Market Report: December 2008

This article was written right before Thanksgiving. The caveat is important because our financial world seems to be changing daily and it is hard to be up to date. Next month I will review the limping commercial real estate market. Thus far it has been spared the worst effects of this recession but that may be changing. The good news is that the Fed will be ruthless in their efforts to drive down long-term mortgage interest rates. Housing must be saved to keep deflation in check so I would not be surprised to see 4% fixed rate loans next Spring. Have a restful holiday season, you will need it.

Mr. Keynes Goes to Washington

The are now two new economic rescue plans in play, the one the President and Congress put in place and the one proposed by the President-elect. Each has different intellectual fathers. The President's plan reflects the trickle down theory of prosperity. This concept is generally attributed to Arthur Laffer and his gang of supply-siders who views dominated the new economic policies of the Reagan administration. This idea is the underpinning of the current plan, the Troubled Asset Relief Plan (TARP), where tax dollars are going not to needy borrowers but to presumably even needier banks and insurance companies. The argument is that cash injected at the top of the economic food chain will eventually find its way to the bottom. Mr. Obama, rooted more in pragmatism and less in ideology, is reaching to another era for his idea. His proposed plan features old-fashioned New Deal-style pump priming-an economic theory popularized by John Maynard Keynes. Mr. Keynes advocated using borrowed government dollars to create programs that exist solely to make new jobs. For some history, there are many buildings and bridges still in use locally that were constructed during the Depression by such agencies as the Works Project Administration.

Owners of residential and commercial properties not in financial distress need these both of these plans to succeed. Those selling property, and other hard assets, have already been mugged by as yet unchecked deflation. Unless presented with an incredible bargain, property buyers tend to postpone purchases because they believe prices will be lower next year. When sellers believe this to be true, there is less incentive to try and hold on to a distressed property or even performing real estate. A declining price cycle feeds even more unwanted property onto the marketplace, leading to more deflation. One need only to look across the Pacific to see a chilling example of this cycle in action.

During the 1990's Japan endured over a decade of collapsing asset values. Stock and real estate prices fell steadily because the Japanese consumer chose to save and not spend, ignoring the lure of negative interest rates. Japan's storm occurred within a sea of inflation-based Western economies that were generally prospering. The difference this time around is that most, if not all, industrialized and non-industrialized economies are facing the same peril. The central bankers of the G20 countries and other significant players know this. Deflation will destabilize governments and societies; marginally unacceptable inflation will not. There will have to be a level of international cooperation amongst them not seen since Bretton Woods. If all the major countries act in concert, they can inflate currency enough to at least stabilize prices of assets and commodities.

Income property owners should pay close attention to this battle. Stocks and most residential real estate have already deflated substantially but there are other potential dangers. True there are geographic pockets and real estate sectors that have only been minimally impacted thus far but owners should not be complacent as the disease may spread to these healthy markets. Without an acceptable amount of consumer activity and job stabilization, owners of all forms of income property may not, in the next one or two years, be able to service or finance their mortgage debt. Without personal spending, there may be a similar bloodbath to what occurred in 1991-1995. During that period there was a wave of commercial foreclosures that destroyed all of our local lending institutions. Remember San Diego Federal?

This is a different and still unfathomable financial world. The electorate is demanding an activist central government that will do more than has been tried thus far. We are lucky in that our friends abroad, long perturbed with our recent behavior, are ready to cooperate to help solve this problem. Because of this I am less inclined to believe in the many doomsday visions of our future. We will still have a painful two years going forward, even with more assistance from the Treasury. The size of the problem is going to require solutions found outside our ideological comfort zone. We, as a nation and as individuals, will learn to adapt and live with less.

Our central government historically has had a limited capacity to affect the course of the business cycle. Mr. Paulson, now in charge at Treasury, has had little success thus far with his top-down approach. Mr. Roosevelt in his first two terms, and only in fits and starts, was arguably more successful with his far bolder bottom up strategy. Mr. Obama, coolly watching on the sidelines, saw TARP shower 125 billion on the banks. Lenders, in spite of all this Federal largesse, still will not loan money in any meaningful manner. Their unwillingness to unfreeze the credit markets has thoroughly discredited the supply-siders.

I am sure the President-elect noticed this disingenuous conduct of the banking industry. These institutions apparently did not follow the election results and are behaving under the rule of the old regime. The money was given to them to loan to businesses and consumers, not to acquire other banks or fatten the balance sheet. Recognizing this, Mr. Obama's first major economic proposal appears to be pure retro-New Deal and bypasses the traditional credit markets. I think the inspiration did not come wholly from Mr. Roosevelt but from a recognition that corporate America is often at odds with the common wealth.

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