Wednesday, October 08, 2008

Is this the bottom? Maybe for now. But not forever.

Mark Cuban is going long. Have we seen the bottom? Maybe. But I doubt it.

Disclaimers first. Mark Cuban is a really bright guy. My entire net work is pocket change for him. If I could predict the future better than anyone else I would own a basketball team too. I don't.

That said, here's my analysis of the situation: the market may go up tomorrow. If it does everyone will breathe a sigh of relief and say, "Whew, that was close," and over time return to business as usual.

And I think that will be bad.

The reason I think it will be bad is because it leaves the underlying problem completely unaddressed. The underlying problem of this economic crisis is not and never has been sub-prime mortgages, nor credit-default swaps, nor the seizing up of the credit markets. All of these are merely symptoms of the *real* problem, which is far more serious. You think the last few weeks were scary? You ain't seen nothin' yet.

All of the events of the past year have been, at root, bookkeeping problems. Let me explain what I mean by that. There are two aspects to any economy. There is the actual physical production of goods and services. And there is the bookkeeping that keeps track of who is entitled to what. The former is "wealth" and the latter is "money." (Paul Graham has a really good primer on the distinction between the two here.) People fret over money, but at the end of the day what really matters is wealth. Money is just a token, a bookkeeping tool. I do not mean to suggest by saying that it is "just" a bookkeeping tool that money is unimportant. It isn't. Money (and the bookkeeping it enables) is absolutely vital to the functioning of a modern economy. You can find breathless expositions on the web about how money is "really worthless" or "just debt" and that the whole of the modern economy is one big con game with a shadowy conspiracy of bankers at its core. But money introduces enormous efficiencies into an economy, indispensable efficiencies in fact. And in that respect, money provides (and therefore has) actual value. Saying that money is fundamentally worthless because it's printed on paper is kind of like saying that software is fundamentally worthless because it's "just bits" and doesn't have any tangible manifestation.

The problem is that money has both actual value and a "proxy value" insofar as money is exchangeable for other forms of actual wealth like cars and sandwiches, and it is extremely difficult to separate the two. This can be seen with a simple parable: three kids (call them K1, K2 and K3) go trick-or-treating. Each ends up with a different kind of candy, C1, C2 and C3 respectively. Trick is, each of the children has a different taste in candy. Here are the children's candy preferences:

K1 prefers C2 over C1 over C3
K2 prefers C3 over C2 over C1
K3 prefers C1 over C3 over C2

In other words, if you arranged the kids in a circle, each one prefers their own candy to the one held by the child adjacent to them in one direction, but not to the one held by the adjacent child in the other direction.

Obviously all three would be better off if they could do a three-way exchange, but let's suppose they can't all get together at once to coordinate one. They can only do pairwise exchanges. This little mini-economy is "seized up" because there is no pairwise exchange that both parties will agree to, since any single pairwise exchange will force one participant to exchange goods in their possession for goods that they themselves judge to be of lesser value.

This economy can be "unfrozen" by an entrepreneurial kid, who can borrow some candy (C1 say) from the candy reserve of the bank of mom and dad. This kid (let's call him B since he's acting like a banker) exchanges his C1 for the C3 held by K3 (keeping a little for himself as his fee). He then trades the C3 to K2 for C2, and finally trades the C2 to K1 for C1, which he then returns to the candy reserve. Everyone is better off, and B has a nice little pile of candy for his efforts.

Now, here is where the trouble starts. K1, K2 and K3 look at B and see that he's gotten himself a nice little pile of candy, but *they* did all the legwork of going from house to house to collect it. They would like to get a little piece of the action, so B makes them the following proposition: Next Halloween, instead of borrowing capital from the bank of mom and dad, let me borrow it from you. I'll use it to lubricate the wheels of the candy economy like I did before, and I'll share the fees with you. This seems like a good deal, and the next year instead of funding three candy trades with one infusion of capital he gets three infusions of capital and funds nine trades. As word of this "easy candy" gets out, B's business grows and grows, and soon he's a candy mogul and is able to afford a nice new chauffeur-driven bicycle.

Everyone is prospering and everyone is happy, and none of this would be possible but for B providing liquidity.

Then one day B notices that as he conducts his candy trade, much of the time the candy he pays out in trades comes immediately back to him in the form of a candy deposit. He has a crucial -- and ultimately catastrophic -- insight: for such transactions he doesn't actually need the physical candy at all. He says to his next customer, "Let's just pretend I gave you the candy, because you're going to turn right back around and give it back to me, so we can just save ourselves the hassle. I'll just make a note in my candy ledger that you now have some candy on deposit here." He is now apparently creating candy out of thin air. According to the candy ledger, everyone is now richer than ever. More and more kids start to look forward to early retirement from trick-or-treating. But as more and more kids start to get their candy from their share of B's fees, fewer and fewer actually go trick-or-treating, and the amount of physical candy in B's vault gets smaller and smaller.

