Taking the pragmatic approach

Approximately a month ago, I began a metaphorical journey to relax my rather narrow-fitting investing thought corset. In writing “Learning by Doing”, posted on April 29^th, I ventured into the world of economic cycles and their inevitable consequences for investors around the world. Since that date, two additional posts have made references to the economic cycle. I’m afraid given the state of affairs in my home country of Spain and indeed in most western economies, this topic will also form the backbone of today’s exposé. Talking to or more precisely, listening to, experts in the dismal science has left me with a sense of not only unease but defeat.

Various academics and macroeconomic sages are openly venturing the idea that the once unthinkable is now likely. Indeed the possibility of a sovereign debt default by Spain and, some even argue, by the USA as early as 2013 is not to be underestimated. For us Iberians, it looks as if this scenario is all but inevitable and our efforts at this juncture would be best directed to “getting used to be treated like a pariah of the credit markets for years to come” as a close friend of mine succinctly put it.

Be that as it may, I remain thankful that, as a nation living in suspended disbelief, most Spaniards willfully continue to ignore the obvious warning signs. From a truly selfish and short-term point of view, this unfounded optimism and happy-go-lucky attitude so prevalent in our nation, is actually a bit of a blessing. After all, we’ve had plenty of scare-mongering from the Roubini’s and the Marc Faber’s of the world since 2008…

The flip side of this “ignorance is bliss” attitude is nonetheless a major concern. Both as an investor and as an ordinary citizen concerned with the progress of my immediate circle there’s plenty to be concerned about. First and foremost, if history serves a purpose (which I sometimes wonder…) no course of action (or as the case maybe, inaction) that I can envisage could possibly be more pernicious. Burying one’s head in the sand is not a wise idea. And yet that is precisely what is being done in Spain.

Sure, some fairly dramatic measures were hastily dawn up and narrowly approved in parliament last Friday. In any case, said measures as limited in their scope and one-sided in their impact. Drawing a parallel between macro-economic policy and security analysis with the subject being the Spanish economy, the actions taken to date serve only to reduce costs whilst doing absolutely nothing to enhance private sector revenues.

Am I too pessimistic? Apparently not. According to a recent study performed by Hussman Funds in their weekly commentary of late May 2010, the path to recovery after major financial crises is clearly laid out, though by no means is it easy to follow.

Using the example of the approaches to various severe financial downfalls in Sweden, Norway, Finland and Japan since the early 1990s some clear and useful conclusions can be drawn. Faced with capital-light structures as a result of ever-lower lending standards (sound familiar yet?), banks in these nations almost collapsed triggering off country-wide credit crises.

In dealing with this situation 2 very different approaches were followed, one by the Nordics and the other by Japan. Sweden, Norway & Finland opted for the pragmatic approach, exposing the true extent of the problems upfront, soliciting debt restructuring assistance and winding down troubled loans, whilst capitalizing their balance sheets.

Japan on the other hand, enforce lax accounting rules destined to render non-performing loans less transparent and continued to lend money to the wrong. By now, we all know how this played out for the Nikkei index over the next 20 years! But how did the Nordic economies and their stock markets perform after 1990?. Only 5 years later, the stock markets of these nations recovered to pre-crisis levels.

Whilst the nature of the 1990’s Nordic banking crisis and today’s macro picture in Spain and beyond may differ, there’ a lesson to be learned in applying a direct, face-on approach.

Unfortunately, for investors and regular citizens alike, recent actions by the Spanish government do not bode well in this sense.