1: How on Earth Did We Get Here?
The author considers the recent implosion of world markets: some $30 trillion in wealth evaporated in a debacle that bankrupted or significantly crippled some of the largest financial institutions. Yet in the years just before, the world economy appeared strong, with globalization and new technology radically improving the outlook for economic growth.
The best and brightest seems as confounded as are laymen by the turn of events, and even after half a decade of slow recovery there is still the fear that the whole system is on the brink of collapse. No one has a satisfactory answer to how it happened, when it will end, and whether we have seen the worst of it.
Do markets work?
An important distinction is that, while the term "markets" is being bandied about, only one industry is showing any sign of dysfunction: the financial markets. In spite of all the economic upheaval, people are still getting the goods and services they need: the markets that provide food, clothing, and every other consumer good are still working efficiently. The chief difference is that financial markets deal in money, an imaginary substance that can be forged or misrepresented.
You do not find, and could scare contrive, a ponzi scheme for oranges or soap powder or any other tangible good, as material goods are rooted in reality. Faking the ledgers does not conjure goods from thin air, and you cannot deliver goods you do not have.
Money, especially since the abandonment of any material basis of its value, can be made up very easily. Most of the trillions of dollars that were "lost" had never, in fact, existed. So not only has that money disappeared, but what has also vanished is the trust in the financial system. And given that money has no value except in the belief of those who accept it in exchange for things, and as buyers of money are not circumspect of the "goods" they are being offered, goods of legitimate value are just as suspect.
So the crisis of recent years is not to do with the production of goods, but in the confidence people have in financial systems - and as confidence is the base of modern financial systems, the position is ghastly.
The author's answer is "a tale of greed, illusion, and self-delusion on a massive scale" that reveals not merely a current situation of markets, but the underlying principles of economy, sociology, and human nature itself.
The meltdown
The author's interpretation of the financial meltdown can best be explained in the history and the underlying causes of the collapse.
The history is fairly straightforward: clever investment bankers invented an alphabet soup of new financial instruments: the CMO, CDO, CMS, and "heaven knows what else." They spoke of a revolution in the world of finance, ignoring the fundamental principles that underlie the "old" ways, which came home to roost.
The net result was an explosion in the availability of consumer finance, most obviously in the mortgage sector: the availability of financing caused a surge in real estate values - never mind that the loans were being made to "ninja" borrowers (No Income, No Job or Assets) whop had no hope of ever repaying the huge sums they borrowed.
Banks were well aware of the problem, and rather than holding onto loans that would invariable result in default, they packed them up into sophisticated securities and sold the risk off to others. The highest risk provided the highest return, and those who wished to maximize their profit took on the riskiest of these securities.
The result was that when the American housing bubble burst, banks in Europe and Asia were holding a great deal of worthless paper that they had accumulated for over a decade. Only when this began to occur did they take a closer look at the bill of goods they had been sold.
The problem then cascaded: no-one wanted these securities anymore, so those who held them were left holding the bag. And while the securities were regarded as worth next to nothing, their full value remained on the books to maintain consumer confidence in banks that were in fact already bankrupted.
It was common practice in the banking industry, which led banks to be worried about other banks' creditworthiness and reluctant to lend to one another: so the drop in confidence in solvency was echoed in a drop in liquidity: regardless of what a bank's assets were on paper, it did not have ready cash to repay its obligations, and others were reluctant to provide any more capital on credit.
The lack of liquidity fed back to the lack of solvency, as banks could not obtain the capital to service their present obligations. In essence, the banks had long been in the position of a consumer who borrows from one party to repay another, and had lost the trust of anyone who might loan them money.
As a result of this, banks even curtailed their most legitimate source of income: lending to creditworthy borrowers - which reduced their own income as well as the capital available for the purchase of real goods and services in other markets.
From meltdown to slump
The meltdown in financial markets soon became a meltdown in consumer markets, as people and companies who were unable to obtain credit with the same alacrity as before began to tighten their belts: consumers cut back on their purchase of big-ticket items while they reduced debt or increased savings.
