A crisis of confidence

I spent my nine years of college studying theoretical linguistics. Basically, the idea was to study recurring patterns in the world’s languages and come up with rules that accounted for those patterns. I hung around with some very smart people, much smarter than me. One professor in particular stood out as being exceptionally quick, sharp, and knowledgeable no matter what topic was under discussion, language or otherwise. But most of the students agreed that he was a lousy linguist, fielding cockamamie explanations of the facts one after another.

I asked a friend whose work I respected why he thought this was so. He told me that he thought the fellow was too smart, that is, he could grasp the most complex explanations so readily that he was unable to distinguish between them and much simpler explanations of the same facts. My friend considered himself blessed that he was baffled by complexity, since it forced him to seek out simple solutions, those being the only ones he could understand.

I took that idea to heart. And even though I abandoned theoretical linguistics when I left college, the idea served me well during my twenty years as a computer programmer, where I specialized in debugging programs (i.e. finding mistakes in them), especially programs that I hadn’t originally written. Computer bugs are like flaws in any other system, manifesting themselves through symptoms that aren’t always easily traceable to the source. A common weakness I saw in other programmers when debugging their own program was that they thought they understood what they had written, and so once they had come up with a plausible explanation for what was going wrong they would make some changes as if their explanation were true. This would often make the symptom go away, and they would pronounce the problem solved. But usually they had only treated the symptom and not the problem, which would manifest itself through other symptoms eventually.

Meanwhile, I always tried to maintain the attitude that I had no idea what was going on, and would spend the time understanding the relevant parts of the program from the ground up until I had that understanding. And, of course, once I understood it usually wasn’t long until the mistake became obvious. You might think that this approach is so obviously superior that everyone would use it; it certainly doesn’t require any special skills or intelligence. But it does require an ability to resist the intense pressure to Do Something!, as well as patience, and I suppose a measure of humility for admitting that you still don’t really understand what is going on.

That approach, never assuming that I understand the situation before I’m certain that I do, became a habit, and has guided me as I’ve tried to learn any sort of new thing. One helpful effect is that it is very easy for me to learn from writers that I mostly disagree with, i.e. eat the fish and leave the bones on the plate. Occasionally I’ll read something that is so contrary to what I think I know that I will instinctively rear up in response—which I have learned is exactly the time I need to calm down and reevaluate, to figure out whether or not I actually know what I think I know.

Sometimes I do, but often what I think I know is actually received wisdom from sources I trusted somewhere along the way. And often that received wisdom is actual wisdom, but all too often it is nowhere near as reliable as I thought it was when I swallowed it whole. One recent example of this is classical economics, which I took for granted as being the right and proper way to conduct an economy until I read a few histories that taught me (a) there are other perfectly reasonable ways to govern economic activity, and (b) classical economics often doesn’t yield the results in practice that it claims in theory. One of those histories is The Shock Doctrine by Naomi Klein, which I was tempted to reject out of hand because of the extreme left position that the writer takes. But after doing some independent research I decided that Klein’s presentation of the facts was accurate and her interpretation even-handed in most respects. So even though I think that Klein paints a picture darker and more conspiratorial than the facts support, and I have no interest in the solutions she proposes, I found her history to be an important corrective against the free-market cheerleading I’ve read way too much of.

My initial interest in agrarianism had nothing to do with economics. In fact, I had no real interest in economics at all until recently; I understood the basics of classical economics, and was willing to accept the word of others that it was true and good and preferable to all other systems. It wasn’t until we had been here on the farm for more than a year that things changed, and only because of an urgent email from a friend in December 2006 forwarding an article saying that the economic situation was now dire. That idea surprised me, but what surprised me more after a bit of reflection was that I really had no idea at all how the modern economic world worked, much less what sort of shape it might be in.

So I started in on studying, subscribing to online contrarian publications, reading up on the things they said that I didn’t understand, noting and digesting any sort of financial news that struck me as unusual or not well explained by what I thought I knew about economics. Along the way I was fortunate enough to stumble across intriguing references to works that have shown me very different ways to understand economic behavior, some of which I’ve posted about on this weblog.

All the while I’ve stayed mostly quiet about what I’ve been learning, not out of shyness or fear of being pegged as a nutjob, but just because I still didn’t understand circumstances sufficiently to say anything helpful to my readers. As close as I’ve come to speaking out is participating in this winter’s discussion of Hazlitt’s Economics in One Lesson, here, here, and here, and that only because I remembered it as being consistent with what I thought; if I had re-read the book before agreeing to discuss it I would have kept silent, since my thinking had diverged significantly from Hazlitt’s but I wasn’t prepared to explain why.

