Prior to the current crisis, economists hailed Alan Greenspan as the “maestro”. Volatility in the markets were at historical lows and monetary policy had conquered the business cycle.
Or so they thought.
What was really going on was the inflation of a global asset bubble. In early 2007, the bubble in housing was obvious enough and the general feeling across the fixed-income spectrum was that things were rich. LBO activity was white hot, which helped fuel valuations in equities. But one person said it plainly and simply. Jeremy Grantham’s April 2007 letter had a deep impact on the way I looked at the world.
It’s Everywhere, In Everything: The First Truly Global Bubble
(Observations following a 6-week Round-the-World Trip)
From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure, and the junkiest bonds to mundane blue chips; it’s bubble time!
The necessary conditions for a bubble to form are quite simple and number only two. First, the fundamental economic conditions must look at least excellent – and near perfect is better. Second, liquidity must be generous in quantity and price: it must be easy and cheap to leverage. If these two conditions have ever been present without causing a bubble it has escaped our attention. Conversely, only one of the conditions without the other may cause an ordinary bull market but this is often not the case. For example, good or even excellent fundamentals with tightening credit often result in a falling market.
That these two conditions have been met now hardly needs statistical support, so widely accepted have they become. Never before have all emerging countries outperformed the U.S. in GDP growth over a 12-month period until now, and this when the U.S. has been doing well. Not a single country anywhere – emerging or developed – out of 42 listed by The Economist grew its GDP by less than Switzerland’s 2.2%! Amazingly uniform strength, and yet another sign of how globalized and correlated fundamentals have become, as well as the financial markets that reflect them.
Bubbles, of course, are based on human behavior, and the mechanism is surprisingly simple: perfect conditions create very strong “animal spirits,” reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism. Sustained strong fundamentals and sustained easy credit go one better; they allow for continued reinforcement: the more leverage you take, the better you do; the better you do, the more leverage you take.
The combination of the enactment of the Commodity Futures Modernization Act of 2000 with easy monetary policy in the US and Japan created an abundance of liquidity together with an increasing need for “yield” for pension funds and endowments. Institutional investors were increasingly drawn to non-traditional assets after the stellar performance of the Harvard and Yale endowments. At the same time, large financial institutions represented a huge brain drain attracting many of the worlds brightest scientists to the promise of riches on Wall Street. These scientists built hugely complex risk models based heavily on market volatility. During a period of decreasing volatility, these models were signaling “Full Speed Ahead!” The credit derivatives boom was born.
Bubbles are natural phenomena and our ability to control them is limited. One might question whether we should even try. Greenspan (and Bernanke for that matter) was firmly in the camp that believed we should only concern ourselves with asset bubbles to the extent that they directly impact core inflation. When a bubble forms, you let it continue until it bursts and then come in with sweeping monetary easing to help clean up the mess. Upon seeing this happen after the crash of 1987, after the Asian crisis of 1997, and after LTCM in 1998 among others, the pattern had been established. The Greenspan put was born and moral hazard had been introduced to the financial system.
In each case, the overriding fear was a recession. At some point along the way, recessions became sinister. Something to be avoided at all costs. Well, we are now seeing what those costs were.
Recessions are a necessary part of healthy, dynamic, long-term economic growth. By attempting to avoid recessions like the plague, elements of the economy that were ill-equipped for survival were unnaturally placed on life support. If recessions had been allowed to take their course, enough shocks would have occurred along the way that would have knocked down houses of cards long before they grew to become “too big to fail”. The business of insuring pools of bonds could not have grown to behemoth proportions if historically sensible rates of defaults had occurred. Mortgage originators would not have been able to offload loans into these pools so profitably if they were paying historically sensible risk premiums.
It all comes down to a common mistake we’ve made and continue to make since Greenspan took over at the Fed in 1987. Trying to avoid recession at all costs.
When you embrace recessions, you can deal with them. You can try to soften the blow to the unemployed and help prepare them for newer and economically healthier opportunities. The alternative is to keep people unnaturally employed in economically inefficient roles. The various impacts of recessions are fairly foreseeable and hence plans can be made to deal with them.
After repeatedly making the same policy mistakes year after year, here we are again putting elements of the economy on life support that should be put out of their misery. Of course those who work in financial institutions will try to tell you that the entire economy will come crumbling down if you let a large bank or insurance company fail. It is time to call their bluff. These institutions are simply doing what they have always done. They are doing what they are good at. They are doing what they should be doing. Making money. I don’t blame them for benefiting from bailout funds in multiple convoluted ways. It is ingenious. The people I am disappointed in are those who fell for the joke: Bernanke, Geithner and ultimately Obama.
It is time we see through the charade. The financial system will not collapse on itself if we let large institutions fail. On the contrary, the likelihood of a systemic collapse is higher if we do not allow them to fail. Let entrepreneurs step in. There is a lot of money to be made lending to corporations and consumers alike if you have capital and people do have capital. By artificially propping up banks, the playing field is not level. Small banks cannot compete with large banks. It is a perverse path we are on and I hope that if enough people voice their opinion, those in power will see the light.
You cannot stop the pain. Poor policies of the last 20 years have put us in a position where no matter what we do now, there is going to be severe pain felt by everyone. Lives will be forever changed. Businesses will fall into bankruptcy. Overextended derivatives insurers will burn. Overextended consumers will lose their homes and cars. It is inevitable and the more we try to stop it, the worse it will be in the end. Instead, we should embrace it. Like battling a flaming inferno. Sometimes you need to tactically burn down strategic areas to stop the destruction. We need to recognize that we have failed. Get over it and stop trying to prevent the inevitable. Let’s let natural selection work its course so that we can evolve into something healthier and more be able to survive the new ecosystem we find ourselves in.