A Dialog Concerning Three Systems: Real Economy, Finance & Credit
The title is a play on Galileo's most famous work ( D ialogue Concerning the Two Chief World Systems)in which he discussed the sun-centered vs the earth-centered models of the solar system (actually the Universe). He almost lost his life, and Bruno did, for espousing the Copernician view despite prior decades of Church sponsorship for his research. The real reason wasn't so much the obvious disagreements but this was at the height of the Wars of Religion where the Church was facing the most serious challenge to it's authority and legitimacy in its' history. When Galileo challenged a worldview he was challenging the authority of the Church and politicians have no sense of humor about things like that. Well today we're faced with a discussion of the nature of three systems: the Economy (Business Cycle), Markets and Credit. Over several months now and with several key recent posts we've been offerring up our view of what we think the Copernician model should be. Judging from today's news headlines about the "surprising" drop in capital orders, new home sales, or the earlier ones on New Homes the common wisdome can by and large be characterized as Aristotelian, that is based on a badly flawed model of the way the Universe is built. Which did explain some data until the larger picture emerged.
Rather than keep stretching the metaphor here let me put a point on it. Last week we were faced with a systemic crisis in the Credit Markets, which normally function smoothly, transpartently and invisibly, that could have led to serious worldwide economic disruptions. Serious as in the D-word or worse. Now I consider that a low proability outcome but the catastrophic consequences are so severe that anything necessary to avert that should be done. I'm also convinced that the Fed has finally found/create a set of policy tools that will enable it to support an orderly un-winding of this mess. The trigger for this post is that, while we've covered all this ground before, some friends e-mailed me a few questions and it was startlingly clear that by using mild and abstract labels that the emotional implications were escaping everyone. So we're going to try and be a bit more blunt here.
To get started let me borrow the dictionary definition of Systemic:
Definition a is the way I"ve been using the word and b is evocative. But c, in a perverse way opens some thoughts up. Below I'll share some e-mail excerpts that speak more directly to all this. And try to be as blunt, short, simple and to-the-point as I can manage.of, relating to, or common to a system: as
a : affecting the body generally
b : supplying those parts of the body that receive blood through the aorta rather than through the pulmonary artery
c : of, relating to, or being a pesticide that as used is harmless to the plant or higher animal but when absorbed into its sap or bloodstream makes the entire organism toxic to pests (as an insect or fungus)
1rst Exceprt
First off the Credit Markets are broken as badly as they've been in our lifetimes. The Fed may finally, repeat repeat repeat, MAY have finally found an instrument to manage orderly writedowns by re-liquifying the market thru taking the ugly stuff off the financials books in return for payback. In the long-run they may actually make a lot. That just keeps the machinery turning over.Make absolutely no mistake about it - while we were all out having fun the markets almost collapsed weekend before last and would, almost literally, taken Western Civilization as we know it with it. The price for Bear was NOT $2 or $10 - it was taking $30B of synthethic debt off it's books that it couldn't trade because nobody thought they were solvent, i.e. could pay their bills. They were and are so tied into all the other major institutions that if they'd gone bankrupt - which they were going to have to do Mon morning - just about every major financial institution in the world would have found itself facing huge writedowns and a giant cascading run on the bank.The reasons for that are that nobody will buy the funny paper, even at cents on the $ because they're not sure what it's worth.My recommended fix is something like the Resolution Trust Corporation which would be funded by the gov't and Fed operations that would force homeowners to write down the value of their houses to something reasonable, pay their remaining mortgages, force the originators and banks to write down their investments and ditto for the other financial institutions.Anything less and you continue to have a risk of systemic collapse - too bland and not emotional enough to convery what might have happened ? Think of an alien space virus running thru the linkages in an entire ecological basin infecting each plant, animal, the soil, the water and the air. And when it enters the body of a living thing it causes their respiratory and circulatory systems to slowly congeal until they can no longer function. And then imagine that at some point the virus auto-catalyzes into metastasis and each infected individual suddenly collapses and infects the things around them in an ever-widening circle of macro catalysis.Does that help ? Since you're not sleeping at night anyway thought I'd give you something to think on.Try these as backups since I just put them up in the last few days trying to specifically analyze these inter-related problems.
2nd Excerpt
Q: Things are bad but you're really, really concerned that things could over the cliff altogether?
A:
How to put this ? Absolutely. But I don't consider it a high probability event. The caveat being that the risk was systemic - everytying unraveling all at once. They went from a credit crunch to a liquidity (got no money to pay my bills) to a solvancy (my margins are being called and I can't sell anything for 1/2 what it's worth so I'm bankrupt) to a close brush with financial collapse.That said I also believe the that Fed's buying bad paper from broker-dealers who are not regulated using adaptations of more traditional intervention instruments was brilliant, a marvelous performance under pressure and may start freeing up the logjam. BSC won't be the last of the problems but we may now be in position to manage an orderly re-liquification of the credit markets, re-pricing of risk and de-leveraging. I repeat orderly. When the machinery of the system siezes up as badly as it did though it's like an engine without oil - with the same sort of consequences.We're about 1/4 or less thru the credit market workdowns, about 1/4 of the way thru the Housing mess and barely started on the cyclic downturn.NOBODY but nobody seems to grasp any of that judging from the headlines. The good to outstanding news is the people who matter do.