Great Minds Work Alike Print E-mail
Great Minds Work Alike



Studies in the art of education took me on an interesting journey. When I was young it pained me to know that I lacked the knowledge that only experience brings. A stroll through my university library made it obvious that while I toiled long and late I had made only a very small dent in the pursuit of the knowledge of wiser men. How could an educator so green bring wisdom to students? Could I possibly live long enough and study diligently enough to become qualified to deliver an education to the minds of others? As was so often the case in times of bewilderment I sought the words of my mom. “Wisdom is found in questions not answers” she said. My first thought was that her reply was some sort of parental dodge aimed to get me out of her kitchen and her hair. It resonated with several of her previous life lessons intended to transform her slovenly and slothful boy into a thinking man worthy of long-term employment and a mortgage.


As the soupy fog of uncertainty thickened I sought out an alternative mentor. The great Tehera was a wizard of the philosophy department at SUNY Stony Brook who tolerated undergrads like he might a case of athlete’s foot. Some have theorized that the Star Wars avatar Yoda was inspired by the great Tehera, a man of deep meditations prone to long periods of silence and insuperable riddles presented as answers. I shared both my question and mom’s response and asked for his counsel. Tehera’s eyes closed, he exhaled deeply and retreated into meditation. I waited a young man’s eternity and decided to clear my throat in hopes of spurring the great one to consciousness. His eyes peeled and he asked, “Was your mother cooking at the time?” “Why yes”, I replied, convinced the great one was clairvoyant. The diminutive professor snorted, “Study the Socratic Method to compensate for your ignorance and stay out of the woman’s kitchen until you are capable of feeding yourself “.


Questions, Questions, Questions



In the educational philosophies of the great Tehera and Socrates (and mom) questions take center stage and encourage curiosity and exploration. Questions promote the most valuable thing of all-the discovery of new ideas. The Socratic Method relies on well conceived questions to launch minds into the unknown while using what is known as the starting point. The Socratic Method shifts the burden of education from the subjective distillation of information by a “teacher” to the expansive universe in the mind of the student. At its essence the method shows the utmost faith in the human capacity for discovery and self- enlightenment. In this excerpt of our quarterly commentary we will employ the Socratic Method not as a dodge to get you out of the ICM kitchen but instead to begin a journey of exploration that examines our economic and financial quagmire. Our goal is to use questions as a launching pad to spur your thoughts about the likely course of future events. And of course we’ll throw our two cents in along the way. A favorite historian of the great and gruff professor Tehera, George Santayana said, “The wisest mind has something yet to learn.” With that mentality we will posit questions for your consideration in hopes of untangling some of the riddles associated with our most interesting times.


Let’s begin with more general questions and progress to those more pointed and detailed. Claremont McKenna College economics professor and Shadow Open Market Committee member Gregory Hess asks, “…how did we get in this mess, how do we get out of this mess, how are we going to make sure this mess never happens again?” Socrates couldn’t have kicked things off much better than that.


How did we get in this mess?



Those frequent readers of ICM’s commentary know our opinion of the origins of the financial crisis. The removal of the restrictions of Glass-Steagall in combination with de-regulation of the banking industry opened the door for damaging abuses to free market capitalism. The moral hazard environment imbedded in the Greenspan years and the emergence of too-big-to-fail financial institutions supplied a rich soil for the cultivation of the murky, calamitous derivatives markets and off balance sheet shenanigans. Compliant ratings companies provided the camouflage to sneak this financial skullduggery into many an institutional and personal portfolio. Our oft-quoted guru Hyman Minsky gave the best explanation for the inquiry “how did we get in this mess?” (To conserve space here I refer you to our musings of Quarter 4, 2007 and Quarter 4, 2008 where we relay the prescient genius of the late great Minsky.) The unsustainable concepts behind “supply side economics” contributed the faulty foundation to our overbuilt economic house of cards.


How do we get out of this mess?



The second part to Professor Hess’s question, “how do we get out of this mess?” demands that we focus on the truth, which is that we do not know if the stimulus actions taken to date will get us out of this mess. Signs of economic bottoming look promising but leave us uncertain. In testament to the Socratic Method this question begs another.


