Friday, February 13, 2009

Ruminations, February 1, 2009

Bold change requires an outsider – someone who has fresh insights. So, if you want to change the education system, don't hire an educator to do it. If you want to change the medical system, don't hire a doctor to do it. If you want to change the legal system, don't hire a lawyer to do it.

People who have professionally grown up in a system and have been successful in that system have vested interest in that system's success and seldom see any reason to make bold changes to it. For boldness, you need someone with new perspectives. Of course, you need input from the professionals – you just don't want them to run the show.

Today, we need to do something with our financial system. The new Treasury Secretary is Timothy Geithner who believes that experimenting with the financial system may resolve the current financial crisis. Is he the right man? Or is his thinking too ingrained in the existing system?

Geithner has a Master of Arts degree in international economics from Johns Hopkins University and in 1988 joined the Treasury Department where he held a variety of positions. In 2003, he became president of the New York Federal Reserve Bank and has been chairman of the Bank for International Settlements. He seems eminently qualified. But, is he too acclimated to the existing way of doing things?

What if President Obama had selected a lawyer whose claim to fame was heading a company that built rail tunnels under rivers? Could someone like that handle Treasury? That's exactly the man that President Woodrow Wilson selected in 1913 to be his Secretary of the Treasury – William Gibbs McAdoo. Of course, the country was not in a financial crisis in 1913 but within one year McAdoo would face one.

McAdoo's first task was to implement the new Federal Reserve System and make it a functional central bank. The U.S. had suffered a financial panic a few years earlier and the Federal Reserve System was seen as a method of remedying that. The fact that the Federal Reserve System has served us for 95 years speaks well of McAdoo.

Then the financial crisis hit. In 1914, Europe plunged into World War I (the U.S. wouldn't be a belligerent for another three years but we were involved immediately). Europe needed cash to pay for their war and, thinking it would be a short war, chose to finance it by selling the securities it held – a significant portion of which was in the New York Stock Market. The market, understandably, began to plunge. The Europeans then planned to convert their sales to gold and export the gold to Europe; that would have depleted the U.S. gold supply. What did McAdoo do? He closed the New York stock market – for four months.

That step may have saved the stock market but it left Europe in sad financial shape. To rectify that and finance the war, Europe issued war bonds and sold many of them to New York financiers – who, thanks to McAdoo, had the wherewithal to handle the bonds that were used to buy war materials from the U.S. McAdoo then issued emergency currency, which kept the financial wheels of progress in motion.

McAdoo's bold action contributed to the move of the world financial center from London to New York and may have stemmed from the fact that he was not a financier.

Of course, selecting an outsider is not a guarantee of success. President Jimmy Carter boldly reached outside the box and selected the late G. William Miller as Federal Reserve Chairman. The dollar had been falling, inflation and interest rates were rising through double digits and the jobless rate kept moving up. Miller had been a successful CEO at Textron and it was hoped that he would take bold action. Miller ended up serving only one year at the Fed before Carter moved him to the Treasury. He was successful in neither position as the dollar continued to fall, and inflation, interest rates and the number of jobless continued to increase.

One wonders what a Timothy Geithner, a Henry Paulson or a Lawrence Summers would have done in 1914. With all their financial acumen, would they have taken the same bold steps as McAdoo?

Are bold steps needed today? It's hard to tell. We can speculate as to what McAdoo would do today but that's just a mental exercise. Geithner is in charge of the Treasury. Whatever is called for, we hope he is up to the task and is successful.

Turn off the bubble machine
In his parody of Lawrence Welk, the late humorist Stan Freberg had a bubble machine run amok and, eventually, overwhelm Welk's orchestra and send it out to sea – amidst Welk's plaintive cries of "Turn off the bubble machine!"

Over the years, several economies could have echoed Welk. Economic bubbles are, if not constant, frequent. An economic bubble can be defined as a situation in which the valuation of a good considerably exceeds its intrinsic value – and the price continues to rise. At some point, someone turns off the bubble machine and the bubble collapses and the price of the good tanks, such as the housing market has recently done.

It's not as if we are unaware of bubbles as they grow. Recall Federal Reserve Chairman Alan Greenspan in 1996 characterizing the NASDAQ market as fueled by "irrational exuberance" (another term for economic bubble). Nonetheless, people continued to invest in dot-coms until the bubble collapsed four years later.

What makes people partake of economic bubbles even when it is obvious what is happening? Why did people continue to rely on increasing housing values in the housing bubble that just collapsed? And we're not just talking about the uninformed general public that assumed the housing values would increase forever; sophisticated financial institutions got caught up in the mess, too.

Economic bubbles exist because people delude themselves. A few of the more prominent delusions are:
  • I'm a fool if I don't join in while everyone else is making money
  • I may be a fool for taking part but there's a bigger fool who will come after me
  • If the market has gone up, it will continue to go up.
But, is there an inverse economic bubble – an ephemeral economic cavity, as it were? As bubbles are characterized by "irrational exuberance," a cavity would be characterized by "irrational apathy." The delusions of a cavity may be:
  • I'm a fool if I don't sell while everyone else is losing money
  • I may be a fool for bailing out but there's a bigger fool who will bail out after me
  • If the market has gone down, it will continue to go down.
It would seem that we are in an economic cavity right now. Just as exuberant people keep driving up the price of a commodity beyond its intrinsic value (in this case, the housing and stock markets), cavity people drive the price of a commodity below its intrinsic value. The action of both groups, ignited by their attitudes, become self-fulfilling prophesies.

Those who seem to be in a position to know (and/or influence others) tell us today that things will get worse before they get better or it will take years to recover. Not that they should offer us Pollyanna-ish bromides, but their rhetoric fits in with those of the economic cavity.

As Stan Freberg's bubble machine swept Lawrence Welk's orchestra out to sea, so the housing market has swept us to the metaphorical sea and transformed us into a cavity of doubt and fear. Maybe somebody should turn on the bubble machine.

Ice storm Katrina
When Hurricane Katrina hit the Gulf Coast, President Bush was excoriated for the federal government's slow response (although Bush disputes this charge, pointing out that 30,000 people were rescued from roof tops as soon as the storm dissipated).

Last week's ice storm left over one million people without power and heat. President Obama has not visited the sites or even flown over them. He has, however, declared the areas hit by the ice storm as disaster areas. What a guy!

Increasing tax revenues
When Timothy Geithner was vetted by the Obama team for the Treasury position, it was found that he had not paid his taxes for several years so he ended up paying some $50,000 in back-taxes and penalties.

When Tom Daschele was vetted by the Obama team for Secretary of Health and Human Services, it was found that he had not paid his taxes for several years so he ended up paying some $150,000 in back-taxes and penalties.

Has the Obama team hit on a new method of detecting tax scofflaws? Will Obama's appointments help reduce the national debt?

Obama and his team are to be applauded for their selection process and we wish them continued success.

Quote without comment
Former President Calvin Coolidge writing in 1928: "It is difficult for men in high office to avoid the malady of self-delusion. They are always surrounded by worshipers. They are constantly, and for the most part sincerely, assured of their greatness. They live in an artificial atmosphere of adulation and exaltation which sooner or later impairs their judgment. They are in grave danger of becoming careless and arrogant."

Robert J. Kulak
West Hartford, Connecticut

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