This then spilled over to manufacturing and services, which were also facing a tightening of credit and, at the same time, bore a loss in revenues. Chiefly, they cut back on their inventories and exports, the latter of which caused a collapse of international trade: for some countries, exports fell by 40% and industrial production went into a free-fall for durable goods producers.
An additional result was a rise in unemployment, as firms that manufactured fewer goods had less need of employees - and unemployment engulfs the whole economy by reducing the ability of consumers to purchase goods.
Further worries lurk in the shadows: for decades, the pension systems in the west have been "an accident waiting to happen." A "pay-as-you-go" system is dependent on having sufficient income from workers to pay retirees, which breaks when unemployment spikes; a "funded" program depends on the ability for the investment principle to earn interest, which breaks when credit is not extended.
In many western countries, there is a large percentage of the population that is not engaged in productivity, but who make an income (with which to purchase goods and services from the economy) from the productivity of others. This consumer segment, too, is in danger when the economy slows down.
The author terms the net result of these forces as "The Great Implosion", producing numbers that have not been seen since the Great Depression, and with the potential to further degrade to meet or exceed the depth of that crisis.
While the crisis in personal debt ahs largely been curtailed by more cautious consumers and tighter credit requirements, there remains a frighteningly high amount of institutional debt among governments, banks, and corporations. There is considerable fear, and justifiably so, for what may happen when this debt goes into default and economies and monetary systems collapse.
But even if the debt crisis resolves itself quietly, it has case a pall over the markets that will last for decades. Consumers, the people who drive economies by their demand for goods, no longer have the sense that their economic conditions are good and will continue to improve, but entirely the opposite. So long as this remains true, the economic gloom will perpetuate and feed upon itself.
What caused it all?
The author posits eight factors as the causes of the present crisis: the bubble in property, the explosion of debt, the fragility of banks, the weakness of risk assessment, erroneous monetary policy, "supersaving" tendencies, complacent and incompetent regulators, and docile assessors. He hints that there is a deeper underlying cause behind these eight factors that he will later reveal.
The property bubble
There have been bubbles throughout financial history, and a series in recent years: bubbles in the US and Japanese equity markets, another in emerging markets, and so on. In each of these situations, those parties involved were devastated, but those who were not involved were largely unharmed.
Consider the technology bubble of a decade ago: the dot-com boom in the late 1990s went bust at the turn of the century. Those who invested in technology or worked inside the industry took shuddering losses, but the remainder of the system was largely unaffected.
Also, consider the savings-and-loan crises of the 1980s, which was caused by a rise in interest rates - such that banks who had written long-term loans at a small amount of interest had to borrow money at a higher short-term interest rate to provide working capital - which inevitably became untenable, such that a sizable taxpayer bailout was necessary to preserve the banking system.
(EN: What is not mentioned here is that it also precipitated a government policy of keeping interest rates low, to the point of short-term interest being virtually nothing, and that a repeat of this crisis is likely to occur when interest rates rise again.)
The present bailout began a decade before the crisis, when a private hedge fund LTCM (Long-Term Capital Management) went bankrupt and was bailed out, for fear that its failure would endanger the entire financial system. No-one seemed to recognize the implications, not even the US Federal Reserve. If the failure of a single firm could threaten the entire system, what would happen when multiple firms failed? The answer was seen a decade later, when it happened.
The property bubble had less to do with real estate than the loans with which the property was financed. When unqualified borrowers defaulted, someone was left holding the bag - and that "someone" was sizable financial institutions all around the world.
The world has seen speculator bubbles arise over various commodities: the black tulip bubble in Holland of the 1600s, the south sea stock bubble of 1720, Australian mining shares in the 1960, etc. The difference being that in each of these instances, the risk was born and the loss suffered by the speculators. But property in 2008 was a massive bubble, and the clever securitization of the risk was held by many who had no idea that they were even involved in real estate investing.