Will the ideas of the economist John Maynard Keynes prove effective in dealing with the near collapse of the world’s financial system and the global economy? We will have the rare opportunity to put economic theory to a real world test. The coming months and years will offer the perfect laboratory for the examination of Keynesian theory. You may recall from previous writings and presentations that Keynes’ ideas were born of the not so great Great Depression. While some argued that the liquidation of unsound financial institutions and the bankruptcy of unwise debtors was the true and just course of capitalism Keynes provided an alternate view. Keynes suggested that the system was prone to manic swings that require rare but occasional intervention of the federal government to avoid wasteful destruction. Keynes theories are the basis for the government actions being taken in response to our financial crisis. The Federal Reserve, the FDIC, Congress, the White House and the Treasury Department are engaged in no fewer than 28 Keynesian style programs that have generated budget deficits measured in the $Trillions. The non-partisan Congressional Budget Office projects U.S. deficits in excess of $1 Trillion for years to come with accumulated debt of over $19 Trillion by 2019. The International Monetary Fund tells us that the public debt of the world’s 10 richest countries will rise from 78% to 114% of Gross Domestic Product representing a debt of $50,000.00 for every one of our collective citizens. The June 13th edition of The Economist had these daunting words for the western world to consider, “Today’s borrowing binge is preceding a slow-motion budget bust caused by the pension and health-care costs of our graying population. By 2050 a third of the rich world’s population will be over 60. The demographic bill is likely to be ten times bigger than the fiscal cost of the financial crisis.” These are sobering words for a world still hung-over from the largest credit bender in history.


 There are signs that the rate of economic deterioration has slowed in some sectors, the most important being the housing market. The rate of price deterioration is slowing with signs that supply is aligning with demand. Employment and manufacturing continue to send alarming signals of weakness. A recent op-ed piece by New York Times writer Bob Herbert asked, “How do you put together a consumer based economy when the consumers are out of work?” According to our friend Bill Gross of PIMCO “underutilized workers”, the unemployed, discouraged and under-employed part timers in America number nearly 30 million. Where do these undertrained workers fit in the new economy?  According to former Federal Reserve Governor Laurence Meyer, “The economy’s full potential is a very, very long way off… full employment or a jobless rate of around 5% won’t return until 2015”. We must re-think our model of the social safety net. Short term relief to bridge from one manufacturing job to the next is not the answer. Technology and globalization make new demands on all the world’s citizens. Life-long education is the only bridge from an obsolete job to self sufficiency.



Will the “Paradox of Thrift” doom the consumer led recovery? Either John Maynard Keynes will emerge from this economic crisis a more revered theorist or he will be relegated to the footnotes of econ texts for eternity. His paradox refers to the phenomenon where individuals operating in their own best interest may harm the overall economy and thus their own interest. Consider the near negative savings rate of Americans over most of the past decade and the ensuing recession. If the under-employed and employed take a lesson from their profligate ways and begin to save something near historical norms, say 8% of disposable income, then the collapse in consumption would lead to lower profits, fewer jobs and a downward spiral of economic activity. The American consumer has taken a $15 trillion beating at the hands of the housing and stock markets. Retirement funding seems far less certain as does the job market. Savings are bound to rise as spending is bound to retreat. The above mentioned budget shortfalls will demand higher taxes that compromise spending and profits. Who among us looks for 20% annual real estate appreciation to pave the way to worry free golden years?  


Boomers will certainly save more, spend less and work longer to make up for decimated 401Ks. BusinessWeek claims 69% of boomers age 54-63 are financially unprepared for retirement. If boomers save 5% of their incomes expect consumption to take a $400 Billion hit. Standard and Poor’s states the Boomers accounted for a staggering 78% of GDP growth from 1995-2005, the bubble years in America . The long term implications of this scenario include slower economic growth, fewer new jobs and stagnant wages. Obstacles to young people entering the job market will mount, keeping unemployment stiflingly high accentuating the concerns of former Fed Governor Meyer and potentially compounding budget shortfalls.

While we would hardly characterize ourselves as strict monetarists at ICM we do share Milton Freidman’s concerns about future inflation and for a double dip recession precipitated by the exhaustion of the current economic stimulation programs. If one listens carefully to the Washington whispers seeds are being sown for a follow up stimulus plan. The risk of serious inflation lies in mismanagement of the Fed’s exit strategy from the unprecedented monetary and credit easing programs.  


Is it inflation or deflation that will cause the greatest risk to the American economy in the near future? Interest rates at zero and ballooning bank reserves measured in the hundreds of billions of dollars gives monetarists great indigestion. If cheap loose financing is at least partly to blame for the credit crisis, and it is, than there is certainly plenty to be concerned about. Consider the implications of the TARP program re-liquefying the shadow banking system replete with off balance sheet toxic waste, asset backed commercial paper and securitization debt markets. This may well perpetuate the cycle of boom and bust in asset values and the funding of questionable business ventures. Funding long term liabilities with short term assets puts vulnerable money markets front and center in the corporate financing business, a practice that transformed illiquidity into insolvency in the blink of an eye.


