Tuesday, September 16, 2008

The Espinal View

By Christopher Espinal

Warren Buffet’s methodology of choosing common stocks involves
one of several principles: there will be a point in time when
every company must return to a stock value such that it
reflects its true intrinsic value.

In a time of managerial testing that demands all energy from
all firms in Wall Street, it seems inevitable that the stock
value of these companies must reflect their true intrinsic
value. The problem is that some of these companies have
intrinsic values close to zero – we can see that the market is
weeding out these firms as we speak.

Now, every man and woman in America have put in place a new
mental guard, aimed at controlling the impulses that put
future incomes and comfort at risk; all probably too late. How
far can this go? What is next? Who will be affected by this
Irrational Exuberance once accommodated by Wall Street?

There may be a simple answer to that question. If we remember
possibly the only useful tool in macroeconomics, the circular
flow diagram of income and production, we remember that
savings and securities investment flows into the financial
system. That money then makes its way into firms that will use
that flow of capital for investment and expansion. As any
reasonable person would conclude, the financial system is the
heart of growth in any country.

Let’s garnish this network of economic systems with today’s
problems. Many households defaulted on sub-prime mortgages
that are putting mortgage institutions in a hot seat. This
develops into an issue for investment banks that traded and
sold securities, backed by these junk-bond-like mortgages, to
their clients. Now investment banks that heavily invested in
these securities are falling apart.

The result is only a declining confidence, which places our
financial system at risk. If people don’t pump money into the
very institutions that serve as trading centers for securities
in the private and public sectors, then they will collapse. We
are currently seeing Lehman Brothers and possibly Goldman
Sachs on life support.

If these companies collapse, everyday Americans will lose
their pension funds, mutual funds, and the various forms of
security derivatives their future depends on. This collapse
will then fall into the commercial banking sector.

The companies that use your money as loans to pay for all
sorts of management issues may not be able to pay back – just
as Lehman Brothers has filed bankruptcy. This will cause banks
to lose your money, and that may create another bank-run, just
like the beginning of the Great Depression.

Milton Friedman, along with several other economists,
concluded that the Great Depression resulted from a lack of
dispatch of liquidity from the Federal Reserve. Ben Bernanke,
whom many call a student of the Great Depression, will seek to
cure his inherited problem by doing just the opposite – making
available to the financial community the dollars necessary to
remain alive, as opposed to stable. Depending on whether
Bernanke believes our current situation to emulate the Great
Depression or the Stagflation era of the 70’s, he will decide
to keep interest rates low to evade a situation like the
former, but will raise interest rates to avoid the latter.

The Great Depression dealt with a banking crisis similar to
the one we are dealing with today. If this situation has a
closer fit to today, then interest rates will remain low. To
be honest, a collapse of the financial system is much worse
than Carter’s stagflation. With no financial system, and no
flow of capital, there will be no growth – just like in the
third world.

But expect one thing to happen as a result of this liquidity
expansion: inflation and thus prices will continue to rise. To
avert this problem, take your savings and exchange those 20%
cotton sheets of paper for commodities with stable values.

Christopher Espinal is an economics student at the University of Chicago. He can be reached at espinalc@uchicago.edu

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