The Bailout: A Good Step for Bad Times By Ernie Ankrim, Ph.D., Chief Investment Strategist Russell Investments October 2008 You already know that the bailout (Emergency Economic Stabilization Act of 2008) passed the Senate in revised form and then the House. The President signed the legislation into law. Now what? Let's set some ground rules before I give you my opinion. I'm writing this on October 3, 2008 while the ink from President Bush's pen dries on the legislation. The fact is, neither I nor anyone else can predict the future. October, to begin with, could be a very rocky month. And the law of unexpected consequences could always kick in. What appears to most of Congress and most financial experts as a sound approach to restoring liquidity and confidence could have a hidden weakness that won't show itself for days, weeks, months or longer. In short, political candidates may have all the answers, but I don't. Most of all, I don't want to sugarcoat the situation. It has been bad. Very bad. That being said, the bailout makes a world of sense. To see why, let's first look at a bit of history. The Great Depression and the Knowledge Base Let me state clearly that as big as the financial shock we've faced may be—and it's not over—we're not staring at another Great Depression. There's a good reason. We've survived one and learned some lessons from it. The Crash in October 1929 featured a major sell-off exacerbated by conditions that we don't have now. Low equity margin requirements created huge leverage that multiplied losses as the market headed downward. But most economists don't see this as the major cause for the depth and duration of the Depression. Instead, they point to bad macroeconomic policy by Washington. In a time of distress during the early 1930s, the Federal Reserve ("the Fed") raised interest rates. It believed that it would encourage responsibility and frugality by suppressing what it considered to be fairly useless borrowing and enabling savers to get high returns. The concept might have been noble, but it was wrong. Furthermore, President Hoover tried to balance the budget. As revenues declined, expenditures had to be cut. This worsened economic contraction. Also, Congress placed tariffs on imports to protect jobs. This, and similar actions by our trading partners, reduced world trade. Any one of these decisions was bad. The three together made this one of the worst experiences in the last century of U.S. economic history. On the plus side, our experience in the 1930s offered a textbook case of what not to do in the face of a financial shock. As a result, the Fed has been aggressive in keeping interest rates low and adding liquidity to the system—and for good reason. Chairman Ben Bernanke was saluted for his research on the Depression while teaching at Stanford and Princeton. Mr. Bernanke truly understands what bad policies and negative reactions to economic shock can do. So we have a Fed chairman who understands better than virtually anyone else what happened then and how to avoid those mistakes now. As to the bailout, if the U.S. decided to increase interest rates, cut expenditures and restrict imports, I'd be very pessimistic. But Mr. Bernanke and Treasury Secretary Henry Paulson have recognized the distress in financial markets and understood that the markets don't operate in a vacuum. They influence the broad economy in a big way. So they're actively engaging in providing added liquidity to financial institutions with assets less valuable than expected, enabling them to eliminate "toxic waste" on their balance sheets. Another Lesson: Japan At the end of the 1980s, Japan's economy suffered a major setback with the collapse of the real estate bubble. As a consequence, the country suffered a "lost decade" of economic stagnation. Here, too, a major lesson appeared. Tokyo's basic approach was to avoid government intervention. The Japanese were very slow to react. The central bank sought to keep monetary policy tight to protect the yen. The long delay in government intervention extended the downturn. A Big First Step with More to Come Again, let me be straightforward. In and of itself, the bailout bill signed on October 3 is not enough. The challenge we face is complex, and we're not done yet. But it represents a critically important first step that had to be taken. I expect more steps to follow. Over the next few weeks, the Fed may lower its target for overnight rates for banks lending to each other. As I write, the inter-day federal funds rate, which banks pay when they borrow from each other, is only 0.66%. The Fed has added so much liquidity that the rate has dropped well below its 2% target. I suspect that the Fed isn't done. Beyond concerns regarding unemployment and inflation, their focus is on maintaining the integrity of our financial system. They're more likely to respond correctly based on historical knowledge. We may see more fiscal stimulation, too. President Bush's stimulus package earlier this year had some effect on sales and GDP. The next president may consider another such package. And although it hasn't happened yet, I think we'll see more liquidity added to their systems by Britain's and the European Union's central banks. While the EU central bank's sole charter is inflation protection, the Continent is slipping into economic distress. In fact, the EU's economy is decelerating faster than