Live, Without a Net

There is one bull market that has been going strong for almost 100 years; it thrives in every climate: in war and peace, in bad times and good, in sickness and in health (yes, we seem to be married to it).  Forecasting its growth is as sure a thing as there has been.  What is it?  Why it is the government of course.  Most people wouldn't argue, although it is arguable, that the government should be a "night watchman", administering criminal justice, enforcing contracts, and defending us from enemies, foreign and domestic.  All of these activities are essentially reactive; the presence of the government is supposed to serve as a discouragement to the criminal, the fraudulent, and militarily aggressive.   In their purest, most "natural" form, none of these activities provide much opportunity for sustained year over year growth.  

 

The typical bull market has an element of mania, a suspension of common sense.  The mania of the bull market in government is the pervasive belief that the government can and should provide a "safety net" to protect us from all of the uncertainties inherent in human existence.  We believe this in spite of the continued failure of government to do protect us.  Times of war have provided government with the most conspicuous opportunities for mania-inspired growth.  The money supply must be expanded; the whole economy must be managed to ensure that production is geared toward winning the war.  Bureaucrats also gain practice in managing resources normally managed by profit-seeking businessmen.  When the war is over, the capital structure of the economy is distorted, bent toward producing war goods not consumer goods.  

 

When the depression hit in Hoover's administration, war mania again overtook society, government needed to be deployed to fight the economic downturn as it fights a war.  Hoover, being a government planner ever since World War I, rapidly came to the rescue, thwarting the adjustment of prices downward so that markets could clear and value be restored.  FDR railed against Hoover's profligate ways and promised to return to sanity-- a balanced budget and lower spending -- in 1932's campaign.  When elected, FDR reversed field and expanded on Hoover's programs and set the foundation for the modern welfare state, the "safety net".  Most people are quite familiar with the income safety net built in and since the 1930s: social security, unemployment insurance, aid to dependent children, and on and on.  Most are less familiar with, or at least have put far less thought into, the other welfare state--the welfare state of credit.  James Grant:

"It [the welfare state of credit] is a structure of regulators, lenders, and borrowers, and the system is dedicated to stability, the greatest good of the welfare state of credit. The Federal Reserve sits at the head of the table. Somewhat below the salt are the various private institutions not deemed critical to the stability of the system itself.

Above the salt are the institutions that are too big to fail and the regulatory bodies. This includes the Comptroller of the Currency, the FDIC, lenient bankruptcy law, and the whole structure of fiat [paper] money generally. Fed policy with respect to domestic interest-rate manipulation and foreign-exchange manipulation also figure into it.

The system is established to avoid runs, panics, depressions, financial turmoil, and other upsets. The idea is to head off the contractions before they happen. It is the financial counterpart of the more familiar welfare state of income and of labor. The welfare state of credit is built to resist a repeat of the events of 1907 and 1931, just as the welfare state of labor--including the 1946 Employment Act--is built to forestall another Great Depression."

And the consequences?

"To promote great bull markets and excessive risk taking in the financial and investment market. The fiscal and labor welfare states generate the perverse effect of feeding the very diseases they are supposedly trying to cure. In a similar way, the welfare state of credit feeds speculative frenzies and excessive risk taking in the financial and investment markets, while attempting to prevent the losses associated with excessive risk taking. It creates the boom that causes the bust, but it attempts to abolish the bust.

The long-run consequence is to subsidize instability and economic stagnation in difficult-to-predict ways. The boom-bust can appear in specific sectors and at other times in whole industries. But it doesn't often appear in extreme ways at the macroeconomic level. The system is designed to prevent that from happening, and it usually does."

Grant said this 1996; let us fast forward to today.  We have finally reached a point where we have an extreme macroeconomic boom-bust.  The housing boom and bust has infected the entire economy.  Why?  Particular to mortgages, we had an almost self-feeding system of what Grant called "mortgage science projects" securitized into Collateralized Debt Obligations.  Even a modest pull back in house prices would cause the collapse of the significant portions of these securities.  House prices went down, along with many borrowers and lenders.  Having been in an economic climate that institutionally encouraged risk, suddenly it made more sense for everyone to become more frugal.  Everyone, that is, except the government.  

Government, having built its own power and prestige on its use of a seemingly bottomless pocketbook, would not and will not stand aside and ponder its own role, as the safety net under the tightrope walker, in bringing on the present crisis, then repent.  Again, government would blame everyone's greed and heedlessness except its own and then embark on another round of blind, extravagant and counter-productive spending.  

So when will the bull market in government end?  Here at Bow Tie, pessimism reigns.  People, both in government and out, seem too ignorant to stop our runaway train before it wrecks.  We still seem believe that the way out of our current mess (any mess really) is to spend and spend and if that doesn't work, spend some more.  Until we recover our common sense, government will grow.  What should an honest man do?  Perhaps the advice of Cato to his son, while resisting being captured by Caesar, applies--when evil men rule, good men should tend to their little corner of the world-- be good, hard-working, and frugal citizens.  Do not rely on the government safety net that will not save you.