The economy's gone into rehab
Yeah, yeah, yeah…

Nobama rally yesterday.

World markets had been recovering from October's drubbing. The Morgan Stanley index, which measures capital market performance around the globe, had risen 20% from last month's lows. But yesterday, stocks got a drubbing again…

…with a big drop for the Dow…minus 486 points.

And the bad news keeps coming.

GM's car sales down 45% in October - even as the price of gasoline dropped back to $3 a gallon.

Mastercard says consumers are getting tight with their money.

"Luxury sales drop sharply," adds the Wall Street Journal.

Foreclosures are up in Miami, New York and Seattle.

And 157,000 people were laid off last month - the most in almost six years.

In England, the Financial Times reports:

"…what was striking about the events of recent days was how suddenly businesses had seized up."

"The bottom has just fallen out," the paper quotes an employment expert.

And even the Pope is cutting back. Bloomberg gives us the news:

"For the first time in almost half a century, Vatican administration staff will clock in for work as part of a clampdown on slackers, a sign that the global financial crisis has also spread to the world's smallest state.

"Timekeeping was scrapped in 1960 under Pope John XXIII. Starting Jan. 1, the practice returns. All Holy See employees will be given magnetic badges and forced to clock in and out in an effort to track their movements and ensure they're working a full day, said a Vatican spokesman who declined to be named.

"'We can't afford any waste,' Bishop Renato Boccardo, secretary of the Governatorate of Vatican City State, told La Stampa newspaper. 'There is a lot of work that needs doing, and the financial situation doesn't allow us to hire more staff.'"

What's going on?

Let's put it this way:

The economy's gone into rehab
Yeah, yeah, yeah…

And here, we take up our explanation from yesterday…

But before we do, we spare a moment to remember Marcus Aurelius. Obama hasn't yet called our "Sovereign Hotline" for advice. But when he does, we're going to recommend he read Marcus Aurelius's meditations.

Obama has pledged to change things. That part will be easy; things are changing fast. Trouble is, they're not changing in the way he would like.

When Marcus Aurelius was emperor, Rome was going through major changes too. There were periods of famine, war and plague. Most alarming, the barbarians were at the gates; Marcus Aurelius spent most of his career trying to keep them out.

But you can't win 'em all. Losses are inevitable. And losses are not necessarily a bad thing:

"Loss is nothing else but change, and change is Nature's delight," he wrote.

If you're wondering how this connects to the economy going into rehab…we're wondering too…oh yes…now we remember…

Over the last few weeks, we've been laying out a view of what is going on. We've explained that corrections are not only inevitable…they're essential and helpful. Like death, no one likes them…but, like death, they clear away the old mistakes and the old wood…making way for new life and new mistakes.

"Change is Nature's delight," as Marcus Aurelius puts it.

(Trying to stop change, on the other hand, is Nature's horror…almost an affront to God himself. But we'll leave that theme for another day…)

When people borrow too much money, for example, the day eventually comes when things change and they have to pay it back.

And when the party gets too wild for too long, inevitably things change and somebody ends up in rehab. Now, following the wildest party in human history, most of the world's economy has gone into rehab…and may not come out for a long time.

*** In this period of rehab, corporations, investors and households need to pull themselves together. They need to get rid of houses, projects, businesses, and speculations that they can't afford. It's a "balance sheet recession," as Richard Koo puts it. Balance sheets need to be repaired. Debt must be paid off or written off. Expenses must be reduced so that they can be supported by revenues, and still leave something left over to pay down debt and build up savings. This is hard to do, because revenues are falling too.

Every man looks to his own. Each one cuts his expenses.

"It's dead out there," said our taxi driver yesterday. "I don't know why I bother to come to work. Everybody's afraid to take a taxi. They're afraid it might bankrupt them. It's silly really. They could save a lot of money by getting rid of their cars and just taking cabs. But I would say that, wouldn't I?"

The taxi driver was talking his book. But he was talking sense too.

"People consider taking a cab a luxury. And it's easy to cut out. You can see them on the street. They raise their arms to hail a cab and then they think again. They put their arms down and go look for a tube [subway] stop. They probably don't really save much money, but it's psychological. Suddenly, everybody thinks he has to save money. I can't remember anything like it."

