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The Red Queen US Economy

Economics / US Economy Nov 27, 2007 - 04:33 AM GMT

By: Paul_Petillo


"Well, in our country," said Alice (of Lewis Carroll's "Through the Looking-Glass" fame), still panting a little, "you'd generally get to somewhere else — if you run very fast for a long time, as we've been doing."

"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"

While the Red Queen suggests that adding speed will make things better, several things are happening on this side of the looking glass that may prove that speed could have been the catalyst for our recent and near future economic woes and how running in place might save us.

The Blame Game
We could begin by pointing a jagged little finger at the housing industry as many have and many will in the coming months but that would be an exercise with little benefit. Much like the downstream effect that cars have on jobs – the creation of an automobile doesn’t just employ the carmaker, it relies on the efforts of hundreds of additional businesses along the way to create the finished product and beyond, housing problems involve just as many interlocking entities.

It would be easy to blame housing as a whole for the mess we are now realizing might be much bigger than previously anticipated. But we would have missed the mark.

Wall Street appears to be suffering from the fallout of numerous bad debt write-downs and the possibility that even more will be uncovered. This, and the unsavory realization that suggests that debt may not be as sure an economic driver as it once was simply reveals that borrowing money without understanding of what is being used for collateral is still reckless and foolhardy.

Not only are the write-downs going to continue well into the next year, the second wave of despair for these banks and lenders of repute will come with the full support of the legal system. The institutions that represent the average investor will sue on our behalf. Sadly, the litigation will come far too late to help anyone but the lawyers.

The Business of being Wrong
Wall Street will not suffer the way we think they might in light of the current credit debacle. Sure the ranks will be thinned among financial institutions big and small. And many of theses banks will be ill prepared when the economy eventually turns around – see, I am optimistic, kind of. The problem is that many on Wall Street continue to profess a Fonzy-like inability to admit they were wrong.

Could Paul J.H. Schoemaker, who not only teaches marketing at the Wharton School of Business but also serves as chairman of Decision Strategies International be correct in his assumption that we are not as prone to risk, as we like to think we are? His contribution to the 2006 paper titled “The Wisdom of Deliberate Mistakes” seems to suggest that the great financial institutions are not really prone to making mistakes and if they are, the quickly dismiss them as merely a bump in the road. This is called a write-down.

Experience, Mr. Schoemaker suggests keeps the amount of mistakes we make to a minimum because we are confident decision makers that hoard similar ideas as our own close to us hoping that whomever is gathering the information we need to make decisions is reliable and without fault. Such mistakes are quickly covered with plausible deniability. The worst that can happen as a result of this behavior is the failure to innovate.

Further down the line and a few feet away from Wall Street are those of us who have mortgages. Here is where real innovation blossomed; unfortunately its weed-like characteristics have proven not so desirable.

Some would say that the banks were to blame and they may very well be when it comes to the subject of sub-prime loans. But those loans were made to folks who would never have qualified at any other time in their financial lives to buy a house and unfortunately, may never have that opportunity again. They were financial bumps.

Now we are faced with the Liar loans. These loans, made without documentation and their soon to be featured cousin, the Nina loan – no income, no assets - have now surfaced on the economic landscape. These loans, although they should have also been qualified as sub-prime, made their way into the prime lending side of the marketplace.

This hurts two groups of people: those looking to refinance and those who cannot because many of many of these much talked about adjustable rate loans came with pre-payment penalties. Perhaps we should fault the borrower for what might become the recession of 2008. But that would be wrong as well.

If not the borrower or the banks or Wall Street and if the fallout of these mistakes affects numerous downstream businesses from builders to retailers and eventually to the service industry – which if you haven’t been paying attention to of late, makes up the lion’s share of the employment reports plus side numbers, who should we blame?

The Red Queen Hypothesis
Not Alan Greenspan, the 81-year-old Federal Reserve Chairman turned author, who, while speaking in Oslo recently suggested that he had nothing to do with the housing downturn. Looking the other way is always politically motivated and not error proof Mr. Greenspan. And if you were not to blame for enabling the industry to innovate with bargain basement rates, then who might be held accountable?

Should we blame Henry Paulson who suddenly feels much the same frustration his immediate predecessors did? His anemic attempt at creating a Superfund, which has many of the larger participants have been begging for smaller banks to pitch in with effort, will fall well short of its goal and like so many other federal attempts, it will be very late to the rescue. Suddenly, the U.S. Treasury Secretary looks lost.

Should we blame Congress as Mr. Paulson has done? True to form, the wrangling reaction to this problem was expected from our lawmakers and in the end, it may save the economy because of their seemingly unconscious ability to “run in place”. Congress doesn’t need to place the taxpayer in danger of paying for a bailout. That, many fear would happen should Congress allow Fannie Mae to help with the clean up.

No. The blame falls squarely on the front doorstep of the White House.

“Alice never could quite make out, in thinking it over afterwards, how it was that they began.”

This administration went to great lengths to encourage the hand-in-hand belief that every economic decision that was made was made with the intention of creating a better economy. Great economies are forged under adversity and become innovative because of it. Institutions that were created following the Great Depression, a housing situation that is remarkably similar to the current one (FHA, The National Association of Real Estate Boards, The Federal Home Loan Bank Board, the Appraisal Institute and eventually, in 1938, FDIC, Fannie Mae) grew from leadership in Washington. First Hoover and then Franklin D. Roosevelt, both of whom created protections that stood relatively steadfast for seven decades.

“And the Queen seemed to guess her thoughts, for she cried, `Faster! Don't try to talk!'

Not that Alice had any idea of doing that. She felt as if she would never be able to talk again, she was getting so much out of breath: and still the Queen cried `Faster! Faster!' and dragged her along.”

Needlessly cutting taxes, professing a strong dollar stance while letting the dollar fall, and funding a war, all done on the backs of foreign debt may have been, in hindsight, the reason we are where we are today.

Unfortunately, unlike the conclusion of Chapter Two in Carroll’s tale, we will not find ourselves back where we began.

“`You may rest a little now.'

Alice looked round her in great surprise. `Why, I do believe we've been under this tree the whole time! Everything's just as it was!'”

We are without a surplus, indebted to the world for over $8 trillion, waging a conflict that saps three-quarters of a billion dollars a day from the coffers (based on the work of Nobel Prize-winning economist Joseph E. Stiglitz and Harvard public finance lecturer Linda J. Bilmes, who suggests that the war in Iraq is costing $720 million a day or $500,000 a minute), and facing the possibility that we will be smack dab in the middle of a recession because of lack of clear economic leadership.

“`Of course it is,' said the Queen, `what would you have it?'”

Leigh Van Valen, noted evolutionary biologist observed something in nature he called the Red Queen Hypothesis.

In it, he described the evolutionary change by one species (a prey or host) could lead to extinction of other species (a predator or parasite). Those changes and the probability that such changes might be reasonably independent of species age were made to avoid extinction. The predator or parasite species had to "run" (evolve) in order to stay in the same place (extant). In other words, we will save ourselves by running in place. What the world will look after such a dramatic financial and evolutionary change is what is unknown.

By Paul Petillo
Managing Editor

Paul Petillo is the Managing Editor of the and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via:

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