History is a Harsh Mistress

During the first stock trading week of the New Year, the Dow dropped nearly 500 hundred points. This down turn may be good news for post-holiday “bargain shoppers.” But rough reality is that this may be a preview road ahead as the markets come to grips with the growing losses associated with the sub-prime meltdown.

Frequently, as investors, we forget the basic equation … that for every buyer, there’s seller and for every winner there must be a loser. If this simple calculus is undermined, markets may become skewed and investors tentative.
While the multitude of bailout measures urged by the President and Congress to stave off a further wave of foreclosures and bank write-downs may appear to be the right think to do, such intervention may cause more long-term economic harm than good. The unintended consequence may be an artificial distortion of risk that deters rather than encourages future investment.

Healthy markets have a “natural order.” Risk and growth go hand-in-hand. Weak investments must be permitted to fail no matter the consequences. If the government intervenes in markets whenever it believes it has a “moral obligation,” this upsets natural order and will engender market confusion. Every gardener knows that a tree must be pruned to stimulate growth. The same analogy is true in the investment marketplace. Bad investments must be shed to before markets can progress.

The advent of low interest rates combined with rising property values precipitated an unprecedented boom in the real estate investment. Home ownership is at its highest level since the end of World War II. But because investment capital is by its very nature a scarce commodity, this flood of dollars into the real estate sector has taken its toll on the rest of the economy.

Real estate investment may lead to the development of personal wealth, but in the long run, does not promote economic progress. Investment in real property does not promote the development of marketable products or sustainable job growth. Consequently, unless and until the unproductive capital currently captive in the real estate sector is exonerated, this economy will remain stagnant and uncertain.

Historically, recessions can be triggered when economic illiquidity is combined with run away government spending and shrinking tax revenues. A protracted trough can be averted if unproductive investment capital is disgorged back into the economy. Under these circumstances, government intervention may not only prolong the economic malaise, but potentially deepen the impact.

A recent example of this economic phenomenon transpired in Japan. The export driven expansion in the 1980's stirred an insatiable Japanese appetite for real estate. Property prices in Japan and abroad inflated in concert with the Japanese buying spree. Japanese banks and investment groups dominated the real estate market in major cities across the globe. This absorption of available investment capital led to a shortage of Japanese liquidity. Instead of allowing the economic forces to take their "natural course," the Japanese government propped up the banks by injecting additional liquidity into the system while at the same time ignoring sound credit practices.

When the real estate "bubble" finally burst, Japan, Inc. was brought to screeching halt. The Japanese economy quickly slid from recession into a lingering deflationary period. This means that persistently declining prices actually retarded continued economic expansion. The impact was widespread. Although the Japanese economy now has regained some of its former luster, this did not occur without substantial economic pain.

Like the Japanese, the U.S. economy is at a crossroads. Should the federal government step in to prevent a collapse in the real estate sector as the Japanese did, or do we allow the economy to take its natural course? While deeper interest rate cuts by the Fed and the injection of additional liquidity into the capital markets may be politically expedient, especially in an election year, it may amount to nothing more than putting a Band-Aid on a bullet wound.

Everyone agrees that home ownership is a virtue to which any economy must aspire. With it comes a sense of national pride and prosperity. But if home ownership is not the byproduct of a fundamentally sound economy, then it ultimately may do more economic harm than good. The hard truth is that sustainable prosperity cannot be conjured by a patchwork of governmental policies. Even in the new alchemy of today’s financial markets, gold may not be spun from an economy that is threadbare. To attempt to do otherwise is to ignore the hard lessons of history.

To learn more about my market recommendations, visit our website at: www.globewestfinancial.com.