Tuesday, November 11, 2008

Calling the Bottom

Remember nine months ago, when economists were marvelling over an exceptionally well-performing world economy? Though energy and commodity prices were high, the overall picture seemed rosy. Consumer confidence was good, and all sorts of productive technologies were coming into application all over the globe. Steady increases in productivity, fostered especially by almost magical information technology, promised rising prosperity and increases in economic activity the world over.

What happened? The real estate speculative bubble burst, and the resulting jitters sent essentially everyone all over the globe to execute a generalized "run on the bank." Investments and assets of all kinds were suddenly being cashed-out. The fall in asset values across the board was thus the very definition of a deflationary crisis. An incredibly rapid contraction of the money supply thus fed this self-reinforcing spiral.

The crisis has been answered with reassuring speed and vigor by concerted central bank actions to re-expand the underlying money supply. Have the credit conditions been responding appropriately? Yes. The single best measure of the liquidity and health of the credit system is probably the "TED-spread." This is the difference in interest rates between Federal Reserve debt obligations and highest-quality commercial obligations for the same term. Effectively, Federal Reserve obligations are the working definition of zero-risk debt. The perceived risk of bonds of the highest quality, then, is effectively a good measure of overall economic confidence in future growth and ability of the entities to repay their obligations. If the spread between these two rates is small, there is confidence globally in the health of the global economy, and thus a willingness and ability to lend to good borrowers for good purposes. Though still rather high by historical standards, the spread as of today, November 11 is 1.75, falling very rapidly indeed from its mind-blowing, absolutely unprecedented peak of 4.64 on October 10, 2008.

By this TED-Spread measure, the current crisis started on the ironic anniversary, 9/11, when the spread stood at 1.21, already moderately high. One week later, it hit a new peak, 3.13, which was completely unprecedented. It had never in its history exceeded much over 2.0. Just another three weeks was needed for this to reach the mind-boggling peak of 4.64. See:

[courtesy of Bloomberg.com,

For a broader perspective, look at this measure over five years:

From the perspective of the credit markets (where this crisis originated and demolished the financial pillars of the "real economy"), the credit "crisis" is now just a moderate credit "crunch" and may well be back to fairly normal range within a week.

So, looking forward, what are the prospects for resumption of brisk growth? Excellent. Although willingness of consumers to spend may be dampened for some months, there is great benefit to having that income saved and re-invested rather than simply consumed. The underlying engine of economic growth--technology and it's inventive application to productive uses of all kinds all over the globe--never took a breather through this crisis. Great plans and ideas are sill on the drawing boards in every country on earth. Computing power and information transmission and processing capabilities are better now than they were a year ago.

There is one advantage right now that the global economy didn't have a year ago. Energy and raw materials are much cheaper. With access to capital for sound infrastructure investments, all those wonderful plans sitting on drawing boards can now be funded and carried out at substantially lower cost than they could have just one year ago. When in the history of economics have such investment opportunities existed before? Never. Never.

What we went through over the past two months is comparable in intensity to what happened during the Crash of 1929 and the Great Depression. The fairly mind-boggling difference is that we went from good times to abyss and now solidly on the way to recovery in two months rather than ten years.

How could this be? Simply, most money exists as information, not physical currency--account balances, ledger entries, contract obligations and the like. This is simply data. In this electronic information age, this data can be transported, recorded, verified, and exchanged all over the globe in the blink of an eye, in quantities that defy the ability of the mind to comprehend. The "positive feedback loops" of money creation and destruction now can now develop and reverse in days to weeks rather than months to years.

As long as the central banks can respond rationally, quickly, and vigorously, these self-reinforcing cycles of money creation and contraction (inflationary spirals and deflationary crashes) can be corrected with breathtaking speed. The central banks today sit at the tiller of a supersonic speedboat, instead of the great wheel of a stately steamship. Through the first eight months of 2008, they didn't realize the economy was drifting towards a deflationary crisis. Once the picture became clear, however, their actions were brisk, vigorous, rational, and concerted. Over this time, the central bankers look first pretty incompetent, and subsequently brilliant and courageous.

This morning, the economic future looks exceptionally bright. The "real economy" however, will surely take a few more months to reflect this reality; it hasn't had time to fully reflect the emergency (and near-catastrope) that has already happened in the financial markets.

In summary, Warren Buffet is surely correct that equity investments today represent an opportunity that may be of unprecedented value in the history of finance. It is time to invest.

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