May 2010 |
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The idea of confidence is a central tenet to most things in life. In financial markets, this is certainly true. But, as important as it is, confidence alone cannot substantially alter reality. Perhaps its only benefit is its ability to buy enough time to help bend reality's path.
As I reflect back on the actions taken by policy makers since the financial crisis began, the most controversial were the TARP and stimulus bills that enacted bailouts of our nation's banks and a few other major public companies.
The bills were classic Keynesian economics on steroids. Very simplistically, Keynesianism works as follows; when the private sector recoils, the public sector must uncoil to help cushion the blow to confidence. The government helps to support private sector confidence, the downturn's depth is ultimately lessened, and the ensuing economic growth pays for the extra government spending in due time. Without any Keynesian cushion, it is feared that an unabated confidence collapse might otherwise scar the economy and erode confidence further.
I'd argue, however, that while the attempt to support confidence may bend reality's path, the ultimate destination of the path remains as it should. Recessions are a natural part of an economic cycle and are necessary to reduce excessive imbalances in the economy. Interfering with this process with massive borrowing and spending to boost confidence actually prevents it from making the adjustments it needs for sustainable growth in the future.
In the past week alone, we've seen a couple examples of this volatile and circular relationship between confidence and reality.
First, on May 6th the Dow Industrial Average fell over 700 points in twelve short minutes. While it was initially reported that it was caused by a massive human trade error, known as the "fat finger", it now appears to have been triggered by the simple brew of ever-building investor nerves, self-preserving human actions and completely unregulated trading rules.
In response to the imbalance of buy and sell orders, the New York Stock Exchange (NYSE) slowed down the filling of trades. Unlike only ten years ago, these unfilled orders were then automatically routed to another electronic exchange in search of the next best available price for that stock. This order routing happens in a micro-second and high-speed computers run it all. Except, unlike the NYSE market makers, these computers have no professional duty to make an orderly market for the investing public.
When the NYSE slowed down its duty bound market-making function, the unregulated market makers (a task that depends solely on profit driven high-frequency-trading desks) operating on alternative electronic exchanges started losing money in such a quick moving environment. They naturally decided to shut off their program trading algorithms in order to limit their losses. When one high-frequency trader shut down, many others did as well and, lo and behold, the most liquid financial market in the world became totally illiquid in a flash. It happened in seconds and lasted for only 12 minutes, remarkably.
The computers were eventually turned back on, the computers took advantage of obvious discrepancies and prices rebounded. However, the confidence in the overall system has not rebounded. This lack of confidence will bend reality in a negative way. All it took was the right sequence of decisions and these decisions were based on logic, duty and simple loss mitigation. Until regulations change, it can certainly happen again.
Next, as I write this commentary, Greece and sovereign debt worries are all over the news. It is very easy to discount what is happening in such a small and economically dysfunctional country. However, its importance very much relates to a broader confidence in Keynesian economics and the global economic recovery.
Greece has lost the confidence of its lenders and the financial markets as its budget deficits and debt have soared over the years. They could have cut spending and raised taxes a while ago to deal with this fiscal imbalance. This prudence would have earned them enough credibility to help them refinance their debts and they could have slowly grown their way back to health. This option is now long gone. Private creditors have now fled the scene and have left unsustainable high interest rates in their wake that no country could afford to pay.
In exchange for getting major financing help from other governments, the government of Greece is now forced to cut spending and raise taxes massively to get themselves back in line. Yet, if they do too much of this, in too short of a time period, their economy will sink further and they'll be no better off financially. Plus, their citizens are not at all happy about this sacrificial path.
On the other hand, the other governments have citizens to consider too and nobody likes bailing out an imprudent relative. This explains the slow motion policy action.
The plan is for Greece to pay off existing lenders with bailout money from other governments who hope that Greece is able to earn back confidence over time. Their current lenders (large European banks and pension funds) really love this idea, obviously. The other Euro zone countries justify providing bailout loans to Greece because, without a bailout, the losses sustained by their big banks would end up forcing an eventual bailout anyway. That line of thinking should sound very familiar to US citizens!
Nonetheless, if the rest of Europe lets Greece fall apart and default on its debt, then how will creditors react to other euro-based countries in difficult financial shape? This contagion fear has apparently forced them to conclude that they might as well commit a large chunk of money to refinance Greece in the attempt to bend that future reality in their favor.
To see how things have snowballed, European leaders first announced a Greece-only $40 billion one-year loan package, it then grew to a $150 billion three-year loan package and it has now grown into a European-wide $1 trillion package.
They are trying to use confidence to stop a contagion of worry. Greece is seen as just the first small domino. Portugal, Spain, Ireland and Italy are lined up behind them. It could be easily argued that the UK, Japan and, perhaps ultimately, the US, are lined up later on down the line. The European Union is being strongly urged by the rest of the world dependent on Europe's economy to work hard to bend fiscal reality and to buy the global recovery some time to grow its way to health.
These two examples of how confidence feeds into reality and back again are not unrelated. In fact, the May 6th plunge of the US stock market cannot simply be explained away by a single human trading error. No, a panic sell-off always needs some level of nervousness to get the ball rolling. The general nervousness that Keynesian policies of deficit spending, no matter the depth of the recession it is trying to fill, is acting as that requisite trigger. It may be that investors are beginning to see the reality that no nation can borrow forever without jeopardizing the confidence of strangers they depend on.
We certainly don't know all the answers, but we suspect that bending reality through superficial confidence games can at least work temporarily on unsuspecting investors. However, it could be that once the veil of ignorance is finally lifted, reality's destination comes into view. Greece's issues and volatile markets may be a sign that the veil is slowly but surely being lifted.