One day a bunch of kids show up to withdraw their candy all at once. A scene from "It's a wonderful life" ensues, and he runs out of candy. At this point two things can happen.

The first thing that can happen is that B goes bankrupt. All of the depositors lose their candy. A great candy depression ensues, and kids who thought they would never have to work again wearily don their Halloween costumes yet again.

The second thing that can happen is that the B can, as he did originally, go back to the Bank of Mom and Dad to get an emergency infusion of candy capital. Everyone breathes a sigh of relief, and prosperity returns to the candy economy. More and more kids take early retirement. Once again everyone is riding high.

Until the next wave of withdrawals hits. And this time it is worse than the time before. This time the Bank of Mom and Dad says, "Son, we just don't have that much candy So we can't help you." More kids than ever before are facing financial ruin. Disgruntled gangs of hungry kids roam the streets smashing windows and overturning cars. B pleads with the Bank of Mom and Dad to rescue the neighborhood from calamity. So Mom and Dad go to the store and buy some more candy, bail out B, and once again prosperity apparently returns. It takes longer this time because everyone is pretty rattled and it takes a while to repair all the broken windows. But eventually everything returns to normal.

This can go on for a long, long time, but eventually Mom and Dad run out of money and have to take out a bank loan. And eventually they use up all their credit. And then the government has to bail them out. And so on and so forth, apparently forever.

Except that it does eventually end. It ends when the store runs out of candy. When that happens, it is a calamity on a scale the neighborhood has never seen before. And there is no recourse.

The real-world equivalent of the candy store shelves being empty is peak oil. We're not there yet. But it's not far off either. It will all but certainly happen within the lifetimes of the kids in my parable.

Now, there is a way to avoid this cataclysmic ending. The kids can learn how to make candy. The real-world equivalent is that we can build a technological infrastructure that doesn't use oil. But this is hard work, and it requires investment and sacrifice and capital and focused determination. Very little of that is in evidence in the response to the current crisis. There are some calls for alternative candy/energy development, but nearly all the talk (and more to the point, the lion's share of the resources) is about reshuffling the books at the candy bank.

I don't know when the really big hard irredeemable crash will come. My guess is this is not it, because there's still plenty of candy. This crisis is not about real wealth, it's about bookkeeping and the resulting unrealistic expectations about entitlements and early retirement. The whole sub-prime thing is really a red-herring, a symptom, but not the real underlying problem. The real underlying problem is much more serious. When it finally hits, if we're not ready, it will be worse than any terrorist attack.

People talk about using torture in the face of a ticking bomb. Well, there's a ticking bomb sitting in the middle of times square. We don't need to torture anyone to find it. And yet, both presidential candidates still consider it political suicide to give a straight answer to the question, "What will you ask us to sacrifice to solve this problem?" And they're probably right.

So while I agree with Mark Cuban that we may have seen the bottom for now, there is almost certainly worse to come. The American People are only now beginning to hint at a willingness to come to grips with the true magnitude of the problems that face us. We've risen to challenges of this magnitude in the past, and we may yet again. But at the moment we're hunkered down underneath our blankets and munching on what's left of our candy.

1 comment:

rabagley said...

We won't have hit bottom until housing prices have returned to sane market values (rent-carrying basis pricing, for instance) and all of the other consequences of those price drops have been worked through. There need to be a lot more foreclosures, a lot more personal bankruptcies, and a lot more business failures (in and out of the financial markets) before we can honestly say that we're at the bottom of this economic correction. This ignores all of the other shady derivatives that are at least as big as the mortgage derivatives. Credit default trading is even bigger and potentially more destabilizing once financial firms start failing and don't get bailed out.

I'm guessing we'll finally reach bottom during 2011 at the absolute earliest. More realistically, I think we're looking at 2015 because of the "shallower but longer" effects of the various government efforts to ease financial pain. By slowing the unwinding of the various systemic risk assessment issues, we'll end up dragging the pain out even longer.

With all due respect to Marc Cuban, those who believe we're already at or near bottom are delusional or at least ignoring the very obvious realities of what's really gone wrong. There are as many ARM resets still to occur as have already occurred based on the huge number of shady loans written in 2006 that will reset in 2009. Other categories of broken financial markets (credit default swaps) have yet to really shake things up. There's still a long way to go.