 As long as the $Billions in bank reserves are safe-harbored at the fed inflation fears will be mostly muted and confined to select commodity markets. Demand pull inflation will be tempered by boomer thrift and the glut of overcapacity in our contracting economy. It is our current belief that inflation is tomorrow’s concern (2010-2011).  The immediate threat of asset deflation while fading remains the preeminent concern in our mix of most potentially damaging occurrences. Deflation is capitalism’s kryptonite and the myriad of Keynesian stimulus programs constitute our lead shield.  If Lord Keynes proves correct than we will survive the current crisis more in debt and poorer for the experience. But we will survive. If he is incorrect the world will pay a terrible price for its recklessness and faith in financial alchemy. Either way our generation’s legacy is one of wasteful neglect.


Should $Billions in reserves make their way to short term lending facilities the monetarists will have the last word on inflation.   


How are we going to make sure this never happens again?



Capitalism is prone to boom and bust cycles. Attempts to manage away the Darwinist nature of this dynamic cyclical system are in part what caused the mess we find ourselves in. The belief that monetary policy could engineer softer recessions, full employment and limit inflation was the stuff of fairy tales. Worse yet this belief lulled Americans into a complacency about risk, economic growth, derivatives, debt and asset appreciation that has brought the greatest economic power the world has ever seen to its knees. We were comfortably asleep at the wheel and hurtling toward a cliff. The “Greenspan put” assured financial risk takers that the Federal Reserve stood at the ready to bail them out if long shot bets didn’t pan out. This moral hazard promoted greed driven irresponsibility seemingly devoid of consequence. This belief system must be altered as it is anathema to our free markets and our way of life. And yet we must encourage what Keynes named “animal spirits”, the optimism for a future more full of promise than fraught with fear and ruin. Any strategy devised to prevent catastrophe must balance “animal spirits” with a healthy respect for the consequence of failure. In capitalism as in life we learn from failure not from rescue.


Will the financial crisis bring about what Joseph Schumpeter coined “creative destruction” which allows innovation, rebirth and entrepreneurship to take root and flourish at the expense of failed business models and institutions? The “too big to fail” doctrine that emerged following the dismantling of the Depression-era Glass-Steagall Act has largely negated Schumpeter. We simply can’t afford to allow destruction no matter how appropriate and desirable to occur in our financial sector. Our best hope is for moderation of the excesses, trimming of risk and leverage, increasing capital reserves at Wall Street casinos, refocusing regulatory supervision and redefining investment banking incentive packages. What are the odds for success?



An historic tug-of-war is going on in back rooms in Washington between opposing factions; one that wants a meaningful overhaul of the financial system and one that wants a return to business as usual. Wall Street is nothing if not rich, powerful and savvy. Vast fortunes and power have served bankers and brokers well. They will spare no expense to maintain what they have accumulated. Wall Street bankers are engaged in a two pronged strategy to remedy the problems created by their improprieties. The current “populist” backlash over the crisis and bailout is palpable and has legs. A strategy combining revisionist history and sophisticated lobbying has been implemented by the Securities Industry and Financial Markets Association (SIFMA). The too- big- to- fail institutions are behind the re-write of history that is intended to shed responsibility and regulatory watchdogs. The re-write goes something like this, the bailout was unnecessary and forced down the throats of the largest institutions to protect their weaker brethren. This is obviously untrue. At the depths of the crisis the stock prices and borrowing cost of all banks displayed a collapse in confidence. Both interbank lending rates and the TED Spread indicated banks were having difficulty securing short term financing from any source save the Federal Reserve. LIBOR in particular showed bankers were unwilling to lend to each other! Counter party exposure put all financial firms at risk. Banks continue to own hundreds of billions in toxic assets that threatened their solvency until the Federal Reserve eased collateral restrictions, provided liquidity and allowed for a return of mark to-make-believe accounting. Even now the loudest protestors are living on government life support in the form of rock bottom interest rates and credit enhancement programs. The banking system needs to rollover $26 trillion in short term corporate financing in the next two years. Could this be accomplished without the backstop of FDIC and the Federal Reserve? Surely some banks are less vulnerable than others but all owe their survival to the lifeline tossed their way at taxpayer expense. To argue otherwise is a lie.


