Our Tinker Bell Economy

Every time a child says, 'I don't believe in fairies,' there is a fairy somewhere that falls down dead.

- Peter Pan, by J.M. Barrie

Anyone who pays close attention to the state of the U.S. economy in general, and to the state of the financial markets in particular, is probably wandering around looking shellshocked.

Who would have guessed this past summer that, before the year was out, not one single American investment bank would remain independent and in that business?  Who could have dreamed that one of the world's largest insurance companies, AIG, would now be all but a wholly-owned subsidiary of the U.S. government?

The only part of this series of catastrophes which could have been foreseen was the collapse of Fannie Mae and Freddie Mac.  That, of course, has been a known problem for many years, which is why Fannie and Freddie invested huge sums paying lobbyists and well-placed politicians to keep the gravy train rolling.

Despite the famous venality of Congress, it would be comforting to think that even they wouldn't have signed the check if they'd known what would come to pass.  So many shoes have dropped that our economy seems most like a centipede getting ready for bed.

Now come the Secretary of the Treasury and the President, saying that in addition to the hundreds of billions of taxpayer dollars already invested in bailouts, we must come up with an additional $700 billion - well, maybe more really, since the proposed legislation gives the Treasury almost unlimited power to shovel money wherever Secretary Paulson thinks best.  The goal, we are told, is to restore stability to the markets by demonstrating the power of the U.S. government to bring stability.

In other words, we're asked to take a small but potentially fantastically expensive step of faith in order to rebuild faith that has been destroyed.

This scenario reveals a fundamental truth about our financial economy that has been forgotten:

Our economy doesn't run on dollars.  It doesn't run on shares of stock, or bonds, or petroleum, or even on manufacturing output.

It runs on one thing and one thing alone: faith.  Without faith, it is impossible to make money - because money is faith.

Hard Assets?  Or Hardly Assets?

What is money, after all?  Once upon a time, as Ron Paul reminds us, a paper dollar bill was a promise to provide a certain amount of gold or silver on demand.  Accepting a dollar still took an act of faith that the gold was available and would be provided if you demanded it, but that faith could be based on knowledge: if the government failed to keep that promise, you'd most likely hear about it pretty quickly.

It's been many years since the days of the gold standard and the silver certificate.  For as long as most people have been alive, the dollar and other world currencies have not been backed by anything in particular.  They float - which is to say, they are worth whatever you can convince somebody they are worth.  Nothing more, and nothing less.

When America had a manufacturing economy, there was an underlying reality to even the most ephemeral stocks or bonds.  A share in General Motors meant that you owned a small part of an actual, physical factory full of actual, physical machines that were worth something, even if the company was liquidated.

As a going concern, General Motors produced actual, physical cars that were worth something too.  They may be worth more or less than it cost GM to make them, of course, but a working car always has some value.  Even if the car is destroyed, it still has the value of its insurance claim.

This fact placed a bottom limit on the worth of a company.  If a company was so incompetently run as to be worth less than the value of its physical assets, an opportunity for risky profit arose: buy the company at its depressed price, liquidate the assets to more able competitors, and pocket the difference.  The great LBOs and corporate raiders of the 1980s worked on this principle, and though a great many workers lost their jobs, a good many others found themselves working for newly energetic companies that actually knew what they were doing, in an example of Joseph Schumpeter's "creative destruction" at work.

Increasingly, though, we find ourselves in a world where there is no underlying value that can be confidently marketed.  The tech boom and bust illustrated this.

A software company can have immense value as a going concern, but only that way - its assets are totally worthless if you close the company and try to sell them off.  Microsoft is worth hundreds of billions thanks to its many software products, but if the company filed for bankruptcy and closed its doors, those products would be worth a tiny fraction, if anything at all.

This is because the newly-unemployed software engineers are immediately going to leave and get a job elsewhere, taking with them all the institutional knowledge which is needed to understand the code.  With a product of the size and complexity of Microsoft's, it's usually easier to start writing fresh code from scratch than to try to understand the existing code without the help of the people who wrote it in the first place.

This was the fate of countless tech companies when they died: the only assets of value that could be converted into cash were the Aeron chairs.  The half-written software was of no value to anyone and it's hard to find anyone who will take used computers even for free.  The higher percentage of our businesses are primarily mental rather than physical, the more often this problem is being encountered.

Now we find the same thing happening to what once were considered hard assets.  Consider the toxic mortgages that started the current crisis: A mortgage, in theory, represents a revenue stream from the borrower as he repays his loan.  But with so many NINJA and "liar" loans open where the borrower actually had no possible resources with which to repay the money, the value isn't there.

Yes, you can foreclose, but you get an abandoned house surrounded by other foreclosed and abandoned houses, which has little if any value.  What looked to be a valuable asset is, financially speaking, all but worthless.

It might possibly be worth something to an individual homeowner who is willing to take a chance on a dying neighborhood, but there aren't enough of those around, they don't have the money, and the banks don't have the money to lend them to buy with anymore.

The only thing they're good for would be housing New Orleans refugees.  After all, giving each New Orleans refugee a foreclosed house would cost less than rebuilding New Orleans.  Of course, that solution is too simple, so the houses are worthless.

Not only that, Congress is talking of forcing mortgage holders to write down the value of their mortgages to the market value of the houses.  Credit card interest rates are high because the loans aren't secured by anything.  If someone declares bankruptcy, the judge can write down the credit card debt to what the judge thinks the borrower can pay.

