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In the popular imagination, every financial crisis
is like all the others. It takes some attention and study to understand the
causes of a crisis. Once you understand the causes, you have a pretty good
idea of the resolution. However, this is almost never done, even by
specialists like academic economists or investor economists, because it is imagined
that every crisis is just like all the others. We don't have to study causes
because the causes are all the same. Every crisis is caused by .... crisis.
Their economic understanding divides history into Good Times and Bad Times,
and that's about as far as the analysis goes. (Sometimes they don't even get
that right.)
The narrative goes something like this: asset market
prices go down. Marginal, overaggressive, and heavily leveraged players go
spectacularly bust. Banks collapse. Businesses go bankrupt. Jobs are lost.
Maybe there is currency turmoil. Important men in expensive suits have
all-night discussions. Congress gnashes its teeth.
Recently, we have seen comparison between the recent
crises and historical events. Some say it is like Japan in the 1990s. Some
say it is like the 1970s (not so many right now). Some say it is like the
Great Depression. Some say it is like the Panic of 1907. In the popular
imagination, all these events are very similar.
The attentive economist understands that all these
events are very different. I've talked about this before, but it's
particularly appropriate now. Let's take a look:
Japan: the
primary problem in Japan was radical currency deflation (rising
currency) combined with tax hikes. Not surprisingly, this led to problems at
banks. Asset markets (stocks and property) were rather extended in late-1980s
Japan, and were due for a correction or bear market, but that would not have
led to extended economic problems if there hadn't been monetary deflation and
tax hikes. There was a similar asset-market blowoff in the early 1960s, which
led to the first failure of Yamaichi Securities in 1965 among other things,
but that didn't really change the overall situation at the time, which was
one of dramatic growth. (There was a recession in 1965, in which the official
GDP real growth rate fell to 5%.) Banks would have had some problem with
their property loans, but it would have been much, much, much less, and
probably resolved by 1994 or so. Bank management was basically OK. The
extended nature of the recession was not caused by banks, credit or lending,
but the continuation of monetary deflation.
1970s: the
primary problem during the 1970s was of course currency devaluation, combined
with tax hikes. Some tax hikes were automatic, via bracket creep (tax
brackets weren't adjusted for inflation in those days). Some tax hikes,
especially in places like Britain and Italy, were legislated. There were high
asset prices at the beginning (stocks and property), but that was reflective
of the sunny economic environment and were not overextended. There was no
apparent credit bubble.
Great Depression: the Great Depression was characterized, first, by dramatic increases
in tariffs around the world, which naturally led to economic difficulties
everywhere. This in turn led to declines in tax revenue, which were addressed
with rather dramatic domestic tax hikes (income taxes, corporate taxes,
etc.). In the deteriorating economic environment, governments reached for
currency devaluation, which introduced new turmoil. There were
"systemic" issues, primarily related to the banking system. Stocks
were extended in the late 1920s but not excessively so -- the U.S. stock
market traded for about 20x trailing earnings (not forward earnings) at the
1929 peak. Property values reflected prosperity, but do not seem to have been
excessive except in some localities like Florida. There was some credit
expansion, but it does not seem to have been excessive.
This is a popular chart these days. It shows a
whopping spike ... sometime between 1924 and 1944 ... which we are led to
believe was some sort of late-1920s credit bubble. Not so. As is labeled
here, the spike was in 1933. Why 1933? Because banks were going crazy with
property loans? No, because nominal GDP, the denominator, dropped about 46%.
And, the government was running huge deficits. Instead, this chart shows that
credit in the late 1920s more-or-less kept pace with economic growth, which
is about what you would expect to see in an economic boom that was not driven
by silly credit. We can also see from this chart that the 1950s-1960s period,
which was really the most successful economy of U.S. history in the time
period of this chart, was also not characterized by undue credit expansion.
Asia Crisis: the Asia Crisis (1997-1998) was primarily one of currency collapse,
exacerbated by corporations' heavy borrowings in foreign currency. IMF
recommendations including tax hikes and destructive high interest rate target
monetary systems made problems worse. Stock markets were rather highly priced
(about 25x trailing) at the time, but that was reflective of high growth
expectations and not what I would consider "bubble" territory. The
credit situation reflected expectations of dramatic growth, but were not
unusually extended in my opinion.
Panic of 1907: the Panic of 1907 was primarily a liquidity shortage crisis, which was
unfortunately common in the 19th century but is practically unheard-of today.
