So my holiday message to President-Elect Obama and his new Treasury Secretary – Timothy Geithner is this…

Don’t ask banks to be your kid’s wimpy version of Santa Claus – giving out gifts to all those who ask nicely … or scream the loudest (autos, anybody?).

Banks can make your dreams come true. Or they can destroy them.

In either case, I’d like them to lend responsibly.

I’ve seen both sides of what banks can do. And I’m sure you have too.

I remember getting a bank loan for my first home. I needed to prove that payments would take up no more than 20 percent of my disposable income. I needed to prove I had a job. I had to show a good credit rating.

Jumping through all these hoops wasn’t optional. No exceptions allowed.

When I got the loan, my wife Cec and I went out to celebrate. It was a big deal.

Then there’s the other side…

My Cousin Harvey had built his door and window business from scratch. They had so much business he applied for a loan to build a bigger facility. The company’s bank gladly gave it to them. After all, the company was flying high on the mini-real estate boom that visited the greater Boston area in the mid-1980s.

Five years later it reversed direction. Housing prices plunged. And housing construction shrank to almost nothing.

Even after downsizing, the company could barely pay its bills. It dipped into its revolving loan more and more. Until one day the bank took it away.

The company lasted a month more before shutting its doors.

I’ve seen the same thing happen to publicly listed companies like the small Texas-based oil company that seemingly was sitting on top of the world.

I was on the phone with the CEO and he was sounding his normal confident self.

The drilling was going great, he said. Every well tested so far found oil. They were ahead of schedule. Their big investment in a potentially huge oil basin off the coast of Nicaragua was also making better-than-expected progress.

Then he dropped the bomb.

The company’s bank was withdrawing their loan.

The CEO tried to cover his tracks. “As far as I’m concerned,” he said, “This gives us an opportunity to find a better bank … a bank that really believes in us.”

But without access to bank credit, they couldn’t pay their bills. Their credit rating plunged. Other banks wouldn’t touch them.

They were forced to sell their promising parcel off the coast of Nicaragua. It bought more time for them. But that parcel was a big part of what made the company so attractive. More shareholders sold off. Their stock price plummeted.

Ten months later, they were de-listed from the New York Stock Exchange. Fifteen months later they declared bankruptcy.

It happened a couple of years ago. But I believe it gives you a sneak preview into 2009 … except for one thing. Next year these won’t be isolated incidents. The market will be littered with dead corpses whose money lifeline was cut off.

Banks matter.

They matter a great deal.

Banks will give loans to companies with cash or with a high credit rating. Other companies will see the back of their hand.

Same thing with individuals. Banks will lend to those who need the money the least: the careful savers … the homeowners who didn’t cash out their home equity … the very well-off.

It’s the nature of the banking business that when you need them the most, that’s when they fade from view.

That doesn’t make them evil. But it doesn’t endear them to the rejected – whether they’re companies or individuals.

And now, with the economy swooning, the government wants banks to act like a three-year old’s version of Santa.

Isn’t that how we got into this mess in the first place?

They don’t want banks to become responsible careful lenders. It would make a sick economy even sicker.

The lesson is clear. If you’ve got cash, nourish it. Hoard it. Save it. Because if you run out, your bank won’t have your back.

Cash is king.

Remember that when you’re looking to invest in 2009. Companies out of cash could also be out of luck.

Source:  A Preview of 2009?

But IndyMac had long focused tightly on mortgages to customers who can’t provide the documentation required for conventional home loans – what are known as “Alt-A” mortgages. This sharp focus left no other business line on which the company could lean, he said.

Other analysts share that view.

Frederick Cannon of Keefe, Bruyette & Woods Inc. said IndyMac had only “a limited focus on the deposit business,” a high- return business that is the bread-and-butter of traditional savings-and-loan companies. On March 31, IndyMac reported $18.9 billion in deposits, 40% more than a year earlier. However, 36.4% of the company’s deposits are expensive and volatile brokered deposits.

