by Lance Helfert

Many people seem bewildered that the government's interventions have not instantly solved the financial crisis and driven the stock market back to pre-crisis levels. This merely emphasizes that the economy is complex, the stock market is imperfect and often inefficient, and human beings are absurdly impatient. The same expectation of instant gratification that fueled our credit binge now plagues the markets. We want answers NOW, just as we wanted bigger homes, bigger flat screen TVs, and bigger SUVs, NOW! Digital cameras give us instant photos, TIVO lets us time-shift our favorite programs and skip commercials, and of course, the Internet lets us find information and do our shopping anywhere, anytime. Ironically, our impatience with others for not fixing the economy distracts us from doing our part to fix the economy by staying calm and behaving rationally.

Even an oversimplified look at the economy shows the tenuousness of the relationships: consumer spending accounts for 70% of economic activity, and consumers get their spending money from their employers or from credit. Many of the consumers' employers manage their cash flow through "commercial paper" (very short-term loans), which are funded by banks that get their money from investors looking for reliable returns. The companies pay back their loans with the cash flow supplied by consumer spending. A slipped gear anywhere in the process can stop the whole machine. 

Some believe the dominoes started falling when consumers ran out of credit. Since real wages have been going down for years, consumers maintained or increased their standard of spending by tapping equity in their homes. When house prices stopped rising, consumers had to stop or slow their spending. This reduced potential corporate profits, which reduced their credit-worthiness. Of course, the banks were already unable or unwilling to make loans, since years of easy credit policies left them undercapitalized and holding bad loans in unknown - but presumably huge - amounts. That's a lot of slipped gears.

Thus, even companies that are doing well cannot get their commercial paper funded - this is the credit freeze you've read so much about. If they cannot fund their business, they must reduce their costs, possibly through layoffs. This reduces personal incomes and slows consumer spending. Moreover, gainfully employed people begin to fear layoffs, so they also stop spending. This reduces corporate profits, which leads to credit problems and layoffs and less consumer spending, and the cycle repeats, sometimes into recession, sometimes beyond.

The problem with our fixes so far is that the government can print money, but it cannot buy courage. "Once bitten, twice shy" lenders who got burned by issuing loans to unqualified borrowers now refuse to extend credit to responsible borrowers. Treasury secretary Paulson could recapitalize the banks, but he could not force them to lend money. And they won't lend money if they fear borrowers cannot repay them in the future. Consumers will not spend if they fear the future. Companies will not hire if they fear the future. It's a cascade of self-fulfilling prophecies.

We've often written that no one can predict the future, but we'll go out on a limb this far: the USA's culture of innovation gives us great confidence in the future. That's why value investors like Warren Buffett advise people to be fearful when others are greedy, and greedy when others are fearful. In a bear market, some very high quality companies with excellent long-term profitability will sell at prices below their intrinsic value. Some are even selling for less than the value of their cash on hand! Amid all the fear and uncertainty of the current economic crisis, opportunities will arise and clear-headed investors will exploit them.

Lance Helfert is co-founder and president of West Coast Asset Management, and a co-author of The Entrepreneurial Investor: The Art, Science and Business of Value Investing. This blog entry is an excerpt from West Coast Asset Management's monthly newsletter, Exclusive Outlook.