All this is prelude to the point of this post, which is that I think I understand something about the current economic crisis well enough to bring it up. It is probably something that you have heard before, but mixed together with a hundred other factors. But I think now that this particular factor is a fundamental one, a lens through which many aspects of the crisis can be viewed and understood.

Basically, the crisis is one of confidence; we no longer have a reasonable expectation that others will be able to do what they promise to do. I think the word “trust” might be more accurate, but it is also loaded. To say that we don’t trust someone implies that we think they are deliberately out to do us wrong, and that’s not what I mean. “Faith” is another possible word to use, indicating that we no longer believe in the promises we’re offered. But I’ll stick with confidence.

Lack of confidence is most clearly seen in the credit crunch. Banks are deciding not to lend, to consumers or businesses or even each other, for a very simple reason: they are no longer confident that they will be repaid. Again, it isn’t that they think they will be defrauded, but just that the economy is so uncertain now that they no longer know with any certainty that the folks taking their money will be in a position to repay them further down the road.

There has always been some amount of uncertainty about this, some risk, but until recently it could be calculated and counted as part of the cost of doing business; some known percentage of loans would go bad, but the money made on the good loans would cover this expense. But that percentag
e is no longer known.

There is a number that shows fairly clearly how much banks trust one another, called the TED spread, roughly the difference between what it costs a bank to borrow money from the government and what they are charging to lend that money to another bank. Usually it runs between 0.25% and 0.5%. Since the crisis began a year ago, the spread has run between 1% and 2%. And here is a graph of how the TED spread has increased over the past three months:

image

This doesn’t include today’s number, which has run as high a 4.13%. But in a real sense the number is meaningless beyond indicating that banks simply don’t want to lend to one another.

Most of the sources I follow claim that the range of actions available to the Fed and the Treasury are completely useless for fixing this problem, which they call “pushing on a string.” They say that the credit markets are frozen not because of a lack of available money, or a balance sheet clogged up with toxic debt, but because lenders can no longer have any certainty that they will get their money back. Offering a lender more money or cheaper money, or even agreeing to take current bad debt off their hands, does nothing to change this uncertainty. Short of taking on the risk itself, i.e. becoming a lender, the government has no way of persuading lenders to lend.

All that is straightforward, and has been said better by folks who are smarter than me. And we’ve all certainly heard enough lately about how credit is the lifeblood of the modern industrial economy. But what exactly does that mean? What is it about the modern economy that depends so heavily on credit?

One lightbulb went on when I read that California is “in need of an emergency $7bn loan to pay for public services such as law enforcement, hospitals and firefighting.” It didn’t surprise me that California is in trouble, but it surprised me very much to learn that taking such a loan is standard operating procedure for the state; along with many others, California regularly takes a huge short-term loan to pay upcoming bills, which it then repays with income it expects later in the year from sales and income tax. Instead of saving up their revenue to pay those bills, they get a year’s jump on things by borrowing and repaying. Worse, this is not emergency borrowing but just normal business procedure.

But for the first time all the usual lenders have told California, “Thanks, but no thanks.” Because those lenders cannot assign a number to the likelihood that California will be unable to repay that loan. Meanwhile, California’s obligations have all been incurred, and the bill comes due at the end of this month. Without that money, the state cannot pay the people who did work for them in exchange for promises of later payment. And those people—the schoolteachers, the firemen, the policemen, the doctors and nurses—are not likely to continue working without payment, and will be much less likely to continue to work in exchange for future promises of payment.

The second lightbulb went off today when I read this article about grain piling up in Canadian ports:

The credit crisis is spilling over into the grain industry as international buyers find themselves unable to come up with payment, forcing sellers to shoulder often substantial losses.

Before cargoes can be loaded at port, buyers typically must produce proof they are good for the money. But more deals are falling through as sellers decide they don’t trust the financial institution named in the buyer’s letter of credit, analysts said.

“There’s all kinds of stuff stacked up on docks right now that can’t be shipped because people can’t get letters of credit,” said Bill Gary, president of Commodity Information Systems in Oklahoma City. “The problem is not demand, and it’s not supply because we have plenty of supply. It’s finding anyone who can come up with the credit to buy.”

Ah, now I see. Credit is actually the mechanism which allows us to operate on expectations rather than tangible value. It is actually a way of commoditizing trust. We cast our bread on the waters in faith that we will eventually receive payment for it. In fact, we can even assign a number to the likelihood that we won’t be dealt with honestly, factoring in the small percentage of cases in which the buyer won’t make good on his promise and setting our prices to account for that expense.

It all works, as long as all participants have confidence in the system. But as soon as a participant loses faith, there is only one way to keep him participating: payment up front, cash on the barrelhead. That puts his buyers in the sudden position of having to pay with cash rather than promises, and to raise the cash they need they must demand cash of their buyers in turn.

