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Monday, October 20, 2008

Jim Grant on Market Confidence

Jim Grant, the editor of Grant's Interest Rate Observer (source: WSJ):

[The Confidence Game ]
In disclosing plans to buy a quarter-trillion dollars of bank stock in the name of the American taxpayer, Treasury Secretary Hank Paulson harped on confidence. "Today, there is a lack of confidence in our financial system, a lack of confidence that must be conquered," he said on Tuesday.

What Mr. Paulson did not get around to mentioning was the excess of confidence that preceded the shortfall. Under the spell of soaring house prices (and before that, of stock prices), Americans trusted the things they ought to have doubted. But markets are cyclical, and there is always a new day. In compensating fashion, people will eventually doubt the things they ought to have trusted. Investment opportunity follows disillusionment. It's complacency that precedes bear markets.

If the confidence deficit seems so high, it's because the preceding confidence surplus was full to overflowing. People suspended critical judgment. They accepted at face value the pretensions of central bankers and the competence of investment bankers. Not one professional investor in 50, probably, doubted that wads of subprime mortgages could be refashioned into bonds that were just as creditworthy as U.S. Treasurys.

....

But it wasn't the vigilance of monetary policy that facilitated the construction of the tree house of leverage that is falling down on our heads today. On the contrary: Artificially low interest rates, imposed by the Federal Reserve itself, were one cause of the trouble. America's privileged place in the monetary world was -- oddly enough -- another. No gold standard checked the emission of new dollar bills during the quarter-century on which the central bankers so pride themselves. And partly because there was no external check on monetary expansion, debt grew much faster than the income with which to service it. Since 1983, debt has expanded by 8.9% a year, GDP by 5.9%. The disparity in growth rates may not look like much, but it generated a powerful result over time. Over the 25 years, total debt -- private and public, financial and non-financial -- has risen by $45.1 trillion, GDP by only $10.9 trillion. You can almost infer the size of the gulf by the lopsided prosperity of the purveyors of debt. In 1983, banks, brokerage houses and other financial businesses contributed 15.8% to domestic corporate profits. It's double that today.

...

In investment markets, confidence and coherence tend to restore themselves. The hardy souls who lead the way back derive their confidence not from the Treasury Secretary but from the pages of "Security Analysis," by Benjamin Graham and David L. Dodd, the value investor's bible.