Lobbying efforts target Washington, London, Brussels and New York and are spearheaded by aids to Henry Paulson the former Treasury Secretary and Chairman of Goldman Sachs. Lobbyists are pitching Congress and the Administration the idea that this crisis was born of a 100 year perfect storm and not of their doing. Short sellers are targeted as a second scapegoat. Short sellers are the undertakers of the securities industry. No company wants to see them coming but to argue that these opportunists were the real source of the meltdown and not billions in bad loans and pathetic corporate governance is to absolve regulators and bankers in one stroke. Wall Street uses lobbyists like a magician relies on pretty girl, to distract observers from the slight of hand.


How is it playing in Washington ? The true measure of our reform will be played out in the struggle between 81 year old former Fed Governor Paul Volker on the side of tough reforms and National Economic Council Director Larry Summers and Treasury Secretary Tim Geithner on the other. The 6’7” Volker made his reputation standing up to Wall Street in the 1980s when he pushed interest rates to 20% while crushing double digit inflation (and the stock markets). Volker administered the medicine in the face of harsh criticism never flinching in the face of powerful opposition. Both Summers and Geithner are at the opposite end of the spectrum appearing most preoccupied with maintaining good relations with the Street. Summers pushed for deregulation and the repeal of Glass-Steagall while in the Clinton Cabinet. Geithner was the President of the New York Fed during the build up to the financial crisis. Summers and Geithner were protégés of Robert Rubin, Clinton’s Treasury Secretary and more recently Citigroup board member when the bank fell from grace under the weight of half a $Trillion in derivatives. Volker must struggle as an outsider to counter the accommodative positions of Summers and Geithner. The proof will be in the legislation that emerges from Congress later this year.


At ICM our fear is that the frailties of representative government will succumb to pressures that have stirred debate since the days of Jefferson and Hamilton. We have probably not seen our last or worst financial calamity. To the President we offer this humble comment: there is no enlightenment, hope or change in perpetuating the status quo. It will result only in an even greater concentration of wealth and power and further socialization of risk to the detriment of The United States of America. 


The Exit Strategy Is the Investment Strategy



Fed Chairman Ben Bernanke performed a bit of magic, slight of hand if you will, when he transformed nearly a $Trillion in toxic and illiquid assets into bank reserves (cash). Ben had no need for a pretty assistant to distract the masses. He had a financial crisis so large and opaque he could have made the Empire State Building disappear. These bank reserves, about $800 Billion has the financial world abuzz with fears of runaway inflation. But remember that these funds were used to relieve banks of their toxic waste and garbage loans while rescuing their balance sheets and the country. The intent was never to provide liquidity for new loans. Today we hear cries that the banks are flush with cash and not making many loans. True! But as the savings rate shows many folks and companies are busy shoring up balance sheets left in tatters by a decade of …well you know. Right now there is less loan demand and fewer qualified borrowers so the money sits at the Fed earning a pittance but safe from loss. The reserves represent a transfer of risk from the banks to the Fed’s balance sheet (read taxpayer). The Fed recently was granted the authority to pay interest on reserves and therein lays the control over this potential source of inflation. When the economy, loan demand and credit quality recover the Fed will raise the rate it pays on these deposits just above bank customer loan rates to keep the money out of circulation. The result of this will be higher Fed Funds Rates and borrowing costs that will cool the economy and inflation pressures. For investors the timing of this is important. We all want to avoid the too familiar scenario of being caught long duration when rates snap higher. At ICM we will watch several Fed activities for clues to policy adjustments. First will be the use of reverse repurchase agreements to drain reserves from banks, GSE’s and other financial institutions. The second thing we will watch will be the sale of T-Bills that are deposited at the Fed that reduce reserves. Third the Fed may offer interest baring term deposits (CDs) to banks removing funds from circulation. Finally the Fed may resort to selling long term toxic bonds exchanged by banks for cash, in the free market.


As is always the case the state of the economy and the liquidity spreads in the bond market will determine the course of Fed Monetary Policy. ICM will be monitoring Fed pronouncements and indicators for a directional change from recession to stabilization to sustainable recovery. For now stabilization is the next step. Rates of decline are slowing in housing and hints of a tentative bottom are emerging. This is a great first step toward the new normal.


We will never stop asking questions and searching for answers. Each answer gives rise to a new question and so the wheel spins. We will strive to keep an open mind and not get wrapped around the axel as we look for clarity to quench our curiosity. Most importantly we will remain focused on your portfolio, your community and your interests.