Editor’s Note: This column has been adapted from Alexei Bayer’s remarks at the Yale Club in New York City on May 5, 2009, upon acceptance of the Excellence in Financial Journalism award presented by the New York State Society of Certified Public Accountants.
The current economic downturn is atypical in at least one respect. There have been so many scapegoats — including bankers, mortgage brokers, regulators and rating agencies — that the usual suspects have been temporarily forgotten. Only rarely do we hear the traditional complaint that economists screwed up, failing to warn us that there was a bubble in the housing market and that so much credit was extended that the financial system was at risk.
But economists did warn about the problem. Some of the most respected economists have been talking about risks in the financial services sector for years. Few got the timing exactly right, but some came remarkably close. (See for instance our interview with Yale economist Robert Shiller in the June issue of Research.) Plenty of mainstream economists saw the U.S. economy as dangerously unbalanced and overextended. As the late Herbert Stein, the chairman of the Council of Economic Advisors under Richard Nixon, postulated in his Stein’s Law: “Things that can’t go on forever never do.”
Actually, you didn’t need sophisticated economic models to know that things were going astray, just common sense. Debt growth, and the leveraging of assets with the help of increasingly sophisticated forms of financial engineering, certainly couldn’t go on forever. Since debt growth was outstripping consumer incomes, there was going to come a time when entire segments of the population would not be able to service their debts. House prices were outpacing income growth as well, which also meant that eventually the bottom was going to fall out of the real estate market. When asset prices increase faster than incomes, they eventually need to come down to become affordable once more, or else inflation will accelerate to raise nominal incomes.
The financial system was supposedly protected by sophisticated risk management models developed by mathematical geniuses working on Wall Street. But the spotty performance of risk management systems in crises — i.e., when they are needed most — was demonstrated in 1998 by the collapse of Long-Term Capital Management (LTCM), a prestigious hedge fund run by some Nobel Prize-winning economists. Its investment strategy seemed solid from the point of view of mathematics, but its algorithms became useless when confronted with reality.
Ordinary consumers and homeowners might not have been aware of the risks involved. They trusted too much in professionals. But professionals themselves — traders, speculators and market participants — could not have been ignorant of the fact that they were playing with fire.
The Madoff Syndrome
When the Bernie Madoff case came to light, people wondered how so many seemingly sophisticated investors — and highly educated people with very high IQs even if they weren’t professional investors — got caught in a Ponzi scheme, one of the oldest and least sophisticated scams in the book. Why didn’t they see through the deception?
My view is that Madoff’s investors suspected that a scam was underway. They were getting a steady rate of return which not only beat the market and outperformed all benchmarks and bested other fund managers’ results, but never varied either in lean or fat years. Everybody knows that this is impossible and that markets are volatile, unpredictable and impossible to outsmart consistently.
But that was Bernie, his investors reasoned. He was the quintessential insider. He had made a pile of money working on Wall Street. He must know something the general public doesn’t. Probably he gets some inside tips and he is smart enough to get away with it. In other words, most of Madoff’s clients knew that such returns as they were getting were impossible in the real world, but preferred to think that Madoff was working some kind of magic.
This is exactly what has been eating into our financial system since the 1990s. We have moved away from the two qualities that made America great in the past: realism and healthy skepticism. We now prefer to think that the usual rules no longer apply and that we live in a new reality. In the 1990s, the same Madoff syndrome told us that we were living in a “new economy.” That economy, we told ourselves, was driven by the technology sector and Silicon Valley had never suffered a recession, only periods of fast growth interspersed with slow growth. Hence, the shares of Internet companies would only go up, sometimes faster and sometimes slower. Skeptics — or realists — like Warren Buffett, who steadfastly refused to buy the Internet myth, were ridiculed as has-beens.
The same Madoff syndrome underpinned the housing bubble of the 2000s. House prices, we told ourselves, never decline. They are going to keep going up and then they will stabilize. And homeowners almost never default on their mortgages, even when they are faced with a negative equity trap.
This brings us to the larger issue of economic policy. Even if you never took an economics class, you know that the capitalist economy is cyclical. In fact, recessions are necessary for the healthy functioning of the economy over the long term. In a recession, businesses and consumers correct economic imbalances and pay down their accumulated debt. Recessions also get rid of the dead wood and knock out overextended players, thinning out the field for more efficient competitors. The economy needs regular recessions just as humans need regular sleep.
The task of bring about periodic recessions falls to the central banks. In the words of one-time Fed Chairman William McChesney Martin, the Fed’s job was to take away the punchbowl just as the party gets going. It is an unenviable — and politically unpopular — task, which is why over the years central banks around the world have become independent of their political masters.
But in the early 1990s, the Fed apparently discovered the Holy Grail. The technological revolution and the outsourcing of manufacturing to the Pacific Rim, Mexico and then China kept headline consumer prices in check. This allowed the Fed to keep its interest rates low even when economic growth was robust, without triggering an inflationary uptick. Alan Greenspan was well aware that the party was getting out of hand. In December 1996, he uttered his famous warning about “irrational exuberance” on Wall Street. At the time, the Dow stood at around 6,500. The next three years marked the bubble in stocks, as the Dow rose 80 percent by early 2000.
When the Internet bubble burst, it was a great opportunity to revitalize the economy and to put it on a more solid footing with a cyclical recession — something like the one in the early 1990s. However, the Fed slashed interest rates to 1 percent — at the time, a record low — and began pumping money into the U.S. economy, encouraging a new bubble to inflate in the real estate market. Politicians were only too happy not to have a recession on their watch and everyone lavished praise on Greenspan. Not unlike Madoff’s investors, we came to believe that we could grow more and more prosperous year after year.
The cost of this delusion can be seen in the example of LTCM. The Fed liquidated the hedge fund without forcing any of its peers to suffer any serious repercussions. The escalation of risk-taking in the decade following LTCM’s collapse can be gauged by the fact that its losses measured only around $5 billion over four months — small change by the standards of 2008-2009. Now, the Fed and central banks around the world are spending trillions to save the financial system. Without the infusion of central bank lending, and multi-trillion dollar deficit spending by Washington, the U.S. and world economy would have fallen into another depression.
Spending all this money has been necessary. But this time we should avoid the trap of thinking that the money we’re borrowing to save the economy will come without a huge bill to pay the piper some time soon.
Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at [email protected]. His monthly “Global Economy” column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past six years, 2004-2009