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Moral Hazard, economic epilogue

Blog entry posted by anciendaze, Aug 27, 2011.

This is an effort to pull this discursive discourse together into something coherent. I'll start with the purely economic side.

At the largest scale we have a macroeconomic view found in "This Time is Different". There is a great deal of dense material in this book, but I'm only going to mention a little. Their figure P-1 shows a graph of countries in default, weighted by their percentage of the global economy. This is a very crude measure of economic ills, with many criticisms possible, but I'm only interested in the most pronounced features.

By this measure, the economic crisis which started in 1914 didn't even reach some kind of stability until 1954. Nothing major marks the end of WWI, the roaring twenties or the Great Depression clearly. Even in 1954 the level of bad debt is distinctly higher than it was prior to 1914. Things don't really return to the 'good old days' prior to WWI until about 2000. This is striking.

(Before you get nostalgic for 'La Belle poque' read Barbara Tuchman's "The Proud Tower". Things only seemed wonderful in retrospect, when compared to the multiple nightmares which followed.)

What this should tell us is that the entire period for which we have convenient economic data is an historical anomaly. A second inference is that the roots of present misery can run very deep indeed.

You might also consider how you might have gone about investing in the future before WWI, even with your present unfair advantage in knowledge. You couldn't very well invest in airlines or communication satellites. Buggy whips were on the way out, and automobiles were the coming thing, but what effect would the Seldon patents have on the industry? If you invest in transportation stocks, are you backing RMS Titanic? (Tip: avoid White Star Line.)

If knowledge of their future still leaves you in doubt, what about those without this advantage? The one obvious thing about investment should have been that it would require enormous flexibility. Everything was about to change. That is still a reasonable expectation today.

Even if you know general trends do you know when the changes that mark an epoch begin? Would any rational investor recognize October 6, 1979 as the start of the junk bond bubble? That is the date on which Paul Volker, chairman of the federal reserve, announced a shift in policy; no longer would the fed. hold interest rates constant and adjust the money supply, now they would hold the money supply approximately constant, and let interest rates float. Suddenly, the backwater of the bond market became interesting to speculators.

Shifts in interest rates could change the value of bonds based on fixed interest rates. Naturally, the riskiest bonds need to pay the highest interest rates to offset risk. 'Junk bonds' started to move. A bond market which had been based on low risk and steady income streams began to show symptoms of bipolar disorder.

Since corporations typically raise money by selling either stocks or bonds, and issuing stock dilutes ownership, buying up stock using leverage provided by bonds became a standard route to 'leveraged takeovers'. Even corporations which survived a challenge became loaded with debt acquired to prevent a buyout. This probably didn't benefit stockholders, but it was vital if upper management was to remain in charge. The result was more debt, risk and more bonds being classed as junk. The interests of management, employees and shareholders were at odds, and the whole process exhibited positive feedback.

Takeovers by corporate raiders were based on the immediate bottom line. Anything which did not contribute to that was jettisoned. In some cases raiders simply stripped companies of assets, dismembering the organization. In other cases the company survived, but its character changed. It stopped building expertise to tackle difficult problems, concentrating on immediate returns. Top management rarely had much experience with the underlying business. They didn't reach the top by following the long path of internal advancement. After a while there weren't any investments in projects slated to pay off 30 years ahead. Entire industries were living on past accomplishments. After 30 years the effects were predictable, the wellsprings of corporate innovation dried up. The management response was also predictable, this was the period when annual reports became opaque or misleading.

(Don't think risky 30-year investments are important? Review the history of aviation from the Wright flyer to the airlines of the 1950s. When you get done, try to imagine any existing corporate culture which would accept such challenges, and persevere despite terrible setbacks.)

Was Volker a fool? He was a man with an urgent problem and a limited number of tools. The economy was stagnant and inflation was high. Any traditional economic stimulus would increase both the money supply and the inflation rate. He did what he felt he had to. Other alternatives were worse. Many, perhaps most, historic economic decisions are made on no better basis.

The next change with hidden implications took place under a different administration. Predictably, Savings and Loans were caught with long-term, fixed-rate loans while other interest rates were fluid. To avert immediate problems, without spending large amounts of money, Congress removed restrictions which prevented S&Ls from competing with banks. (The alternative would have been for the federal government to buy up those loans, an expensive option. Since the government was already guaranteeing deposits and many mortgages, deregulation allowed explicit liability to stay off the books.) We were on our way into the real S&L crisis of the 1980s. The financial perfect storm of the 2000s was brewing, though you would be hard pressed to find anyone thinking that far ahead.