The bulk of brokered deposits are likely to be withdrawn soon or run off within the next 12 months, Arnold and Cannon said. IndyMac disclosed two weeks ago that about $100 million of deposits had already been withdrawn after U.S. Sen. Charles Schumer, D-N.Y., raised concerns about the company in a letter to Federal Deposit Insurance Corp. Chairwoman

Sheila Bair.

All right, it’s really a digital tiger. But we still
refer to central banks as “cranking up the printing
presses” when we really mean “increasing the money supply.”
The old image of fiat paper money is with us still, so I
refer to China as a paper money tiger.

Mao referred to America as a paper tiger. America
wasn’t at the time. China is today: not weak, but highly
vulnerable. China’s central bank, the People’s Bank of
China, has been pursuing a policy of monetary inflation as
no large modern country ever has in peacetime. Year after
year, M-1 increases at about 20%. This has fueled an
economic boom of unprecedented proportions. This boom has
been a particular kind of economic growth, one weighted
heavily toward exports.

Now this inflation-fueled boom is facing its day of
reckoning: rising domestic prices, especially of rice.
Most of the 400 million residents the booming cities can
afford to buy rice. The poor 900 million of the
countryside are finding it difficult to buy rice. It is
being exported to the cities, where residents can afford to
pay for it.

The response of the government to rising prices has
been to impose price controls on key products. This has
created shortages, as price controls always do whenever a
government’s central bank is inflating.

There is a simple solution. The People’s Bank of
China should cease inflating. It should cease buying U.S.
Treasury debt, Chinese government debt, or any other kind
of debt. But that would produce China’s first post-
Communist recession. The real estate boom would turn into
a bust that would dwarf the recent downturn in the United
States. The flow of millions of people into the cities
would slow. The unemployment rate in the cities would
soar.

Then the riots would begin.

When you think “riots in China,” think “geriatric
Communist oligarchy.” Think “Tibet.”

The oligarchs are riding the paper money tiger. So
are you. So am I.

How should we get off? That is not our decision. How
will we get off? That is the #1 investment question of the
next five years, all over the world.

FOUR THEORIES OF NATIONAL WEALTH

To understand what China has accomplished since 1978,
we must understand the history of modern economic thought.
There have been four main streams of economic thought:
mercantilism, capitalism, socialism, and Keynesianism.

Mercantilism was the dominant economic outlook prior
to Adam Smith’s book, “The Wealth of Nations” (1776).
Mercantilists believed that national wealth is based on
gold. A nation’s wealth increases by means of foreign
trade, but always government-controlled trade. The sign of
increasing national wealth is an increase in the supply of
gold in the national government’s treasury.

The mercantilists believed that a nation increases its
wealth by exporting more than it imports, with gold
imported rather than consumer goods. Goods flow out; gold
flows in. This makes the nation richer.

Smith disproved this theory. Actually, David Hume had
disproved it three decades earlier. He pointed out that
the inflow of gold increases prices in the exporting
nation. Meanwhile, the outflow of gold reduces prices in
the importing nation. As domestic prices rise, a nation’s
exports become more expensive to foreigners. So, it is
able to export less. The system balances itself without
government intervention. Hume’s brief essay was short and
to the point, but it was not widely known or believed
inside elite circles. Smith changed elite opinion over
time: 1776 to about 1846 in England.

Free market capitalism teaches that wealth is based on
consumer-satisfying production, not gold. Wealth is
achieved by free trade, stable money, and open markets.

Socialism is an alternative to both mercantilism and
free market capitalism. It arose in the nineteenth century
and was widely believed by a minority of Western
intellectuals until August 19-21, 1991, when the Soviet
Union’s leaders officially abandoned Communism, confiscated
the Party’s funds, and distributed the money to themselves,
who then sent it to Western banks. (This is not the story
in the textbooks, which steadfastly refuse to follow the
money.)

