Failure is Still an Option

With the crescendos of fear echoing through the investment community this weekend and many signs pointing to a bearish open tomorrow, I thought it might be time to review what I think are the critical factors for success or failure in re-energizing the national and global economies:

1. Stable financial systems: do banks have the faith of depositors, is bank-to-bank lending taking place, and are solid creditors receiving loans? In general, the answer is yes, however there is a great deal of unrest among financial investors, who have pushed common stock to new lows amid concerns that underperforming "toxic" assets will fail at much higher rates than loss reserves could cover. The fear is that common stock holders would be wiped out if the government were to force issue through nationalization, although I have not yet heard a credible argument for why either the government or the struggling banks themselves would want to go there.
   Note: I don't think it's good enough to say the market won't recover until we know the full scope of the losses - there's a kind of Heisenberg uncertainty principle here and the cost of getting a full accounting is that it can only be done by forcing the sale of those assets at the lowest possible price and thus guaranteeing the failure of the institutions that hold them, which will have massive systematic ripple effects throughout the system at the worst possible time -- forcing a bottom at any cost is a guarantee of failure at so many levels that we will have no choice than to follow the 1930s pattern (downward cascades eventually followed by upward cascades that get us back to the same starting point) when I think the 70s pattern (ugly and drawn out but range-bound) is still playable.
   
2. Free-flowing global trade: at the moment, no major new trade barriers have been thrown up. We know from history that new trade barriers were a major factor in making the depression worse than it would have been in the 1930s. However, political pressure for "buy American" clauses in infrastructure spending and similar pressures abroad are laying the groundwork for new trade barriers that would almost certainly harm any recovery.
   
3. Long-term incentives for investment, growth, and job creation: In addition to huge trade tariffs, the imposition of significant new taxes helped dry up business investment in the 1930s as the rewards for risk-taking became further limited by confiscatory taxation. Already we're seeing understandable anger at executive compensation starting to lead to new legislative proposals around compensation and taxation that if not carefully written may have the unanticipated side effect of discouraging new investment right when we need it the most. And other legislation aimed at preserving or creating new jobs may backfire if it ends up distorting investment decisions in the short term in ways that do not lead to long-term profitability that can be sustained over time.
   
4. Clear and effective regulation with consistent enforcement: If everyone knows the rules of the game and they are enforced, long term investment decisions can be made and executed. If the rules are constantly changing and enforcement practices are constantly in flux, investors will avoid placing their capital at risk. Unfortunately for us, the rules of the game are not only changing but it's far from clear when and how they will eventually settle down. Obama appears to be willing to keep changing the rules until the game is going the way everyone wants, all but ignoring the fact that communicating that stance to investors is akin to telling investors he does not have their back if they are decide to take risks and make long-term commitments--and virtually guaranteeing the downturn will take longer to play out as a result.

Bottom line: the early successes in responding to the credit crisis and great disruption will mean nothing if Obama succumbs to the temptation to nationalize banks, add new trade barriers and taxes, and in general keep changing the rules month-by-month. Failure is still very much an option, and given the dysfunctional nature of American politics over the previous decade I would suggest that failure is the default option right now. If Obama steps up as a leader this month and stays consistent over time, we're looking at a 70s scenario - ugly but manageable. That's as good as it can get, folks. Otherwise, we're dealing with a 30s cascading crashes scenario that we won't be able to exit until we're united by a bigger cause -- and we can only hope that's not more war like it was for FDR.