These are characterized by super-high short-term lending rates (in this case
over 100%), reflecting a shortage of base money available. For some reason,
people have been making comparisons between the Panic of 1907 and recent
events. This seems to be because prominent bankers are gathering for
meetings. Such is the level of economic analysis today.
I wrote about all these events in more detail in my
book Gold: the Once and Future Money. Some readers wondered why I went
into all that heavy history. This is so you can learn how to analyze and
distinguish different kinds of economic causes and effects.
It is hard to find any example of a crisis that was
caused simply by excessive stock prices. We saw that the TMT bubble of
1999-2000 (it really was a bubble, with 100x+ p/es for those companies that
had earnings) went spectacularly bust without too excessive an effect on the
rest of the economy. Taiwan's stock market hit 100x p/e in 1989 -- and so
what? Of course it collapsed afterwards, and nothing particularly horrible
happend to the Taiwanese economy. Even the huge bankruptcies of the 2002-2003
period (Global Crossing, Enron, etc.) didn't dent things too badly. This was
in part because the monetary and tax situations were improving, with monetary
reflation from the deflationary conditions of 2000, and the Bush tax cuts.
(Things were improving around the world, too.) I don't think the emergence of
the housing/credit bubble in the 2002-2003 period was the sole preventative
of widespread disaster, although it certainly helped keep things afloat more
than they would have otherwise.
Nor have I seen many examples where a major economic
event was caused by widespread credit stupidity. There have always been a few
bubble pockets, like Florida real estate in 1925 or U.S. commercial real
estate in the late 1980s. In most cases, loans were made on a reasonable
basis on reasonable assumptions, such as a healthy economic environment. When
the environment changes, many loans go bust, but at the time and conditions
and expectations they were made, they were relatively prudent. Banks don't
take stupidly excessive leverage either. The typical 10x leverage of banks
has enough of a cushion to keep them going even when they have credit issues.
All of this can lead to a recession but rarely to a disaster.
The present situation is something of an anomaly in
that regard. There have always been property bubbles, but rarely have they
been so broad in extent. The result is that the nationwide statistics, such
as price/rent, price/income, cap rates etc. reached unprecedented extremes.
This was combined with leverage at banks (mostly off-balance sheet via
derivatives) reaching similarly extreme levels. Underwriting standards
absolutely collapsed, due to the loan securitization process which made
things so opaque that rating agencies could declare it all investment grade
and nobody thought it unusual. (Normally, property prices are somewhat
restrained by underwriting standards, since at some point bankers determine
that borrowers are unable to pay the inflated prices. Obviously, that went
out the window.) Similar lending practices were widespread in credit cards
and auto loans as well, not to mention the idiocy of private equity
"levered loans." None of this stuff could withstand even a typical
recession. The result, of course, is that financial companies are almost
universally insolvent. Those that seem OK, like JP Morgan/Chase, BofA and
Wells Fargo, mostly have been lying in my opinion, and have friends in high
places. Normally, typical banking practices (typical leverage and
semi-prudent underwriting standards) have enough margin of safety that it
takes serious errors on the part of the government (tax hikes and currency
issues, for example) to put banks into crisis. However, banks today not only
chewed through all that margin of safety, they got themselves into a
situation where failure was basically assured, no matter what happened. (We
haven't even had the great CDS unwind yet!)
Other governments have had bank insolvency issues in
the past. Usually, the government recapitalizes banks via common or preferred
equity, in effect nationalizing them in extreme cases, and eventually things
work out. This is much like Warren Buffett's recent investment in Goldman
Sachs, and completely unlike Hank Paulson's proposal, which is just a scheme
for Wall Street to steal from the taxpayers.
* * *
The doomer types are on overdrive. This crisis is
really a reflection of Peak Oil, they write, or environmental
degradation/climate change. Sorry, this crisis is 100% financial. We may soon
have a Peak Oil crisis or a rising-seas crisis. But not yet.
Nathan Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street
Journal Asia, the Japan Times, Pravda, and other publications. He has
appeared on financial television in the United States, Japan, and the Middle
East. About the Book: Gold: The Once and Future Money (Wiley, 2007, ISBN:
978-0-470-04766-8, $27.95) is available at bookstores nationwide, from all
major online booksellers, and direct from the publisher at
www.wileyfinance.com or 800-225-5945. In Canada, call 800-567-4797.
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