The Cascading Crisis of Confidence

There is not enough money in the world to give everyone who is suffering through hard times some kind of bailout.  Be they individuals, small businesses or corporations, some will have to be allowed to fail.  The remains of their capital will have to be freed from their hands to be invested anew in more promising ventures to build the foundation for the next economic expansion.  Throughout economic history, risk either begets reward, or failure.  This rule must ring true in this economic cycle if the free markets of financial and intellectual capital will flourish again.

The problem is, you wouldn’t know it by looking at the initiatives taken by governments all around the world.  The risk has been removed from the market and assumed by governments.  Governments are offering bailouts and guarantees to banks, companies and even individuals (through mortgage workouts) to keep the economy from tanking further.  So, why don’t we feel better about our future prospects? Why are corporations curtailing their projects and employment rosters, and consumers their spending?  The answer is that we don’t believe that what is being done is enough, nor can it ever be enough to circumvent the classic economic cycles of contraction and expansion.

It all started with Lehman Brothers

The US government was doing a decent job of managing the crisis and consumer expectations until it made the arbitrary decision to allow Lehman Brothers to fail.  The White House, Treasury Department and Federal Reserve needed to make an example of one of the investment banks to send a message to Wall Street that “someone had to pay” for the excesses of the past decade.  That arbitrary choice, one that had survived the US Civil War and two world wars, was Lehman.  The government figured that the assets would be sold off, and other investment banking institutions would seek capital injection from the markets or team up with deposit-taking institutions to ensure their survival.

The government failed to understand the psychological impact of letting Lehman fail; the markets came to believe that if an institution like Lehman was not safe, then no one was safe.  The fragile sense that the banking system could work its way out of the mess with the assistance of government was broken.  If Lehman could be allowed to fail, then why not Goldman Sachs, or Merrill Lynch, or Morgan Stanley?  Extending that logic of vulnerability, then certainly any regional bank like Fleet Financial or Key Bank would be allowed to collapse as well.  The market lost all confidence that the banking system could or would be saved.  The US government was forced into a far more drastic rescue package involving direct capital injection into the banks as well as guaranteeing interbank lending and expanding the coverage of individual deposit accounts in order to restore confidence.  Had Lehman been saved, the message to the markets would have been much different and ultimately the rescue package committed to by the US government would have been a lot less extensive and expensive.

The European Circus

As bad as the US process was, the European bailout was a calamity of errors.  When the Euro was created, along with a Central European Bank, the expectation was that the governments involved would act in unison in any crisis.  Instead, they behaved like the old collection of closet nationalists they used to be and began acting to protect their own peoples without considering the effect on the whole inter-related system.  First, on October 2nd, the Irish government announced a plan to guarantee all retail bank deposits.  Fearing a flight of capital to the emerald isle, the Germans announced their own retail deposit guarantee plan a few days later.  What a bunch of amateurs!  These two nations basically sent the entire EU scrambling to put together a similar guarantee plan in order to prevent the massive transfer of retail deposits to two jurisdictions.  It fell to the UK’s Gordon Brown, not a Euro member state but intertwined with the economics of the continents nonetheless, to propose a plan of direct capital investment in the banks that ultimately stabilized the European financial network.  If the EU nations and the UK had come forward with a unified plan at the end of September, the panic would have been minimized and the intervention required less expensive as well, just like in the US.

Canada: To catch a falling star

Canada is the best positioned nation among the G8 to weather the current economic crisis.  Our government has been in surplus for almost 10 years and has been reducing the federal dept, giving us greater fiscal room to maneuver than other developed nations.  Our unemployment level was at a 30 year low and our inflation rate was under control.  Historically high commodity prices ensured long term development projects that were capital intensive and were long-term job creators.  Finally, our financial institutions were well-capitalized and considered the stars of the developed world.

By all accounts, there should have been a rush to invest in Canada, just as world money was flooding into the US following their banking workout plan announced by the US Treasury.  Instead, the Canadian Dollar has been pummeled lower by over 10 cents this month alone, the worst result in almost sixty years.  What happened?  World investors have been dumping Canadian investments, along with our dollar, leaving our currency to track the international price of oil on the way down just as it appreciated along with oil over the past six years.  Canada is so much more than an oil producer, and our dollar should not be relegated to the status of a petrodollar, yet that is exactly what we are living with.

Harper’s six-point plan to manage the Canadian angle of the international financial crisis was not convincing.  Basically, be promised to talk to everyone in government and finance around the country and the world, watch government spending and adjust if necessary.  This is not an overly compelling initiative to restore consumer confidence, and it rings hollow for most Canadians.  Its impact in international financial circles was equally muted.  As a result, our dollar was slammed along with most other currencies in the flight to safety.

Canada failed to sell itself effectively as a diversified, vibrant, innovative and competitive home for international capital.  Our government must do a better job in the future, because we already don’t deserve the treatment we are receiving when we’re in better shape than our international competitors.  Imagine what kind of investment treatment Canada would receive if we were actually in a weaker macroeconomic state than our trading partners!

Watch the ultimate confidence indicator: gold!

The price of gold has undergone wild swings over the past several months, settling below its all-time high above $1000 US at $730 US.  Earlier in the month, gold has soared to over $900 before the flight to the USD began in earnest.

Investors have traditionally turned to gold when they have lost confidence in international currencies.  As I have written in previous articles, the massive trillions of dollars injected into world economies to sustain the markets debases the value of the currencies and eventually leads to a flight to hard assets.  Gold is universally attractive because it has a worldwide following, it is portable, and has many uses.  If the confidence game played by governments ultimately fails, then the price of gold will soar as a result.  Eventually the ability of governments to bail out successive industries will be exhausted and those with liquid investments left will seek safety in the yellow metal.  If you want to know when the confidence game has run its course, follow the price of gold; when it spikes over $1000 USD and stays there, you will know when the next phase of the financial crisis is ready to begin.