The “errors” of which the economist spoke were outlined by the late Milton Friedman both in his 1963 A Monetary History of the United States (written with Anna Schwartz) and his popular Free to Choose (with Rose Friedman), published in 1979.

According to Friedman and his coauthors, the economic collapse that occurred in the United States from 1930 to 1933 came about because the Federal Reserve System failed to act in the face of bank failures and banking panics, leading to a massive contraction in the amount of money in circulation, which ultimately led to the calamity.

The anti-free market arguments

Friedman made his arguments as a means to counteract the common explanation of the Great Depression — that it was the result of the “internal contradictions” of capitalism. The typical explanation, popularized by John Kenneth Galbraith as well as the gaggle of Keynesians that proliferated in US universities, was that the capitalist system tends toward “underconsumption” or its evil twin, “overproduction.”

(Galbraith held that underconsumption occurred because the income “gap” between the wealthy and poor grew during the 1920s — another “natural” outcome of capitalism — while John Maynard Keynes and his followers held that private investment spending was volatile because of the “animal spirits” of investors. The system had a built-in, self-multiplying, downward spiral whenever private investors were unwilling to throw more money into the economy.)

Those who blamed the Great Depression on the “failures” of the free market were all too happy to come up with their own “solutions,” including attempts to cartelise the entire US economy or to force up wages via increased minimum-wage legislation or through the endorsement of expanding labor unions.

Some, like Galbraith, went further and advocated out-and-out socialism and central economic planning. The free-market system, they have argued, is too inherently unstable to be left to its own devices. (This is the same argument that Paul Krugman makes twice a week from his perch on the New York Times op-ed page.)

Friedman believed the monetary system was prone to failure

Thus, Friedman was seeking not only to explain why he believed the Great Depression occurred, but he also was trying to defend the free-market system, or at least was trying to defend most of the free market system. There was one portion of the system that was prone to failure, he argued, and that was the monetary system.

This alone is quite interesting, as Friedman was willing to buy into a government-run monetary system — “socialist” money — even as he tended to condemn other things socialist. However, he also was willing to admit that the fractional-reserve banking system (which he heartily endorsed) was subject to all of the instabilities one would expect when there exists a monetary system in which multiple claims are made on a single source.

Nonetheless, I do not wish to dwell on Friedman’s inconsistency. Instead, I wish to look specifically at his claim that the Great Depression could have been avoided had the Fed simply provided enough “liquidity” in the system. This is more than an esoteric exercise, as it seems that Bernanke has taken a page — or, perhaps, a number of pages — from Friedman’s playbook.

The Fed’s latest move — permitting reeling financial institutions to use near-worthless mortgage securities as collateral for about $200 billion in loans — is yet another example of Bernanke’s promise to “provide liquidity” at every step, as though the real crisis here is the lack of play money in the nation’s financial system. The problem here is that the original Friedman thesis was wrong, and that Bernanke’s glorified dropping of money from the Official Fed Helicopter is just as foolish.

The Smoot-Hawley Tariff Act

Murray Rothbard’s America’s Great Depression was first published, ironically, in 1963, but it tells a very different story than does Friedman. Rothbard’s book points out that the economic collapse from 1930 to 1933 did not happen because the Fed failed to provide “liquidity” to the system, but rather because the government intervened in an economic downturn and managed to turn a recession into an out-and-out calamity.

For example, Friedman notes (accurately) that there were more than 4,000 bank failures during this period. He somehow wants us to believe that had the Fed loaned enough money (via the printing press) to enough banks, that we would not have seen so many bank failures. However, he leaves out something that is very important: the passage of the Smoot-Hawley Tariff Act in 1930.

This infamous tariff, passed and signed by President Herbert Hoover despite the pleas of more than 1,000 economists who signed a letter urging him to veto the bill, not only made it nearly impossible to import consumer and capital goods from abroad, but also destroyed the export market for US farmers. Thus, a bill passed to raise production prices ultimately ended up reducing prices for agricultural products.