Retrospective histories can give all this the stately inevitability of Greek tragedy. I want to offer a discordant view. Imagine the state of the economy as a pinball speeding along fairly direct and predictable paths between the bumpers and flippers of existing regulations and new legislation. While many aspects are predictable, there is a sensitive dependence of outcome on the exact moment some economic variable crosses a threshold leading to a reaction. Imagine your job and life savings bet on the outcome. The inevitability of downfall comes not from the precise sequence of events so much as the fact that you somehow got into such a game.

Switching analogies, the idea that some horse will win a race is such a safe bet no one will bet against you. Picking which horse is much riskier. Predicting the balance of political and economic forces in play next year is like betting on trifectas.

(If my abstract and depersonalized descriptions aren't to your taste, read "Liar's Poker" for a light-hearted look at individual people managing large amounts of money on a moment-to-moment basis. There you can meet such engaging characters as 'the human piranha'.)

Over the entire period when I have been (more or less) aware of what was going on there have been three trends: increasing speed and/or complexity, decreasing transparency and a shift from long-term to short-term interests. When the connection of prices with what are called 'fundamentals' became vague, we entered the domain of opinion unrelated to fact. Few people noticed any difference.

Opinions are far easier to understand, not to mention more entertaining, than facts, and we invest them with great emotional significance. People were too busy enjoying the action to think about the possibility their paycheck and pension might depend on the equivalent of celebrity marriage futures.

Extrapolate the trends above and what you get is not globalized economy, civilization, or culture. It is a dystopian fantasy like "Road Warrior".

(People who believe these must not have experience growing their own food. If technological civilization breaks down, people won't spend much time riding motorcycles. In most previous civilizations, the vast majority of people spent the vast majority of their time trying to get enough to eat. Having more than 5% of your time for lighter concerns was prosperity. None of those civilizations came close to supporting 6 billion humans.)

After the last month it should be clear to everyone that even the suggestion of default by a nation can have serious consequences. Governments routinely borrow heavily using short-term loans, because uncertainty over long-term interest rates pushes the cost of long-term financing higher. This is also true for corporations. Scaring investors can result in ruinous costs for servicing debt. The crisis of 2008 was a crisis of confidence, and the effects are still with us.

Even if market psychology were not a factor, we would be faced with predictably unpredictable economic stresses due to natural disasters. (These are "known unknowns" in a now-famous phrase. See "The Existential Poetry of Donald Rumsfeld".) Prudence would suggest a government reserve of hundreds of billions. Private insurers should have at least 100 billion available. Globally, the need is in the trillions. There may be no guarantee such funds will be spent wisely in a crisis, but the absence of funds or commitments guarantees inadequate preparation and bad decisions under pressure of time and circumstance.

The earthquake and tsunami in Japan illustrated many problems, but the Japanese preparation for recovery from crises is among the best in the world. Perhaps the major role of their self-defense forces is in recovering from disasters, instead of causing them. There is a cultural understanding that Japanese do not abandon other Japanese. Their economy is now doing better than predicted in the immediate aftermath of the quake. Unfortunately, such prudence is the exception rather than the rule among nations.

Assuming a crash is not forthcoming, we will need to work together to reverse the trends described. There are no longer peasants in the developed world who will meekly accept their station in life. People will not simply accept the edicts of a privileged minority of experts. No one is likely to replace self-interest with altruism, as least not in this species. The only way out is to make long-term individual self-interest broadly comprehensible to most people and consistent with common weal. This is unlikely to happen by accident.

Demographics in the developed world already marks the 21st century as a period when health and aging will be major economic concerns. My final post in this series will connect this with biology and medicine.
anciendaze

About the Author

As the name suggests, I am old and dazed. The avatar illustrates my rule of thumb: "Hang on! This ride isn't over."
  1. anciendaze
    I still don't have anything definite on that story about bulk real estate sales. If anyone has something solid, I'm interested.

    Meanwhile, looking for material on a completely different subject, I ran across this video of N.N.Taleb discussing the measures taken in 2009 to deal with the economic crisis. N.B. I did not take the title of this series from him, because I had not heard him use it.
  2. xrayspex
    I've said for 20 years I foresee a road warrior, gibson-style future for our country. hadn't heard about the real estate scam for the elite, wonder if its as he says.
  3. anciendaze
    I can't top that, but I can throw this item out for comment. Does anyone out there know any more about this?
  4. markmc20001
    Road warrior world without motorcyle riding? Now that's no fun!

    The existential poetry of Donald Rumsfeld. Love that.