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Sunday
Jan182009

Part Trap(ed); Part T.A.R.P.(ed)

This post is in part influenced by the seemingly infinite depth of government pockets for the banks as demonstrated by the inclusion of Bank of America under what I’m calling The US Nationalization Bank. And the de-leveraging effect – and the resulting need for even more government capital - continues to be a headline story as banks announce their quarterly losses. A constant reminder that we are far from out of the woods.

In addition, this post is influenced in part by the upcoming earnings season for US airlines. Wall Street’s best analysts already suggest that 2009 may be a very good year for the industry. But I’m uncomfortable about some of these predictions which are based on how far the revenue line would have to fall before it overwhelms the savings in fuel, without giving appropriate consideration to demand.

John Maynard Keynes and the Liquidity Trap

As the stimulus story unfolds, we are reminded that Keynesian economics are back in vogue and more important than monetarist policies in helping to pull the US out of this downturn.

For those who remember Economics 101, Keynes theory promotes that C (consumption) + I (investment) + G (government spending) + X (exports) – M (imports) = National Income. We have talked many times here about the virtuous circle of airline prosperity. Keynes also held that there was a virtuous circle: the flow of the money supply whereby one person’s spending becomes another person’s income, propagating a cycle where consumption drives incomes, drives more spending, and so on.

Keynes first made a name for himself during the Great Depression based on the other side of his theory in which he argued that savings or investment slows consumption, contributing to negative economic output, or a recessionary environment. According to Keynes, a depression occurs when a recession falls into a “liquidity trap”. A liquidity trap occurs when consumers curtail spending to conserve cash; banks do not loan or businesses do not see a need to borrow; and there is little investment because prospects are not promising.

From Keynes perspective, government intervention through increasing the money supply is the solution to the liquidity trap, allowing the virtuous circle to begin anew.

Fear and Greed; Greed and Fear

It is said that fear and greed are the two primary psychological drivers of investing and the markets. In the past I have referenced the concept of the velocity of the money supply, where greed has been at the epicenter for some time. Greed is bad in that it ultimately leads to asset bubbles as emotional buying supplants proven practices of smart buying. But just as devastating is fear which leads to emotional selling and unintended consequences for the macroeconomy.

Is T.A.R.P. a Trap?

There are many smart economists out there assessing not only the credit crisis and all things banks but also the policies and programs that may succeed in steering the country back onto the virtuous circle of economic prosperity. In this space, I’ve discussed the deleveraging of banks and the multipliers at work as banks do just that.

For simplicity’s sake, let’s think about in terms of a multiplier of 10. The banks have stepped up their timetables to announce their financials – in this case likely multi-billion dollar losses.

In the banking world, these losses should be multiplied by 10 to determine the effect on the money supply. Assume the banks announce pre-tax losses of $100 billion for the current quarter, a good starting point because the initial outlays from T.A.R.P. tranche #1 have been made. So, absent even more government intervention, a $100 billion loss would have another $1 trillion impact on the money supply. Bank of America is the most recent example. Having already announced losses greater than expected, the government hands over $20 billion more in T.A.R.P. funds and agrees to backstop even more.

The problem is that the U.S. government keeps writing checks we cannot afford. The question is whether we can afford to not write the checks? A supply of money with no velocity does no one any good. The unintended consequence is consumer fear. And cautious consumers may lead to a hoarding of disposable income except for items that are essential for day-to-day living - thus perpetuating a self-fulfilling prophecy.

What Does Any of This Have to Do With the Airline Industry?

The success of the airline industry is unequivocally tied to the health of the macroeconomy.

I cringe at recent media reports that Delta Air Lines expects industry revenue to shrink 10 percent in 2009. For Delta alone, that implies a revenue loss as high as $2.5 billion. The reports then go on to paint a rosier picture based on fuel costs that, at current prices, could save Delta as much as $5 billion this year. Does that mean a $2.5 billion profit for Delta and windfalls across the industry?

Ain’t gonna happen.

Time will tell. But I’m not ready to jump on the bandwagon that is predicting airline profitability just yet. Yes, the industry’s efforts to cut costs and control capacity have impressed analysts and that could be a boon for airline shareholders who have been on a wild ride in recent years.

But a closer analysis through a Keynesian lens tells a more cautious tale. History provides a prism to make learned predictions. Keynes would say that a Depression is the result of a recession that fell into a liquidity trap. We may not be there yet, but I fail to see how the other tools in Keynesian Theory could be used to stimulate economic activity today. Unless consumers begin to feel, and act, more optimistic, airlines should not count on a stronger demand for their product. As the industry continues its remake in response to an ever changing economic environment – and capacity likely to shrink further – it is increasingly difficult to predict what 2009 will bring for U.S. airlines.

I am not confident that we really understand the true demand for air travel because, historically, the numbers include a large component of emotional, non-core demand. A fair question is whether yesterday's emotionally purchased air travel should be included in today's demand calculus or not? Therefore, until we can fully understand the true demand for air travel, predicting widespread profitability for an industry subject to the every ebb and flow of the economy seems to be walking into a trap. A trap that sets off a series of others - I fear.

And we have not even started discussing what all of this might mean for some of the credit card issuers. The enabler of the consumer-led expansion. That too is for another time - I fear.