Economic Commentary: Occupy Wall St

Investors,

60 years ago a wealthy man owned and operated a factory and made 20x what his workers made. Today, the wealthy man got wealthy by lying about the value of derivatives and made 100x the earnings of the workers in the pension fund he fleeced. The Occupy Wall St movement reflects disillusionment and anger; beyond that there are few shared goals. However, it plays a critical role in the 70 year boom-bust cycle we're experiencing now. In this commentary I'll discuss the movement, where we are in the boom-bust cycle, and some political views. First, a very brief rehash of the recent news and market action.

Recent News and Market Action:
Eurozone political leaders announced a new resolution; it's far from a solution to the Euro problem, but a legitimate strong step in the right direction. They've organized an orderly default of Greece (that will not legally be called default to avoid triggering Credit Default Swaps), an increase in the EFSF bailout facility to a trillion euros, a plan to recapitalize banks, and additional austerity measures. It reduces the risk of a catastrophic disorderly default, and so the market rallied strongly on the news. Equities were oversold at the start of the month, so the anticipation and realization of this good news led to a whopping 14% rally. I just sold my long crude oil position for a 13% gain, probably far too early but I am again uncomfortable being long any risk assets. If the market continues to rally I will scale into a larger short equity position. Global economic releases have been generally bad suggesting a global recession is still the base case.

The 70 year boom-bust cycle:
Historically, developed markets experience 70 year credit booms followed by major busts. The basic pattern is that the boom begins with real growth in productivity, this kindles "animal spirits" and encourages entrepreneurship, investment, and easier credit. Over time the general public becomes giddy with the pace of development; politicians reduce regulation which leads to booming profits, especially in the financial sector. Eventually the credit gets too easy and rational greed becomes stupid greed and we get a bubble. When the ponzi scheme of easy credit reaches its pinnacle, the bubble collapses and we go through a painful deleveraging process. Excessive debt can be eliminated in 2 basic ways - you can pay it off with profits (or taxes in the case of national debt) or you can forgive the debt in bankruptcy court or a similar restructuring. When a credit bubble is unwinding, profits and tax revenues are shrinking, so option #1 is impossible. So far, the government has tried to shuffle the debt to parties more able to bear it and to push the debt into the distant future when hopefully tax revenues will be higher. There are also plans for additional debt forgiveness for homeowners and students.

The role of social unrest:
You may recall in mid 2009 that I questioned why we didn't see more social unrest. In my studies of history, every major credit crisis has resulted in significant social upheaval. I wasn't expecting revolution in the USA, but isolated riots could be expected. At the time, this influenced my belief that the "bust" portion of the cycle had much further to go. I continue to believe that until we see major social unrest and the average american swear off equity investing, that the "bust" portion of the cycle is not complete. Right now we're seeing the early stages of a major social movement. The mainstream media continually understates the size of the demonstrations, but they are large and growing. What can we expect in the future? This is a difficult question because early stage social movements are chaotic beasts. I am very curious as to how the social will eventually be converted to the political. President Obama seems to be trying to co-opt the movement, but he has proven he lacks the stomach to confront special interests. The ultimate outcome of the anger will likely be sweeping regulatory reform. Economists and politicians currently believe that the "too big to fail" banks must be kept gigantic; they believe that there are inherent economies of scale in banking and that smaller banks will either be uncompetitive or simply reunite like the Ma Bell telephone companies. If this view holds, the only option is to more thoroughly socialize the banking system. Banks will likely be separated into retail banks with government backing and implicit subsidies that remain huge, and investment banks that will effectively be forced to shrink in size as they lose the implicit government support. The result will likely be that the finance sector in general becomes smaller and much less profitable, both at the corporate and individual level. As investments, the financial sector is likely to underperform the broad market over the next twenty years.

The politics:
A frequent criticism of the Occupy Wall St movement is that it has no cohesive goals. This is a valid criticism - the movement includes both socialists and libertarians - its members call for more government redistribution of wealth and better health care and support for unions - and the exact opposite. The greatest theme that resonates with me, and I believe will eventually resonate with the middle class, is one of fairness. I am a tremendous champion of capitalism. The problem today is that the government is supporting crony capitalism. Small banks recently had their fees and taxes hiked to pay to support a handful of "too big to fail" banks. Incompetent CEOs are receiving $10+ million dollar golden parachutes even as their companies are saved from bankruptcy with taxpayer money. Companies like General Electric have an entire branch devoted to lobbying government for customized tax loopholes; these loopholes make it nearly impossible for smaller companies that can't afford similar lobbying to compete. This isn't a question of wage inequality or liberal vs conservative politics. This is a question of integrity. It appears to many observers (myself included), that government regulation is actually entrenching corrupt business practices. Businesses are then forced to either compete with their own lobbyists and unethical financial schemes or to resign themselves to shrinking profits or even bankruptcy. Citigroup CEO Charles Prince said, "When the music's playing, you've got to dance." In today's oligopolistic industries which include the banking sector, ratings agencies, and even software, our only hope is for the government to turn off the music and stop encouraging the unethical behavior.

Back in 2009 I tried to do my part and voiced support for a "Tobin Tax": http://www.riskoverreward.com/2009/11/in-support-of-tobin-tax-vega.html

Cheers,
Ari