I have a confession to make.  I questioned whether the 2002 "bottom" of the market was truly the end of the bear market in stocks.  The previous mania had simply been too great and the decline had ended too soon to purge the excesses from the system.  A period of retrenchment was needed as businesses and citizens rebuilt their finances and stocks declined to the point where they represented "great values."  But as painful as the decline and the recession were, both were relatively brief and then the housing and credit boom took over.  As the years went by and the market rose to new highs, I wondered how all of this was possible when wages for most working Americans were stagnant and debt levels were growing faster than GDP.  But I also noted that the markets only rose as the US dollar fell and that in gold, commodities, and most foreign currencies, the market never reached new highs.  Moreover, with debt levels exploding, consumers were not only taking on huge debt but tapping home equity for billions to support spending. Most alarmingly,  they were being encouraged to impoverish themselves by our "leaders."  What could this mean?

For several decades we have been borrowing from the future as everyone from politicians to central bankers have been "kicking the can" down the road in an effort to make sure that the music did not stop on their watch.  This meant that the deflating stock bubble had to be fought by finding other bubbles to inflate and that consumers had to be made to borrow more and more, regardless of the resulting damage to their finances.   In my previous post, I argued that dealing with this crisis would be more difficult as we had run out of easily inflatable bubble material.

What does it mean when the collective leadership of a country, Democratic and Republican alike, are unable or unwilling to tell the American people the truth and to lead?  I fear it means trouble.  It means that leaders, political parties and the very institutions we depend on lose credibility and legitimacy.  It means that the potential exists for not only the economy to unravel but the social fabric itself as we watch the simultaneous upending of a real estate bubble, a bubble in credit, and global bubbles in hard assets and emerging markets.   Even today with the stock market off to its worst start in history, with credit shrinking, and home prices declining at alarming rates, our leaders tell us that they are monitoring the situation and are ready to act to avoid the worst consequences of the credit crisis. What could they possibly be waiting for?  Could it be that the situation is not easily remedied and that the policy options readily available may not be that effective?  This is a truly sobering thought.

Wall street screams that we are several months into the credit crisis without decisive action.  Forget that central banks in the US, Brittan and the EU have pumped $500 billion in loans into the banking system, forget that the fed funds rate has been lowered by 1% and the discount rate by a similar amount--it's not enough and the market is unnerved by the resulting uncertainty.  What could account for this?  Could it be that a combination of factors have constrained the actions of both central bankers and politicians?  Maybe this is what happens when you let your currency sink to new lows, debt levels rise to new highs, when you allow unsound derivitave products to be sold, when you refuse to exercise proper oversight over the financial markets, when you impliment poor monetary and fiscal policy, when you do not have the courage to enact a realistic energy policy, and when trade agreements destroy good jobs by the million?

In situations like this, I like to turn to history.  Let's go back to the Nixon Administration when inflation levels, similar to what we see today, lead this Republican president to impose wage and price controls. Cutting interest rates in the face of such inflationary pressure was not considered.  Today, the ECB and Brittan are reluctant to cut rates as headline inflation greatly exceeds their targets.  Today I read that transportation workers in Europe negotiated an 11% increase in wages.  Today, global food prices are going through the roof, energy prices are high and the resulting transfer of wealth from energy consumers to energy producers threatens global stability. Today markets around the world fell by over 5%--more in some places. Meanwhile, housing prices went up at such a rapid rate during the bubble that despite the recent fall, many people still cannot afford to buy a home. Classical economists would argue that trying to stabilize artificially high prices--for homes or other items that have been impacted by recent bubbles is what caused the problem, is not a solution, but is instead a recipe for stagflation.

I have no doubt that rates will be much lower in the near future and that multiple stimulus plans will be enacted in Washington, but what we face is more than a liquidity problem, it is a solvency problem that will take the next 2-3 years to resolve.  While I remain confident that the US will survive this crisis and prosper in the future, I would not be surprised to see the markets retest the 2002 lows. As the great unraveling proceeds, I also suspect that a reform movement will emerge that holds the potential to be as powerful as the reform movements of the early late 19th and early 20th Century.  In fact, we could use another Teddy Roosevelt right about now.

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