On the Banks of the Rubicon


“Those who forget the past are condemned to repeat it.” – George Santayana

Santayana’s famous remark about the lessons of history is usually remembered the way we put it above, though it isn’t exactly what he said: he wrote that the forgetful are condemned to “fulfill” history. While “repeat” is undeniably catchier and captures the spirit well, “fulfill” may indeed be the exact name of the route the Germans are scrambling to travel. The destination will be the same.

Consider Western democracies. Despite the evidence that a program of budget-balancing and austerity during a recession only worsens the condition – the U.S. attempt in 1937 is a spectacular and well-known failure in the annals of economic history – we are seeing a wave of such medicine being espoused around the globe. Human nature being what it is, the fact almost no one remains alive with an adult memory of that year provides some understanding of our myopia.

But then there is Greece and Europe. Greece is pursuing austerity with a vengeance (its neighbors’ vengeance, we should add), and the result is a back-breaking recession: its GDP has fallen by 7.3% so far this year (annualized). That’s current vintage as opposed to 1937. But you know, it’s Greece, and those southern people don’t really know how to work hard. Right. “Feed a cold, starve a fever,” runs the old axiom, but not in Johnny’s case because you know, he needs to lose a few pounds anyway so don’t give him anything. And if he dies, well he never was very healthy, was he?

In the spring of 2008, the investment bank Bear Stearns found itself foundering in a storm it wasn’t able to survive. Like an overloaded ship at sea, the overleveraged bank found itself surprisingly vulnerable (to its management, anyway) to waves of short-selling, rumors and a growing loss of confidence in the bank and the asset-backed securities market it had become intertwined with. When JP Morgan (JPM) cleaned out most of its cash with a margin call, the bank’s access to short-term funding (the fuel that all the banks were running on) was cut off and Bear was dead in the water.

Enter the Federal Reserve, doing the job its Depression-era veterans had outfitted it to do. The central bank acted as lender of last resort, arranging a sale of the contents to JP Morgan (how deliciously ironic) and guaranteeing the booty. From an economic point of view, it was nearly perfect: equity holders bore nearly all of the loss (the Bear Stearns building alone was worth the $2 share price JP Morgan paid), the system was protected against contagion, and the final bill to the taxpayers almost nil. Score a big one for central banking.

But that wasn’t enough. Though seemingly a great victory for intelligent foresight, the action angered many who had come to watch the ship sink. There wasn’t enough punishment inflicted to suit a certain view, though the many Bear Stearns employees who had most of their net worth wiped out in a few weeks wouldn’t agree. As the ship of Bear Stearns foundered, many voyeurs were angered at being cheated out of the spectacle (and for some, profit) of a bloodier demise.

It was morally wrong, went the thinking, the usual pretext offered by those excited by the chance to see the wicked (those with a different world view) come to a brutal and savage end (whippings, hangings, car crashes, planes flown into buildings) either because the crew and owners hadn’t been punished enough (the more common view) or because it interfered with a magical divine hand (the view of laissez-faire and other extremists).

So when an even more leveraged bank, Lehman Brothers, found itself similarly unable to get its ship to shore six months later, the central bank did not act. No more bailout money for the Wall Street big shots, went the common view. Let the market clear itself, said the laissez-faire zealots. It could cost the taxpayers as much as fifty billion dollars, pleaded the outmaneuvered and outgunned Fed chairman Ben Bernanke. For want of the proverbial nail, the ship was lost and the rejected fifty-billion dollar ounce of prevention rapidly metastasized into trillions of dollars of cure.

That isn’t how laissez-faire Bolsheviks (the resemblances merit the name) see it, of course. As the quack doctor who has just bled his patient to death sternly announces that what killed the patient was not leeches, but not enough leeches, so our fellow fanatics claim that more destruction is necessary to “clear” the system (the fact that if they ever got their way, they’d be amongst the first to be led to the guillotine seems to elude them as completely as it did many of the Parisians of the French Revolution).

Now Germany finds itself in a similar position of trying to reconcile wishful fantasies about what ought to happen against the empirical evidence of what really does happen. Our view of what needs to be done: write down the periphery debt and recapitalize the affected banks.

However, that would reward those lazy southerners by letting them off the hook. What they need is more austerity, more suffering, more punishment! Why should Germany have to do it? Because while the Greeks might catch a break, Europe gets a bigger one.

If your neighbor’s house is burning down, one can sit on the porch and cluck about their poor habits and construction materials and how they deserved it. However, if the wind changes, you will suddenly find yourself wishing you had been trying to put out the fire when it started, rather than moralizing about neighborly shortcomings.

Germany can do the right thing and stop the fire before it spreads, or they can go on sniffing about lazy sun people and claim that the house burning next door isn’t their problem. The first approach means a bill of 200 billion euros or more, going by what the IMF (International Monetary Fund) has hinted at. Unpleasant, perhaps, but jointly affordable. Asset markets in Europe would rally and growth would re-accelerate.

The other approach is to bury the head in the sand, as decision makers did with Lehman, leading to a run on the banks throughout the European banking system and another global credit crisis. Rumors over the weekend had Germany making contingency plans to ringfence its own banks, but that is just more wishful thinking, of the same sort that led to the Lehman debacle (Hank Paulson predicted that the stock markets would rally after the uncertainty over Lehman’s fate was finally removed). That bill will be in the trillions and the pleasure of being morally superior will vanish almost instantly, to be replaced by massive fear.

Be grown-up and global, put up the money and get on with it, or play the small-town virtue card and believe that the rising wind is morally obligated to go away. So ask yourself, European bankers: are you feeling lucky?

The Economic Beat

A quiet week for U.S. data brought little respite to its markets. The main data release in the holiday-shortened week was the ISM non-manufacturing report, which reported a better-than-expected survey reading of 53.3 versus consensus estimates of 51 (and fears of a negative number). Ten sectors reported growth versus six contracting, the same as the manufacturing report the week before. Though not robust, it was reassuring because it indicates that most of U.S. business kept going in spite of the debt ceiling mess.

However, the weekly unemployment claims number edged up again and the revisions are running higher too. We fear that the likely consequence of these numbers is a net decrease looming for the September jobs report. The problem isn’t that the economy can’t withstand a pause – the Labor Department’s JOLTS survey (Job Openings and Labor Turnover) showed no change from July – but that the markets are wildly inflating each step. The upside is that the turmoil forces action upon the deadlocked and frozen; the risk is that extreme options only become possible at extreme moments.

Inventories grew mildly compared to sales at the wholesale level in July, while export growth did better than import growth and the trade deficit narrowed.

Looking ahead to next week, Wednesday and Thursday are the two biggest days domestically, with August retail sales and Producer Price Index (PPI) data on the former and a raft of industrial data on the latter: manufacturing surveys from the New York and Philadelphia Feds, national production data from the central bank, and the Consumer Price Index (CPI). The rest of the week includes a bit more inventory data, import-export price movements and another sentiment survey on Friday, which is also a quadruple-witching day (options, futures, futures options all expiring). There is a smattering of earnings reports, notably National Semi (NSM) on Thursday, but the focus will remain on Europe until the Fed meets again the following week.

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