How might such a trend play out in everyday life? Well, one obvious example is that you may no longer be able to buy a car without paying in advance. That by itself is an idea that isn’t too hard to swallow, since it would keep people out of debt and prevent them from spending beyond their means, both good (if painful) things.

But even having the cash in hand, will you be able to walk onto a car lot and choose a vehicle to buy? Probably not, because those oceans of cars we see today are there based on promises of future payment from the dealer to the manufacturer. So if the dealer was demanding cash on the barrelhead, you would have to first hand your cash to the dealer, who would then send it to the manufacturer along with the order for your car.

Which, as it happens, doesn’t even exist in finished form, because the manufacture is unable to obtain the materials to create your car without paying his parts suppliers in advance. So he also needs to wait for an order to come in, accompanied by payment, so that he can in turn send orders with payment to the suppliers.

Now, I don’t think it would be necessary to take this to the absolute limit. A supplier not wait for payment before taking the very first step; he might have an inventory, i.e. materials that he has invested his own savings in, so that he can fill an order promptly when it comes in. The car manufacturer might have paid in advance for enough materials to assemble the cars it thinks will be ordered within a reasonable amount of time. The car dealer may have used his own money to order some cars to have on the lot available for sale to people with the money to buy them. Here on the farm we plant crops in advance with no guarantees that the buyers will buy them, but with reasonable expectations that they will (and minimal investment lost if it turns out that they won’t).

But perhaps you now have an inkling of how much flexibility will be eliminated from the system if promises are no longer accepted as payment. Look at the next ten things you buy with cash, and try to understand how much of the economic system is waiting for their eventual slice of your payment. And ponder whether it will be worthwhile or even possible for someone to put a car in a lot, or a can of beans on a shelf, or a shirt on a rack, or a movie in a theater, or gas in a pump, if even some of the participants involved in creating the product begin to demand payment in advance.

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5 thoughts on “A crisis of confidence

  1. Good post Rick, you are right. I think the govt. is committed to socializing whatever is going to be required. I watched some of the 401K hearings on C-SPAN the other day and there are some who are salivating over the idea of taking control of 401K’s and creating a new forced govt. controlled retirement plan. Maybe they will allow Paulson to do it over night and let Bill Gross from PIMCO run the whole thing! Scary times. Many thanks to you, I moved my 401K holdings out of S&P a year ago into the most conservative cash options I had. I would not have done that if you had not pointed me towards some of the folks like Mish. Hard to know what move to take next, as you say these are uncertain times.

  2. This is one of the best, concise explanations of our current problem I’ve heard yet. I’m forwarding it on to my family.

    I looked at my 401(k) yesterday – I wish I’d done as Ethan did. If this keeps up, I’m going to start calling it my 301(k).

  3. Rick, thank you for taking the time to write this out.

    I have been following links all over the place for explanations of what is currently happening, but the reading is daunting. I’m homeschooling young children and it’s all I can do to keep ahead of their reading. I tried to follow the Economics in One Lesson readings and posts, but just couldn’t keep up for several reasons.

    I want to “break it all down and put it back together” but am not sure where to even start. And then there’s been this election thing coming up…

    Anyway, my husband and I appreciate what you wrote here.

  4. Russell Kirk once commented that Ludwig Von Mises. of the Austrian school of economics, was complaining of the “myths”, ie, custom, tradition, morality, religon, etc, that got in the way of pure capitalism. Kirk reminded him, that without those “myths” that Von Mises wanted to dissipate, that economics simply, eventually would not work. Your comments about banks not trusting each other, reminded me of Kirks observations on the subject. Everybody trying to pull financial trickery on each other, has created a world where NO one trusts anyone else. We have come a long way since the day several thousand years ago, when people starting trading pieces of metal,”coins” for things they wanted. Now the economic system has become so bizarrely complex, that people can’t figure out what anythings worth. The financial crowd became way too clever by half, and out foxed themselves. I am like you. I used to think that classical economics was the gospel. but over time and study, I began to realize that other kinds of economic systems had been around, some effective for a very long time. They didn’t produce the wealth capitalism does, but were often more stable over time. And were less wasteful with resources. Some of the ideas of Distributism fascinate me. but I don’t know how practical it is. I do know how much I hate the fact that everything in this society revolves around money. Sigh, maybe trading a pig to the doctor for birthing a child, had certain advantages to it, sometimes……….

  5. Your conclusion was proven today as the Fed took action to uclog the flow of credit precisely due to the “confidence” situation.

    http://biz.yahoo.com/ap/081014/financial_meltdown.html

    “Said Treasury Secretary Henry Paulson: ‘We regret having to take these actions. Today’s actions are not what we ever wanted to do — but today’s actions are what we must do to restore confidence to our financial system.'”

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