Monday, August 30, 2010

This is No Way to Run a Railroad - By Michael Lewitt

The misallocation of capital to speculative rather than productive uses is a great American tragedy. As described in detail in The Death of Capital, the manifestations of this misallocation include most private equity transactions and the lion’s share of the derivatives and computer-driven trades of stocks and other financial instruments on the world’s securities markets.

The markets are dominated by investment strategies that have as their common denominator a reliance on momentum. There are many flaws in these strategies, beginning with the fact that they typify the “Greater Fool” theory. Adding insult to injury, the economy currently underlying the market is evidencing little momentum one way or the other. As a result, most investors have spent 2010 chasing their tails. Unfortunately, one of the most plausible arguments for believing that financial markets will rally is to endorse the view that investors will be as cynical and short-sighted in their thinking as their political and business leaders. That’s a hell of way to run a railroad.

The railroad known as the United States economy is also chasing its own tail these days. Driven by misbegotten fiscal and monetary policies that ignore the lessons of history in favor of discredited financial and economic theories, the economy is trapped in a cycle of boom and bust. Every time the economy falters, our political leaders run to bail it out with politically-mandated Keynesian prescriptions that only exacerbate the underlying excesses and imbalances. Little or nothing is done to direct capital to productive uses and speculation is allowed to reign. As John Hussman recently wrote: “If our only response to excess consumption is to pull out all the stops trying to ‘stimulate’ consumption every time it falters; if our only response to reckless lending is to defend the bondholders every time their poor allocation of capital threatens to produce a loss for them, then quite simply, we will destroy our economy, our future, and our standard of living….[I]t’s difficult to envision a return to long-term saving, productive investment, and thoughtful allocation of capital until – as happens every two or three decades – the speculative elements of Wall Street are crushed to powder.”

We have self-appointed diminutive macho-men like Rahm Emanuel barking about how crises are terrible things to waste while proceeding to do precisely that – squandering the opportunity that crises offer to effect meaningful reform by surrendering to special interests and lacking the courage to engage in genuine systemic change. The result – an expensive and profoundly flawed healthcare bill, an absurdly complex and at its core neutered financial reform bill – is not that the status quo is left in place but that it is made even worse. For this reason, the debates about whether the U.S. economy is enjoying a self-sustaining economy (HCM believes the recovery has been primarily government funded and is already fading as stimulus recedes) is primarily of short-term interest. In the long term, absent dramatic entitlement and other reforms, the economic outlook is bleak. There is genuine doubt concerning the ability of the U.S. government, as currently operative under the Constitution and other laws of the land, to deal with the mess in which we find ourselves.


Related books:

The Death of Capital

Crisis on Campus