But one man's expense is another man's income. The man who saves a pound by not taking a London cab, denies a taxi driver a pound of revenue…who then buys a pound less of gasoline…or a pound less of clothing…or a pound less of something. It is what economists call the "fallacy of composition," the mistaken idea that what is good for one person is necessarily good for the whole lot. Cutting back on spending is clearly good for the individual, but it does to an economy roughly what a visit from a sniffling grandson does to a bedridden great-grandmother. Pretty soon, the old lady is dead.

"Losses happen," Marcus Aurelius might say. "Get over it."

Instead of getting over it, the feds are going to fight it every step of the way. Of course, Japan tried to fight it too, and that its efforts didn't work. Just look at the evidence: the Japanese tried fiscal stimulus (government spending) and monetary stimulus (central bank policies). They ran deficits of 6% of GDP - equivalent to about a trillion-dollar deficit in the United States. And they took interest rates down to near zero and left them there for years. What else could they do?

Still, as of last week, Japanese investors were about $15 trillion poorer than they had been 18 years ago.

That is why we say these efforts didn't work. But maybe they worked better than we realize. Maybe the damage might have been a lot worse if the Japanese had not done what they did.

Whatever the case, Obama is about to follow the lead of Hata, Obuchi, Mori and Murayama. And Ben Bernanke, too, will follow the lead of the Japanese. He will cut rates …just like the Bank of Japan did.

But there are two crucial differences between Japan and the United States. First, Japan had a healthier economy, with a positive trade balance, and huge savings. Second, the United States has the world's reserve currency.

Japan could easily spend 6% of its GDP trying to replace private spending with government spending. The Japanese saved 19% of GDP. The government could simply borrow from its own people - like the U.S. did to finance WWII. But America can't finance huge deficits internally; it doesn't have the money. Its people don't save. They have no savings to lend their government. Any money the government gets from Americans will have to come out of current private spending or out of other investments. Obviously, this is not going to do much good, since there is no net increase in spending or investing. Nor can the U.S. government expect to bring in unlimited financing from foreign sources. The foreigners save, but they need their money to rescue their own economies. What's worse, the more the U.S. government has to compete for funds with other borrowers, the more interest rates will go up - worsening the picture for the economy as a whole.

The other point is vitally important too. Not only did Japan have a cushion of cash to comfortably sit out the correction, it had no reason to do otherwise. With money in the bank, the Japanese were never threatened by an economic breakdown. And what money they owed, they owed to themselves.

America has neither of those two comforts. Millions live paycheck to paycheck, depending on credit cards to fill in the gaps. When unemployment rises above 10%…maybe above 15%…they will howl so loud the government will be forced to take desperate measures, which could send the deficit to $2 trillion. Then, crushed under the weight of so much debt, it won't be long before the feds realize that we don't "owe it to ourselves." Instead, we owe trillions to foreigners. Foreign central banks alone hold about $2.4 trillion worth of U.S. government debt. About $10 trillion is said to be the total of all US-based securities in foreign hands. That is a burden that could be easily lightened…if, for example, the dollar weren't worth quite so much…

More to come…

Bill Bonner
The Daily Reckoning

The Daily Reckoning PRESENTS: The cat is out of the bag. Wall Street has now become the official graveyard for some of the world's largest financial institutions. But even more disconcerting than the demise of the United States' five largest investment banks is the subsequent intervention from the U.S. government. Puru Saxena explores…

SELECTVE SOCIALISM
by Puru Saxena

Unless you have been sleeping under a tree over the past month or so, I am sure you have heard about the demise of the five largest investment banks:

Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman and Morgan Stanley.

The immense scale of the carnage has been impressive so far, but what is more astonishing is the mind-numbing intervention by the U.S. establishment. Over the past month alone, thanks to the bail-out of Fannie Mae and Freddie Mac, the US has more than doubled its national debt. Moreover, the 'Troubled Assets Relief Program' (TARP) would have further increased America's debt to U.S.$11.3 trillion. And as if this level of indebtedness was not enough, Mr. Paulson has also agreed to insure money-market funds.

Let there be no mistake; the U.S. has now transformed itself into a great socialist society by using taxpayers' money to buy-out private companies. In my view, this ridiculous measure is a slap in the face of capitalism and will further promote reckless and dubious practices. Essentially, by bailing out the behemoths (Fannie Mae, Freddie Mac and AIG) and allowing the smaller fish (Lehman Brothers) to fail, the U.S. establishment is sending out the following message:

"If you want government protection, please become too big to fail. If your demise threatens our entire financial system, we will help you. Otherwise, we will let you fail."