ours. Global expansion of liquidity will increase people's desire to buy financial assets and lend money by bolstering confidence that loans made now will be repaid in future. Government at its Best and Worst A question asked in the vice presidential debate on October 2, 2008—perhaps anticipating the second version of the bailout bill—was, "Have we seen an example of Congress at its best or worst?" I believe we've seen both. Here's the good: Let's understand that no one could come up with the perfect answer to our crisis in a week. All the flaws in any plan can't possibly be ironed out even in a month or two. But if we waited until everyone debated the issue and pounded out a perfect fix (if such a thing exists), another five major banks could have failed and hundreds of other companies gone under. As Steve McQueen's character (a sailor) in the 1966 movie, "The Sand Pebbles," shouted while under attack, "Do something!" Congress rallied and reached out to each other across the aisle. They did something. And I can't emphasize enough that acting offers us a far better chance of succeeding than doing nothing and extending our credit stress. And here's the bad: There's a reason that the Senate passed its own version of the bill after the House voted down the initial bailout plan. Two thirds of Senators aren't running for re-election in November. Every member of the House is. Our representatives yielded to an American public that was, for the most part, under-informed (rather than misinformed). The bill was characterized as a $700 billion tax bill. Many people actually believed they'd get a bill in the mail. But the bailout does not represent an actual expenditure of money. It's an investment of assets. The House first failed to come together because fearful representatives followed polls among constituents rather than leading. One more thought here. I spoke to a group recently that included a high school student who offered that maybe we should have a depression to wring the excesses out of the economy. Much of the public and many of our representatives espoused this kind of thinking. I consider this the troubling remark of people who never experienced the personal suffering associated with double-digit unemployment and the loss of homes. Talk with anyone who lived through the Depression. They'll tell you that this wouldn't be a prudent way to go. Bottom line? The crisis in our financial system could never simply settle itself out. Facing up to the "R Word" Things will probably get worse before they get better. Today, after President Bush signed the bailout, the U.S. market, as reflected by the broad-market Russell 3000® Index, which had initially showed a positive reaction, ended the day down 1.6%. Obviously, this bill won't restore all lost confidence at once. But without it we easily could have been down 5% that day. Don't think I'm cheerful, however. At least, not in the short run. I believe we'll be in a recession in the fourth quarter of 2008 and through the second quarter of 2009. I didn't think things would be so bad a year ago, but the scale of our financial mess was larger than most analysts, myself included, imagined. That being said, I don't expect a recession as bad as those in 2001-02 or 1973-77. To get us moving forward, the next president will have to make sure we stay committed to the bailout solution. This will buy important insurance against repeating the mistaken experiences of the 1930s when credit evaporated. What exactly will happen? No one knows. But the bailout enables us to avoid dooming ourselves. So What Do You Do Now, Mr. and Ms. America? Everyone is asking, "Is my money safe?" If you're holding cash, up to a certain point, the answer is yes. The FDIC now insures savings and money-market accounts up to $250,000 per account. But a caveat is in order. People who want safety in a scary environment may find that they're hurting their investment strategy. I don't advise buying equities for the sake of buying. I can't possibly tell you which way the market is headed—short-term at least. I can say that folks who hunker down for 12 to 24 months with low savings and money-market interest rates risk missing out on the market's eventual upturn. It's a tough time. It's a tough call. But we've taken a critical step forward and can pause a moment to catch our breath. We've been through a lot. I believe that we'll pull through. When we have to "do something," we do. These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only. Nothing contained in these materials is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. The Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. The Russell logo is a trademark and service mark of Russell Investments. Copyright© Russell Investments 2008. All rights reserved. Securities products and services offered through Russell Financial Services, Inc. (formerly Russell Fund Distributors, Inc.), member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. RFD 08-1145 First used: October 2008			Subscribe to our Education Center RSS Learn more about using and subscribing to RSS   Comment on this Perspective What is your impression of Ernie Ankrim's insights? Provide your feedback.   Why Russell? See the difference Russell's investment approach can make   Printer friendly version of this page Send feedback or comments Site Search

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