The only reason that mortgage interest rates have been lower than credit card interest rates was that if push came to shove, the mortgage holder could take over the house and sell it.  Having the house as security meant that the banks faced lower risks so they could offer loans at lower interest rates.

What will happen to mortgage rates if Congress re-writes mortgages so that they drop in face value if the market goes down?  If they actually do that, banks will know that they no longer have any security in being able to take the house.

Mortgage loans will be no safer than credit card loans, so mortgage interest rates will rise to the level of credit card rates.  What will that do for home ownership?  No problem, Congress will set up yet another subsidy program like Fannie and Freddie whose excesses started this whole disaster.  The new program will help out "qualified" buyers who can't get loans and the whole cycle will start over...

Wishing Will Make It So

Now that our finance-based economy is spiraling down, we can see its true nature.  Most of our companies, and most of our national assets, are just like Tinker Bell and the rest of the fairies in Peter Pan's world: they are alive if you believe in them, but if you don't believe, they die.

How can companies worth trillions last week be bankrupt this week?  Easy: people stopped believing their assets were worth anything, and in a free market, that's what their value became.

Current accounting "mark-to-market" rules, which were put in place to prevent another Enron, mean that anyone who owns assets whose value has declined must immediately recognize this new fact - meaning that they, too, now become worthless, and their owners write them down, and so on.

As long as investors believed stocks, bonds, mortgages, houses, and companies had value, they had value.  But as soon as enough people started to question that value... it disappeared.  And the domino effect goes on.

Like it or not, we live in a post-industrial economy.  The days when American jobs revolved around making physical things that you can hold are probably gone forever.

We now make money by moving bits around - whether those bits represent money, or intellectual property, or just plain knowledge, those bits are pretty much all we have.  If we stop believing in them, we have nothing left - and that's exactly the situation our markets are in.

The American people are well aware that the media have been "talking down" our economy for a long time.  This happens every time there's a national election with a Republican president in office, because the overwhelmingly liberal media know that if voters are feeling worried, they'll tend to vote for the party out of office; it's just another way they try to help Democrats.  The opposite is true too: in 1996 and 2000, when Bill Clinton was the incumbent, all the news could talk about was how great everything was and how well everyone was doing to help the Democrats stay in the Oval Office.

The media didn't realize just how much our economy depends on faith.  A little skepticism is a healthy thing, but too much kills you.

The media has been shooting holes in the bottom of the boat in an effort to provoke a mutiny against the administration and may have succeeded in igniting the powder magazine and blowing us all to smithereens instead.  Thanks to their labors, so many people are saying "I don't believe in Wall Street!" that the whole economy has fallen down dead just like Tinker Bell.

Government "Credibility?"

Our national leaders say that government must bail out the markets because the government is the only entity in which people have any confidence.  If the Treasury underwrites the big companies, then the faith people have in the government will extend to the companies it supports, and we can "jumpstart" faith in the economy as a whole.

The weak point in this plan is that confidence in government is not unlimited.  In fact, thanks in large part to media attacks on the Bush administration over the last eight years coupled with boundless incompetence at all levels of government, faith in government is about as low as it has ever been.  Within the course of this year, both Congress and the President have set record lows in the polls concerning their performance.  Do we really want to rely on this dying faith to restore faith elsewhere?

Remember, a dollar is only worth what you can convince someone to give you for it.  The Treasury proposes to back the financial firms with an amount of money that is more than the Department of Defense, the Department of Homeland Security, and the Department of State spend combined.

Where is this money coming from?  Does anyone think it's real?  Does our government actually have this amount stashed away somewhere?  Of course not - they are going to borrow it.

For this to work, lenders have to have faith that they'll get their money back.  Do we have $700 billion worth of faith left in all the world after all the disasters that have transpired in the last month?  Do we really want to bet everything we have that we do?

Revive My Faith, O President

Right now, what we need is not just faith in the dollar; it's faith in the ability of companies to earn enough dollars to pay enough taxes and salaries to pay back all these new loans.  We know many things that harm the economy and thereby harm people's ability to pay taxes - even Barack Obama admitted in a debate that higher taxes harm not only earnings, but also cut tax revenues.

A number of economists have suggested that a cut or even suspension of the capital gains tax would be just the thing to revive faith in the economy.  Tort reform would help too, as would removal of the many, many remaining restrictions on drilling for American oil; in fact, cutting red tape and regulations of any kind would help the economy.

Which, no doubt, is why that's exactly the opposite of what we hear from Congress and from both candidates: not less regulation, but more.  The patient is dying of asphyxiation and our potential leaders propose to strangle it more tightly!  No wonder there's not enough faith left to get things moving again.

It's now generally recognized that the Great Depression did not have to happen and that it was not caused by Herbert Hoover's lack of action.  It was caused by government strangulation of production and the money supply - of production, by instituting the Smoot-Hawley tariffs that led to a trade war, and of money supply, by failing to provide liquidity when it was needed.

A stock-market crash may lead to a recession, but a recession becomes a depression only through government incompetence and interference.  Far from saving America's economy, FDR's New Deal extended the pain.

If our government had left well enough alone, there would have been a recession lasting perhaps a few years, but not a complete meltdown of the economy.  What we need right now is a master cheerleader like Ronald Reagan, who painted a picture of "Morning in America," waved his mantle over the image, and brought it to full-breathing life.

Instead, we have... Senator Obama and Senator McCain.  Will they learn from history or make the same mistakes?  One again, Peter Pan has the answer:

All of this has happened before and all of it will happen again.

- Peter Pan, by J.M. Barrie