“Confidence grows like a coconut tree and drops like a coconut”(attributed to an economist in India)
It took 50 years to build confidence in the economy and financial system to what Malcolm Gladwell calls a tipping point. That tipping point was reached where investors believed in the prudence of 80% or higher equity ratios, consumers thought the value of their home would rise inexorably, financial firms believed that leverage of 30-to-1 was safe, banks thought they had found the secret of safely lending to subprime borrowers through securitization, and the invention of credit default swaps enabled the buying and selling of credit disconnected from any direct investment in the securities of the borrower. It was when we were tipped into the final orgiastic debt explosion leading to the worst financial/economic crisis of our age.
During those 50 years we:
- successfully overcame recessions without putting huge dents in incomes and wealth
- gained victory in a major battle with inflation (1973-1983)
- were victorious in the Cold War
- experienced peaceful and successful transitions following assassinations and presidential disgraces
- made immense progress toward the integration of minorities
- saw accelerated technological progress
- raised our environmental consciousness
- had persistent erosion of unionization and labor disruptions
- benefited from a worldwide move toward privatization and democratic capitalism
- enjoyed unimpeded trade and capital flows
- watched and enjoyed accelerated economic progress in the less developed world
- saw taxes on capital cut to the lowest level sine the ‘20’s
- had minimal governmental intrusion a decline of regulatory actions
- seemingly have prevented major recurrence of terrorist acts
- had historically unprecedented economic stability
- had a persistent, even if not consistent, bull market
To be sure, there were some frightening crises, stumbles, hiccoughs, and fevers along the way. As they occurred it was easy and even rational to regard them as very serious and as having lasting consequences. But they were contained by a combination of basic strengths in the structure of the economy and policy measures, particularly monetary policy. And the lasting consequences always turned out to have been overestimated.
Retrospectively, we can see that as we overcame each crisis/problem the economic and financial confidence of the participants went up another notch. Yes, there was one very major interruption in the 1970’s as inflation took a vicious turn that required painful medicine. But by and large, it was a fantastic period for economic stability and progress, with the result of a growing willingness to assume risk and take on debt.
Then came our “Minsky Moment”. By now most readers have heard of Hyman Minsky, an economist who died in 1996. He has become fashionably revered as a prophet who predicted that crises like the current one would be the inevitable result of long periods of stability. You should and can read more about Minsky in a New Yorker article that appeared in February of 2008, or in Wikipedia
Minsky, in saying that stability leads to instability, saw the financial system as an important promulgator of business cycles. A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”
Often, Minsky’s ideas are linked to the shorter term, that is, just the business cycle. But his basic idea can also relate to the longer term over which stability becomes such a trusted piece of the economic fabric that it leads to excesses of a more secular variety, particularly the accumulation of debt, such as we saw created in the 20 years through 2007.
Today it is commonly heard that the damage to wealth and incomes resulting from the financial crisis and the recession is so severe that we will see a lasting impact on economic behavior. Frequently, I have said this myself. But after considering this retrospective on how confidence was built, I have realized there is another possible outcome. I am not ready to say it is the most likely outcome, but we should be aware of it.
It came to me on a recent day when I asked myself this question: if stability sows the seeds of its own destruction and creates instability, what seeds does instability sow?
We know we are currently in the midst of significant reform efforts with the worthy objective of preventing another financial crisis. We don’t know all the specifics yet but these few generalities are clear:
- there will be government oversight of systemic financial risk
- we’ll see financial leverage limits and stricter capital requirements for financial firms
- “too big to fail” may be an intolerable idea for the long-run, implying more and smaller financial institutions
- exotic, non-standardized derivatives, with counterparty risk, are likely to be replaced by standardized contracts, traded anonymously on a central market
- compensation schemes will be limited in their incentives to assume risk
- there will be more transparency requirements for the “shadow banks”, mainly hedge funds
This almost certainly is not a complete list. But, I ask you, with such reforms in place, will you have more or less trust in the integrity of financial markets? My own answer is “more”, even “lots more”. Of course, I am ignoring other influences including economic fundamentals and their effects on volatility and valuations, but I conclude that reform can be, of itself, a very positive force.
How about economic fundamentals? Once consumers have reduced their leverage, and after housing prices have stopped declining, don’t we then have a more trustworthy economy, free of excesses? It’s a question of when, not if these things happen, and we may, indeed, see more unpleasant developments between then and now. But eventually, consumers will return as a growth force. And when they do, they will be far healthier than when we entered the current mess.
Two of the more depressed markets, autos and housing, are now at levels below their “natural” demand levels. Auto scrappage rates have declined in recent years as auto quality/durability has improved, but scrappage is still in the area of 11-12 million units on average, compared with current demand of only 9-10 million. Current housing starts of under a 500,000 annual rate compare with family formation of 1.5-1.6 million units. So once we work through the excess supply plaguing today’s market, housing will have the fundamentals necessary to return to health.
One of the disequilibria that has been worrisome, and which was a result of the consumer-led, trade-deficit-causing boom in the U.S., was the amassing of immense dollar assets by our trading partners, especially China. But this too may look better in the coming years as China puts more emphasis on domestic consumption and less on export growth as a growth engine. The Chinese may well be less adamant about maintaining an undervalued currency and thus enable more balanced growth in tandem with their trading partners.
I have been pleasantly surprised at how well corporate profits have performed so far, in the midst of what was probably the sharpest part of the contraction. It seems that there was a high degree of anticipation on the part of managements, as well as very fast reaction time in reducing expenses. Productivity, which usually declines as volume contracts, has actually risen through the first quarter. When volume begins to return to the marketplace the leverage to profits is likely to be substantial
If we emerge from this recession, adjustment, contraction, whatever you call it, with no further large disasters, will investors look at the outcome as a confidence-building success? Might it be considered as evidence that we can overcome even a near-death experience and thereby induce a return of risk-taking? Might we not have generated proof that we have the policy know-how to prevent a cumulative decline? Farfetched perhaps, but not impossible.
My point is not that recent problems are behind us. It’s much too early to say that. And I am not naive about difficulties we will have withdrawing monetary and fiscal stimuli. But I hear considerable despair about what may follow, so I think it’s valuable to ask what positive things might result from the pain we’ve been enduring.