What is magical thinking? It is a detachment of causality from the source of an action. It is simply, to believe that if certain conditions are met, a natural outcome is to be expected.
Magical thinking comes in many flavors, but isn’t entirely unuseful. It helps when systems are so complex that it would take so much time to simply understand the system of events required that it would be impractical to act before a rational decision could no longer be effective. Much of what we see today in public economic forums is massive amounts of magical thinking. That somehow, if we meet certain conditions of yesteryear, we will “put a floor” in on home prices, the stock market, and the economy as a whole. Unfortunately, we are in some cases only delaying the inevitable, and in many cases worsening the outcome of the housing bubble.
In a rational, efficient market, participants act in a personally beneficial way. Often, when participants act in a personally beneficial way, this benefits society as a whole. However, because the system of decisions needed is inherently complex, a bit of the system sometimes needs to be mentally “fudged” to make the whole issue work. This is often what people mean when they refer to the “50,000 foot view”. In centralized organizations, a leader with this type of view depend on their underlings being able to translate this kind of vision with on-the-ground experience to execute the plan.
Some examples that have recently come to the forefront:
1. Provide a tax credit to homebuyers
2. Banks failures cause more hardship than paying to save them
3. Large industrial producers cannot be reduced because they will crash our economy
Tax Credit to Homebuyers:
Unfortunately, it appears that we have more turned into a Cargo Cult that focuses not on the productive activities, but to somehow hearken back the golden days of yore through repeating the same stupid rituals that brought the original cargo planes and our former riches. This is a complete erosion of the American fabric; a lie to western peoples that economists know the way out better than prudent business people.
Many in the government have noted that in the last 20 years, rising home prices produced a large benefit to homeowners. They were able to borrow against their houses to fund growth in the economy. The solution to our ailing consumption, it must mean, that houses are undervalued and need to be propped up. Never mind that the last 20 years has been an historical aberration, a flyspeck on the overvalued of all overvalues. In our current policy, “reversion to trend” means an upward reversion of the home price appreciation to +10% per year. No matter that in many locales in the US, our incomes have not kept pace with the cost of homes and therefore we are already dedicating too much of our income to housing. We all need a REDUCTION in home prices for consumer spending to increase. Anything else (such as increased incomes) would put us as a country even further behind in competitiveness with respect to global wage arbitrage. I’m not a purist in the sense that I feel that we need to have a large manufacturing base, but our economy has got to consist of more than trading houses and debt amongst ourselves. The longer we wait to realize this and return incentives to work, risk, and honest reward, the more we as a country suffer. There should never be a return to leisurely earning above the rest of the world because there is no such thing as barriers to entry in the long run. Eventually, our wealth will be eroded if we do not continue to maintain a global competitive advantage (and I don’t mean in financial engineering).
People are currently rational. They’d love nothing more than to return the heady days of 2007 where they spent willy-nilly on consumer goods. They really would, but they also realize that the only way to do that is to reduce their consumption of something else. Something that doesn’t produce much satisfaction in their lives: housing.
Bank Failures
This is perhaps one of the most prevalent of magical thinking. In the participants mind, the bank failures of the 1930’s created a fear of banks when they failed. At that time, this had 2 effects: 1. People would have rather stuffed the money in their mattresses, collapsing monetary velocity and trade. 2. This collapse of bank deposits put otherwise healthy banks in a more precarious positions since they could not maintain adequate reserve ratios and were then insolvent. I believe that we do not have this type of environment, partially because of the lessons learned over the past 80 years. The FDIC creates a kind of buffer that assures accountholders that their money is safe (within limits) Most can ensure all of their money is safe by maintaining multiple accounts at multiple banks. People do not want money stuffed in their mattresses, and will only do so if they believe the government will begin to confiscate it. Harebrained ideas such as an asset tax or cash taxes will assuredly collapse velocity and many banks along with it as depositors choose to stuff Ben Franklins in their pillow cases.
Today’s problem has little to do with the same problems as the 1930s. Today, the mark-to-market accounting rules have substantially decreased the value of assets that depositors’ money was attached to while bank deposits have not done much. However, most of those assets should never have been purchased because they were junk to begin with. Most were a Ponzi Scheme where the greater fool needed to come along before their next balance sheet review or FDIC stress test. In the past, the FDIC would sieze the bank and sell off the parts, making the secured creditors partially whole and making the equity holders eat dirt. The shortcomings on depositors would be made whole by the FDIC before anyone else.
Circumventing normal market clearing practices for these liabilities and assets will ensure that the required write-downs necessary to produce never happen and that the remaining “Zombie Banks” will continue in perpetuity with damaged assets; unable to lend due to the need to recapitalize. More importantly, (or at least as important), the current leadership fails to be deposed; ensuring the problems of yesteryear are never allowed to become discovered and the organization can never move on from prior mistakes. The leadership is every bit as damaged as the assets the banks hold. To keep them in place is to reward bad behavior and ensure that we do not have a return to long-term profitable business practices.
Our current populace is engaging in magical thinking to believe that if we just keep the banks alive for a little while longer that they will be able to return from the dead. The only result will inevitably be zombies; having the appearance of life, but dead and hungry for brains.
Large Industrial Producers
This one is about GM. I believe this one to be a very different animal than banks and requires a more sophisticated resolution; but let’s be clear: allowing GM to continue to operate without destroying the unions as they now exist is in effect transferring taxpayer money directly to GM union workers.
At the present time, bankruptcy for GM holds 2 major obstacles that are not related to the above
1. No sufficient Debtor In Posession (DIP) financing exists in the private sector. Without government intervention, GM could only progress directly to Ch7, which would be a shock to the economy.
2. Even progressing to a Ch11 bankruptcy protection shows that consumers would likely boycott GM products as a safety measure.
Therefore, you can see that a traditional bankruptcy for GM is not an option if we do not want to add several hundred thousand directly to the dole and probably reach several million before all is said and done.
In the 80’s Chrysler was bailed out with a loan from the government. It is simply magical thinking to believe that we can make a loan with attractive terms and the whole problem will go away. The issue is that with each infusion, the company becomes more dependent on the donor. We are raising a vegetable company. Therefore, the problem must be attacked with swiftness and exactness. Most importantly, the 30 and done has to be removed and made retroactive. Sorry, you shouldn’t be able to retire until 70, and if that sucks, it sucks; get a job lowlife. None of the rest of America has a cush job with secure retirement; you won’t be getting it either. Sorry.
However, doing nothing while making large loans that go directly to pension beneficiaries is inherently unfair to workers everywhere and distorts normal competitive markets. With the kind of money that GM is getting, many skilled could come forward and rebuild a competitive auto company. The failed leadership that has complained about the problem yet done thing for the last 30 years while foreign competitors ate our lunch cannot be rewarded, nor should bondholders who are essentially being treated like Treasury holders be either.
In conclusion:
I believe our country’s leadership is unable to see how the magical thinking of today will translate into actionable items of tomorrow either because they fail to see personal motivations of participants, or because they have failed to see the solution and worked their way back putting into place contingency plans. Until we have a workable solution, we will continue to pour money down the drain and extend the recover further.