There can be no doubt that this policy of 'selective socialism' is totally insane for several reasons. First and foremost, who has given these officials the power to decide which company is worth saving and which one is insignificant enough to fail? Next, what kind of message are they giving to the remaining banks - please merge quickly and grow in size or else you will be allowed to fail? Furthermore, America already has a horrendous debt problem (debt to GDP ratio in excess of 400%) so who has given the U.S. Treasury the authority to take on more debt? Finally, who is going to pay for these trillions of dollars of bailouts?

Although these bailouts may offer short-term respite, I am of the opinion that the recent antics of the U.S. establishment will make matters much worse over the mid- to long-term. History has shown time and time again that no nation has ever printed its way to prosperity. In fact, all the of the nations that have resorted to money-printing in the past, ultimately saw a total economic collapse. Furthermore, the middle-class and the impoverished people in those countries got totally wiped out due to runaway inflation. And apart from a handful of rich people who were able to ride the inflationary wave, everyone else suffered a great deal. I wish I could come up with more cheerful news, but I am afraid the same economic outcome is likely in the United States. If the clowns in Washington continue with their senseless inflation agenda by adding more monetary fuel to an already raging fire, I suspect we will see a massive deterioration in the American way of life.

Now, I am aware that the majority of commentators and pundits are applauding the recent bailouts. According to these folks, the bailouts were necessary to prevent an outright collapse of the financial system and the government intervention also helped to restore calm in the financial markets.

For sure, the recent nationalization of assets may have helped the markets in the near-term, however I fail to see how it can be good for the global economy over the long-term. Remember, it was the same reckless money-printing in the aftermath of the NASDAQ bust which caused this massive financial crisis, and now the U.S. establishment is throwing more money into the system! In the short-term, this injection of liquidity may act like a shot of heroin for the desperate drug addict, but in the longer-term, this dosage of monetary poison will end up killing this terminally-ill patient. After all, how can these bailouts be good when they will further destroy the purchasing power of the U.S. dollar? How can these measures be hailed by the investment community when they will cause food and energy prices to skyrocket in the years ahead? How can more monetary inflation be good if it punishes savers at the expense of debtors?

Make no mistake, this reckless monetary inflation will eventually cause the U.S. dollar to become worthless and America may have no option but to issue a new dollar bill (Figure 1). And if other nations also embark on this inflationary road to nowhere, we will see a terrible hyper-inflationary depression with currencies plummeting against tangible assets.

Figure 1: US Treasury's new dollar bill?

Courtesy: Hank & Ben's Money Printing Corporation

Despite the horrendous economic environment we find ourselves in, it is fascinating to observe the sheer denial amongst the investment community. Most fund managers, economists and analysts still want the public to believe that the United States is not in a recession and that its housing situation is about to improve! Nothing could be further from the truth. How can the United States not be in a recession when entire industries have been wiped out? Next time, when somebody tells you that the U.S. economy is stronger than you might think, please ask them which industry or group of industries are growing? As far as I am aware, investment banks, automobiles, homebuilders, consumer discretionary and mortgage related businesses are all facing a severe slump. Yet, Mr. Bush and his comrades have no problem in citing the strength of the American economy.

In summary, I maintain my view that the current crisis is far from over and I suggest that you stay well clear of the financial sector. Although, the financial companies may seem cheap due to the recent declines, I can assure you that they could get a whole lot cheaper. The truth is that nobody knows what is on and off the balance sheets of these institutions and at the very best, we may see a lengthy period of consolidation before we get a sustainable recovery in financial stocks.

As far as the broad market is concerned, I suspect the stock market is extremely oversold at the current levels and we may get a technical rally over the coming weeks. Unfortunately, our fundamentally superior resources stocks got sold off in the recent stock-market rout and this may be the best opportunity you will ever get to buy solid, viable companies at such fire-sale prices. So, if you have not done so already, I suggest that you invest your capital in energy, food and metals as these assets are likely to move higher when the newly created 'money' seeps through the system.

Regards,

Puru Saxena
for The Daily Reckoning

Editor's Note: Puru Saxena is the founder of Puru Saxena Limited, his Hong Kong based firm which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.

Puru publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action. Money Matters is available by subscription here.

-- Posted Thursday, 6 November 2008 | Digg This Article