Looking forward

I have been reminded with great frequency over the past few months of the accuracy of that old Chinese curse, “may you live in interesting times”. Those old Chinese, and presumably the younger Chinese, knew a thing or two. Well, at least from the perspective of the poor writer, there is no shortage of subject matter!

As I sit here in late March, it is now generally acknowledged that we are in the worst bear market/economic crisis since at least the 1930s. Some people are starting to say the worst ever, which remains to be seen but is less hyperbolic than it once seemed. Whether we are at the beginning, middle, or towards the end of this crisis is a matter of debate, although only the most blithely optimistic would say that we are anywhere near the end of it.

The big problem is that it’s, well, a big problem. No one has ever tackled a problem of this magnitude before. The closest would be the Japanese economic crisis of the late 1990s triggered by a collapse in real estate prices which caused widespread bank failures (sound familiar?) and their solution didn’t work so well, taking over 10 years before any real recovery. We may learn from their example, although it’s not clear that our solution will be any easier or any quicker, as our economic problems are even more profound.

Our current focus is on fixing the banks. This is both necessary and appropriate. Without a working banking system, we have no credit and without credit, we have no economy. Fixing it will not be easy, and it will not be cheap. Even if it happens quickly (and it may not), there will remain a number of other problems which will have to be fixed before the American, or world, economy, can return to any semblance of normal. These problems include the housing market (remember…where this all started), commercial real estate, credit card defaults, the federal budget deficit (accumulated and ongoing), and dealing with the enormous increase in our money supply.

Any one of these problems is potentially as serious as the savings and loan “crisis” of the early 1990s. At the time, that was viewed at the time as the worst financial crisis since the Depression…oh, how life would be easy if that were the extent of our problems now!

Let’s not fool ourselves. There is no guarantee that anything the government is doing right now is going to “work”, if by work one means restoring the economy to its previous health. Remember that the reason that we’re in this mess is because a bubble in real estate values collapsed, causing enormous losses to both owners and lenders. Unless real estate prices return to 2006 levels – which is, in the short term, out of the question – the problem does not go away. The best anyone can do is hope that (1) it doesn’t get a lot worse (through some sort of foreclosure mitigation program) and (2) the spillover to the rest of the economy is limited…which requires recapitalizing the banks.

Everyone needs to recognize that the scope and size of these problems is beyond anything that has ever been experienced before – and recognize that solutions are not easy, not quick, and not obvious. There is a tremendous push from public and press to “do something”. The people in the administration are smart and hard working and trying to do what they believe to be the right thing. That does not mean that they will always do the right thing. Since no one really knows right now what the “right thing” is, that should not come as a surprise. Some things they try may not work or even make things worse.

If Congress continues to be focused more on posturing and sound bites than on actually fixing the problems in a bipartisan, intelligent, and cooperative way – not, unfortunately, its usual modus operandi -- it can ensure that whatever the administration is trying to do will fail.

There are going to be unattractive consequences of whatever the government undertakes. Rescuing a bank, or an industrial corporation like GM, means that its executives fail to suffer the consequences of their poor judgment. Rescuing overcommitted home buyers rewards them at the expense of people who bought within their means, or didn’t buy at all. It is distasteful, even maddening, to contemplate rewards to the undeserving at taxpayer expense. However, the alternative…punishing every corporate executive and every borrower and every lender that exhibited poor judgment …means that the virtuous among us wrap themselves in self-congratulation while the economy goes down the drain. Cutting off your nose to spite your face, my mother used to call it.

Even if and when the banking sector gets back to business, the economic landscape of America will change in a profound way. For too long, America’s economy has been fueled by a manic orgy of buying fueled by borrowings against home equity and credit cards. Those days are over. The new American economy will be more sober, more restrained, and more sustainable. It will also be less profitable for manufacturers and (one hopes!) more profitable, in the long term for lenders since loans will be based on realistic views of income and asset values. What this means for long-term profitability of banking and industry is impossible to say at present.

I do not know how long it will take to fix these problems, or what it will require, or what America’s economy will look like at the end of it. I do know, with a great deal of certainty, that whenever and wherever we end up, the American economy is not going to look the same as it looked in 2005. This may not be a bad thing, as there were lots of unhealthy activities going on then (as we now recognize).

No matter how it ends up, there will be a great deal of uncertainty about the investment and economic outlook for months, and perhaps years, to come. Uncertainty means volatility and volatility means risk. Because of our view that the uncertainty in the market will be lasting and significant, we have taken a very conservative position with respect to US equities. This does not mean that we doubt that there will ultimately be a recovery, but that we recognize that we are in a very long and very dark tunnel. While there will inevitably be some light at the end, it may take us a very long time to emerge from this tunnel and we are not exactly sure where we will be when we come out. Until we have more certainty, we would prefer to err on the side of caution.

Fixing the problems that lie ahead of us will represent a marathon effort. To those who have become addicted to the quick fix and the easy answer, there is bound to be much disappointment ahead. To conquer all of these obstacles will take more time, more resolution, more strength, more will, and more cooperation than anything this country has undertaken since World War II. Be prepared.