While some problems can be traced far back in history, the fundamental change in the economy before the current crisis can be conveniently bounded by the War on Terror. This is a touchy subject, and I will do my best to avoid unnecessary judgments. There is an economic aspect which needs to be highlighted, especially since the attacks were conceived as economic warfare.
In short form, many people died, buildings fell, but the economy did not. The wars in Afghanistan and Iraq were financed by deficits, but this is the way wars are generally run. There was no conscription, no huge shift to war production, no huge, untapped labor force taking over jobs left open by departing servicemen. The civilian economy kept running with remarkably little change. There were no special war bonds. Scarcely anyone had to tighten their belt.
The expansion of national debt meant cautious investors with the ability to wait could get acceptable returns on bonds backed by the full faith of the government of the wealthiest and most powerful nation on earth. Concern about economic contraction as resources were diverted to war meant central banks kept the levers on the throttle for the money supply wide open. It was a situation made to attract speculative investment.
The big problem was where to get financing repeatedly for speculation at low enough rates to make this profitable. Once speculators started using ordinary sources for loans central banks would predictably tighten controls on money. This is where the hidden loopholes in bonds based on high-risk mortgages come in. Magical practices spinning the straw of sub-prime mortgages into AAA gold provided a way to circumvent regulators and ratings, by hiding risks. Effectively, many big financial institutions were printing money. While children believed in Harry Potter, adults believed in three-letter acronyms (TLA) like CDO and CDS, when presented with compelling mathematical mumbo-jumbo.
With the civilian economy bizarrely unaffected by war, borrowing could be used to finance homes in the Sunbelt for retirement or vacations. Even timeshare condominiums were a popular investment. One might have asked how retirement and vacations were going to result in economic activity to pay back these loans. By 2002 people were too busy flipping houses to care. This is a classic bubble, in which the primary idea behind investment is that you can always find a bigger fool to buy your position when you want to get out.
(Don't assume this is a purely American mess. Spain also overbuilt expensive property intended for sale or rental. The legal snarls of mortgaged property in Arizona with investors in New York and clients in Michigan pale compared to property in Spain backed by Chinese investors with clients in northern Europe financing through French or British banks. Decades may elapse before some of these are resolved.)
This is now considered ancient history. The supply of sub-prime mortgages on which those CDOs were based pretty well dried up in 2006. By 2007 there were worrying increases in the rate of defaults. Somehow, this never reached the level of weakening investments based on those mortgages until 2008. (This should have been a warning signal. Why didn't derived financial products reflect changes in the underlying assets?)
Even then denial was profound. The collapse of Bear-Stearns should have been an unmistakable wake-up call. Instead, business-as-usual continued for another six months. There were attempts to suppress adverse opinions. You can almost hear the back channel communication: "You can't publish that, it will spook the marks!"
Had investment been more transparent a correction would have started in 2006 or 2007. Had the absurdity of the whole loan repackaging business been exposed from the beginning the only people who would have put their hard-earned savings into it would have been those who patronize casinos with one-armed bandits. Instead, we all found ourselves in the middle of a crap shoot even when we made traditionally conservative investments like buying a home, or planning retirement. We didn't have to play the market ourselves, those managing our bank accounts, insurance and pension funds would do it for us.
At this point I need to step back and ask what was behind the exceptional compensation for people and organizations handling large amounts of money during the run up. Conventional explanations talk about deep knowledge acquired over many years, great skill and enormous responsibilities.
In 1992, long before recent fiascoes, legendary investor Felix Rohatyn described derivatives this way "26-year-olds with computers are creating financial hydrogen bombs." (By 2003 Warren Buffet was talking about "financial weapons of mass destruction".) During the run up phase of a bubble you can make money by investing almost anywhere, without regard to risk. When expertise becomes most important, it is in the period where it is still possible to get out and keep your shirt. How did our experts do during this phase?
The answer I get is that you could do better by taking their reassurances to mean exactly the opposite of what they said. In fact, my own theory is that it is easy to find bad financial advice which is an even better leading indicator of what not to do. When my mailbox recently produced a card touting "unlimited potential" and "great leverage", it confirmed my belief that the time to get out of any leveraged investment had come, (had I been in the market.)
With knowledge and skill discounted, we have to look into responsibility. Do CEOs with golden parachutes show responsibility to stockholders? Does the ability to call the Secretary of the Treasury (or the Chairman of the Fed.) when you get in trouble encourage responsible behavior? How many financial leaders made hard decisions early enough to make a big difference in outcome?
How many organizations with highly-compensated staffs of thousands did better than Warren Buffet and his more modestly compensated staff of 20? I could make a good case that the correlation between compensation and responsibility becomes negative at a surprisingly low level. People who really need their jobs will be very cautious about risking them.
Mysterious flows of information and money have produced predictable results. Given the structure of incentives, and the debased currency of financial information, what the invisible hand of the marketplace did was, in a sense, completely predictable in outline, even if the specific sequence and timing of events was unique to particular circumstances.
While many are busy trying to affix blame to others, the circus has not ended, just moved from one ring to another. At present those mortgages ending in short sales, defaults and/or foreclosures have produced a new kind of financial product. There is a very active market in 'deficiencies' of mortgage contracts. Packages of these are being sold.
People who lost their homes and savings are still being dunned for money they were not able to pay for overpriced real estate, despite the fact that financial institutions have seized the property and resold it, in the process unequivocally demonstrating that it was not worth the loan value. The people most targeted are those without money to pay attorneys. Fiduciary responsibility now seems to apply only to people with the least financial expertise.
Has finance improved with respect to transparency and accountability? At the beginning of the crisis, there were more, and more varied, major financial institutions. Some were brokerages, some insurance companies, some investment or commercial banks, some partnerships. The major firms have now become bank holding companies. The limited liability of corporate law places those making decisions farther from consequences of their actions than before. Rational investors, (should any still exist,) now have to evaluate another level of quarterly reports and 10ks to decide what an investment in these might be worth.
Almost all surviving firms are huge. Evaluating any one of them is the examiner's equivalent of climbing Everest or K2. It is apparent from the behavior of markets you can't simply remove doubts about real value by calling in auditors. People won't believe them.
This is no longer a question of us and them. Assigning blame is not going to resolve the problem. If criminal prosecution were going to be effective, it should have been started years ago. At present the roots of past disaster lie at or beyond limits set by statutes of limitations.
My own prescription would be a renewed commitment to honesty, transparency and accountability, particularly concerning risk, with a thorough overhaul of institutions which fall short of these standards. An economy based on deception is a dead end. There is another important aspect, a willingness to live and work with people even when you can only agree to disagree.
One point I keep trying to illustrate is the empirical nature of our economic successes. Nobody is consistently right about the future. The basis of robust economic decisions is closely linked to political pluralism. Having read "The Wealth of Nations" I can tell you it mainly talks about what governments should not do. Capitalism is simply not a form of government. Regardless of systems of government the underlying requirement for continued economic success is pluralism. This includes the right to be wrong. (Though not full immunity from consequences of being wrong, which destroys useful feedback.)
Unfortunately, we are now entering a typical eighteen-month election year, when the silly season never ends. I had better pause here, until I get over that thought.
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Moral Hazard, part twelve
Blog entry posted by anciendaze, Aug 20, 2011.