The Financial Markets: Credibility Versus Credulity

The airwaves, TV screens, and newspapers are awash with pleas from the most senior of our political leaders for "confidence" and "patience." These notables, who have reinforced the faltering legions of FED "policymakers" in pleading for "time" and "confidence" coincidentally overlook their own role in undermining the very confidence for which they now plead.

Abraham Lincoln's famous formulation about fooling all of the people some of the time, some of the people all of the time, but not being able to fool all of the people all of the time DOES NOT APPLY to financial markets. While it is certainly true that markets can go a long, long way beyond the injunctions of rationality, valuation, and prudence IT IS MOST ASSUREDLY NOT TRUE THAT THEY CAN DO SO WITHOUT THAT MAGIC INGREDIENT -- CONFIDENCE.

CONFIDENCE in the financial markets is based upon CREDIBILITY, NOT CREDULITY. During periods of stress, confidence can be a fragile thing. Once broken it is hard -- and costly -- to repair.

Nothing destroys confidence like the repetition of grossly erroneous prognostications by central bank policymakers and senior political officeholders AS THE INCORRECTNESS OF THESE REPEATED PROGNOSTICATIONS becomes increasingly clear. Markets have no respect for such officials, and place less and less credence in their assurances, which are increasingly perceived as akin to magical incantations which have no basis in reality. The credit markets vote, and they vote by allocating and pricing credit. Their judgments can be astoundingly clear.

In the current crisis, the bedrock reality is that the credit market has CONTINUED TO DETERIORATE. Credit is both scarce and dear, except where confidence continues to exist -- viz., in the Treasury market. The commercial paper market continues to shrink. That the rate of contraction has diminished is hardly justification for the incipient hosannas we are hearing. It is getting WORSE, in both absolute and relative terms. Ditto the mortgage-backed market, and the overall market for low quality (ie, junk) bonds.

We read daily of "private" bailouts -- banks taking onto their own their balance sheets the assets and liabilities of their SIVs (Structured Investment Vehicles -- ie, off-balance sheet units which hold staggering quantities of dubious paper, which continues to erode in value and is in many cases unsalable), banks taking up the slack in the commercial paper market, central banks injecting hundreds of billions of liquidity for brief periods into the money market. These are serious matters indeed, posing as they do the potential for a classic financial collapse, followed by a serious recession, or even a traditional depression. (Yes, the "D" word is much scarier than the "R" word -- that is why no one dares use it).

Having allowed the situation in the credit market to reach this dangerous pass, the Federal Reserve will now have to lower interest rates MUCH MORE than would have been the case had they acted in a more timely manner. The forthcoming flood of central bank manufactured liquidity will be much greater than it need have been, and the inflationary consequences down the road will be greater. Bottom line: substantially lower growth in coming years than would otherwise have been the case.

If the wages of sin are death, then the wages of inept central bank policymaking based upon lagging indicators and failure to implement their regulatory duties are long-term economic underperformance punctuated by periods of intense economic misery for the most vulnerable in our society.