month away from the election and three months from a new congress and president. In that amount of time we can face a complete economic, as well as financial, collapse. If our congressional leaders cannot create a new solution before the end of the week it will be too late. I am afraid we are destined to relive the great depression. Hello 1932. Hoovervilles will be Bush Bergs, Buddy can you spare a dime will become fella can you spare a 5, and 25+% unemployment will rein.