Monday, March 17, 2008

Palpable fear

The question is this: When we look back on this moment, will it mark the beginning of the end of this economic cycle, the market bottom of a regular, if turbulent, economic downturn. After all, the S&P500 is 20% off its highs of last fall. The yield curve, once inverted and predicting a downturn, has a strong positive slope. And fear is palpable in the markets, and in the public square. All of these can be signs of a market bottom.

Or perhaps not. Perhaps this is just the end of the beginning. With the collapse of Bear Stearns and the plummeting dollar, is what we are seeing in the flight from the dollar into hard assets just the first stage in the final reckoning, for the United States and for the world. Could this be the moment when the dollar’s slide marks more than the balancing of accounts as envisioned at Bretton Woods a half-century ago? Could this instead accelerate the movement away from the dollar as the world’s reserve currency and the basis of economic transactions far beyond our shores. Is this the moment that Eurocentrism is to be put to the test, and the question raised at Versailles and put to rest at Nuremburg will once again be on the table. Is Europe really able to lead the world?

Despite the rhetoric, this is not yet the Asian century. The threat of a collapse in the American economy has given the lie to the pretense of a multi-polar world. For all of their assets, their reserves and their sovereign wealth funds, the Asian economies still live on the margin of the American economy. Nothing has made this evident than the plight of the dollar, with the emerging fears that a 3% downturn in America could become a 20% downturn in Taiwan, and the realization that China, with 500 million people living in poverty, remains a mercantilist nation decades away from being ready to turn her attention to the plight of her neighbors.

This week, all of the questions remain unanswered. Ben Bernanke has bet the house on stanching the tide of the sub-prime crisis. Tuesday, the Fed will drop the Fed Funds target rate by 75 or 100 basis points, a move that will further exacerbate the dollar's decline. The Fed has placed its bet, and would rather see the dollar go down than the banking system. This is coming in the wake of the busiest week on record for the Fed. This past Tuesday, the Fed announced a $200 billion program to take illiquid mortgage-backed securities back from the banks, and then on Friday arranged for JPMorgan—the Whitest of the old White Shoe investment houses—to acquire Bear Stearns, a firm whose roots are from a distinctly different tradition. But the Fed did more than arrange this marriage, it provided the dowry as well, agreeing to share with JP the downside risk.

Some will balk at the notion of a bailout, but the stockholders and employees of Bear Stearns would challenge that description of the deal. After all, at a price of $2 per share, the employees at Bear—half of whom stand to lose their jobs—saw the value of their 35% stake in the company fall by 99% from $8 billion to around $80 million, with much of that decline coming since the closing bell on Friday. Instead, this should lead to calls for reregulation of the financial sector, which was largely deregulated in 1999.

Ben Bernanke has given the lie to the notion that deregulation in the banking sector is a balanced policy, and it is hard to imagine who in his shoes would act differently. Faced with the looming collapse of the financial sector, the problem of moral hazard—the risk that failing to let those who made bad bets suffer will contribute to future bad behavior—will not prevent intervention. In the moment, when the world is collapsing around you, there is just too much at stake to dwell on ethical and market theory. But don’t blame Bernanke, after all, we went through Continental Illinois, Long-Term Capital and the Savings & Loan mess ad seriatum. Same story. Same result. More or less.

Thus, the question of whether we sit at the beginning of the end or the end of the beginning is not an academic one. Our country—which has been living beyond its means for decades—may actually have finally bitten off more that we can chew. With a $3 trillion war and a $2 trillion financial crisis both in full swing, and both requiring massive infusions of foreign capital, the fix this time might involve some pain. Maybe it is time to set some new rules, for the private sector and for the public sector as well.

But at the end of the day, the rest of the world has a stake in our survival—at least for the moment—because we are kind of like a big Wall Street investment bank that has done some stupid things. Many people may want us to pay the price for our conduct, but they don't want to get hurt in the process. They don't want to play a game of chicken when their own future is at stake.

So you tell me, is this the time to buy, or what?

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