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Unlike most market participants, during 2002 Leithner & Co. was in no hurry to sing “Happy Days Are Here Again.” Yet far from crimping our fortunes, this severe and disbelieving stance helped us to achieve good results (in both absolute terms and relative to others). What explains this cautious attitude and these reasonable outcomes? The conviction that if 2001 was the Year of Measuring Dangerously, then 2002 was the Year of Reasoning Invalidly. This set of circulars sets out six examples of invalid reasoning that were repeated fervently, relentlessly and far and wide during the year.
Example #1: Misconceiving and Misdiagnosing the Bust
During 2002 governments and most market participants continued to misconceive, misdiagnose – and in a great many instances prematurely to declare the end of – the bust. A bust is not two consecutive quarters of shrinking real GNP. It is not triggered by terrorist attacks, drought or the threat of war; nor is it gauged in terms of decrements of business and consumer confidence. A bust, in short, is not a quantitative phenomenon: rather, it is a qualitative, subjectivist and above all regenerative process whereby clusters of entrepreneurial error (facilitated and in not a few instances created by misguided government policies) are recognised and liquidated. A bust, despite the pain that undoubtedly accompanies it, is both necessary and salutary: it is only by this process that a structure of production conforming to consumers’ demands can be re-established.
This adjustment usually but does not necessarily entail a decrease of the volume and deceleration of the pace of economic activity, and its length and severity depend upon individuals’ pool of funding. A growing pool renders the process of purging entrepreneurial error shorter and less painful. Conversely, a stagnant or a declining pool makes the liquidation of “malinvestments” lengthier and more excruciating. Alas (and as detailed in Australia’s Post-Olympic Reality Cheque), the pool of funding in this country is meagre and in recent years has shrunk. Letter 24-25 stated “if the causes of the boom of the late 1990s and its subsequent bust have been widely misdiagnosed, then the remedies ubiquitously, repeatedly and massively prescribed to combat the bust – the creation of credit and rises of government expenditure – are likely to do no good and possibly much harm. Policymakers and market participants in Anglo-American countries are a devoutly religious lot, and a foundation of their faith is the conviction that governments (via aggressive monetary and fiscal policies) can engineer economic security and prosperity. According to this view, not only will a given turn of the policy lever produce the anticipated (good) result: there will be no unintended (bad) consequences.”
Example #2: Cancelling the Greenspan Put
This conviction, it seems to me, remains strong but weakened during 2002. More specifically, it appears that the so-called “Greenspan Put,” which was in the money from 1998 to 2001, expired earlier this year. This phrase entered the financial lexicon after the collapse of Long-Term Capital Management in 1998. The idea is that central banks, particularly the U.S. Federal Reserve, have in recent years attempted to create a floor under the prices of financial assets. Market participants, resembling Pavlov’s dogs, have been conditioned by Y2K, LTCM, Russian bond and Mexican and Argentine currency fiascos, attacks on New York and Washington, etc., to expect that banks will inject large amounts of credit into financial markets whenever anything is the matter. The effect of these injections has been to support asset prices (or, at least, to mitigate declines of prices). This perceived put option on the general price level of financial assets has convinced many participants that they would be able to sell assets in the future at some fixed and likely higher price. Hence the Greenspan Put – and, not incidentally, the veneration of fractional-reserve banking by most market participants since the mid-1990s. Clearly, however, reserve banks can indirectly support asset prices only to the extent that (and as long as) they can force interest rates lower; and they can do this only as long as they can cause credit to be freely available. Equally clearly, however, they cannot create unlimited amounts of credit indefinitely. Nor can they transform a poor credit risk into an acceptable one (see Interest Rates, Corporate Debt and the Business Cycle). Accordingly, at some stage the put option they create must expire, and at that point things become interesting.
That point may be nigh. As Barry Dunstan wrote (The Australian Financial Review 11 November), “the fears of some pessimists that the United States central bank may not have enough shots left in its locker to turn around the American stock market and economy are beginning to look uncomfortably prescient … The Fed must be worried after what Bridgewater Associates described as the weakest stock market action seen following a sizeable cut in interest rates. In fact, says Bridgewater, ‘Fed easing has been impotent to reverse the stock market for the first time since 1930.’ The worry is that if 5.25 percentage points of cuts haven’t achieved a stock market rally, it’s doubtful that the last 1.25 per cent will be much different.”
 
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