Tuesday, March 3, 2009

Conceptual paradigms can create mental blindness

The US is the home of the 'financial crisis', which was created by bad political decisions. Conditions have deteriorated due to bad political management. The concept has been to throw huge amounts of money at the problem, expanding liquidity and financing this by deficits and increased public debt. Unless the US government gets out credit allocation, cleans up the banking system and starts focusing on encouraging savings and cash flow from production, it is unlikely that any recovery will be in sight.

FED Chairman Ben Bernanke is the ultimate in financial engineering. Unable mentally to process what has happened over the last year and half, he seems to see the only possible operative paradigm as the 'status quo ante'. Worse, he has a romanticized view of it too. By minimizing the importance of low saving rates (a cash flow issue) and emphasizing the role of increasing asset values (a balance sheet issue), Bernanke fundamentally misunderstood the vulnerability of households to negative shocks to real income.

Basically he does not seem to understand that having asset appreciation fueled by debt is neither healthy economically nor even sustainable. He seems to ignore the basic economics principle that we cannot divorce credit access from the ability to repay. Repayment is normally by cash flow from earnings and by savings.

Value is determined by a constellation of social conventions at some point in time. If the social convention is that financing is limited by ability to repay, then cash flow (largely income), not asset appreciation, is the appropriate metric for valuing houses. "Restarting" the credit markets alone will not alter this convention; it was the willingness to disregard this convention that was the fundamental failure of credit markets. So trying to pump up the markets by massive government injected liquidity is unlikely to restore asset values and stabilize the markets.

Likewise President Obama is also locked into paradigm thinking that is not constructive. He sees himself as a modern day FDR who is going to replace the private economy with government spending that is financed by – guess what? Deficit spending and public debt! Already the American consumer is busted and bankrupt without saving. Now Obama wants to risk US public debt sovereignty by massive increases in government debt.

It may come as a surprise to him as a politician, but an economy cannot run solely on loans! Credit stopped flowing in the U.S. for a very good reason: there was no more savings left to loan. Government efforts to simply make credit available, without cleaning up the banking system, rebuilding productive capacity or increasing savings, are doomed to destroy what is left of the US economy.

The sad truth is that the productive capacity of the American economy is now largely in tatters. The Obama Administration seems to want to tax and trash the US industrial economy, looking to replace it by a reliance on health care, financial services and government spending as it sees fit. The US needs to get back to the basics of production. The administration does not seem to understand that without production that generates positive cash flow and encouragement of savings, the tax base will dry up and the whole system will simply collapse on its own weight.

They would have us believe that we can all spend the day relaxing in a tub while the FED printing press does all the work for us. The problem comes when you get out of the tub to go to dinner and the only thing on your plate will be an IOU for steak.

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