Moreover, there is a distinct difference between collapses in the equity market and those in the property market. Few people purchase stocks and commodities futures by borrowing money they cannot repay if their investment turns sour. Most people, however, purchase property with borrowed money and their creditors feel secure in the prospect of repayment. Where repayment is not made, and where the assets that serve as collateral are undervalues, the loss falls on the banking and financial system as a whole.
Debt and the fragility of the banks
Another factor that contributed to the degree of the problems was the "perilous" state of the financial system in general and the banking system,
Specifically, "low finance" had ballooned: mortgages were extended at up to 125% of property values and six to seven times self-reported income of applicants who were already well over their heads in credit card and other consumer debt. There was little prospect of such debts ever being repaid.
Meanwhile, "high finance" securitized these debts into sophisticated financial instruments that made it nearly impossible to determine who, exactly, was responsible for the balance of these loans in the event the borrowers defaulted.
Meanwhile in banking, such investments formed part of the capital reserves, the "secure" equity and accounting practices enabled banks to shuffle assets off their balance sheets into subsidiaries and financial vehicles whose capital requirements were lower or nonexistent, enabling banks to extend even more loans. Ultimately, the banks themselves were highly leveraged, borrowing as much as 40 times their capital.
Why would bankers do this? Because investors demanded it: the success of a bank was judged by the return on a bank's assets, and these practices had become industry standard, such that any bank that failed to join in was seen as uncompetitive and would likely fail to earn sufficient income to cover its expenses.
Essentially, the entire financial system was turned into a gigantic pyramid scheme of debt, in which there was a very small amount of actual capital.
Risk management
Banks were well aware of the risk involved - they hired fleets of risk managers (one bank had a staff of 400 such individuals) to track this. However, they were applying flawed statistical models and specious interpretations of data.
Statistics itself is based on a bell-curve distribution that is assumed to reflect reality, but which very seldom does. In particular, risk managers applied a normal distribution based on assumptions that did not bear true in reality: the sense that an "average" number of people will default on their loans is an untenable position when the vast majority of loans are extended to unqualified applicants.
Statistics is also geared to long-term probabilities: a heads/tails coin toss has a 50/50 probability such that over the long run, each will come up an even number of times. But it is entirely possible for heads to come up ten times in a row, which foils gamblers who have a limited bankroll to keep increasing their bets to cover past losses. More to the point, the financial markets have great short-term volatility - such that even if statistics work out in the long run (which was highly improbable), a short-term shift in the market would create substantial losses, such that banks' own bankrolls would not sustain them.
Most importantly, statistical analysis is borrowed from the physical science without much consideration of whether it is applicable to human affairs. Simply stated: it is not. The decisions of people, especially when they interact with one another, are not isolated or independent, but are highly influenced by one another.
That is, when you toss a coin, the outcome is not influenced by the previous toss or the results of any other coin being tossed. When you're dealing with investors, their decisions are heavily influenced by the success or failure they have had in the past or that which they see around them.
Consequently, the number of statisticians calculating risk does not make their outcome more accurate when all of them are using the same flawed premises and practices - they all arrive at the same bad conclusions.
Monetary policy errors
Much of the blame is directed toward the policymakers in central banks, Alan Greenspan and his equivalents in other central banks, whose job is ostensibly to keep the financial systems safe and sound. This rests upon the ill-founded notion that such individuals hold power and are not beholden to the agendas of political leadership.
But in fact, ensuring the stability of the entire financial system is not the responsibility of central banks, and it has never been within their assigned duties to control private investing and speculation. Aside of setting the nominal interest rate for borrowing money from the central bank, they had no mechanism to govern asset valuation and the extension of credit.
Greenspan in particular, took the viewpoint that he could not be certain there was a bubble; even if there was there wasn't anything he could do about it; and the proper way to react was to let the market play itself through, to ensure stability of the currency during the bubble and "clear up the mess afterward." This doctrine was broadly accepted by other central banks.
In terms of monetary policy, rampant inflation had been contained since the disaster of the 1970s, and other asset bubbles had come and gone without doing serious damage to the monetary system. It is to their credit that inflation has been tightly contained throughout the recent crisis.
That is to say that the supply and demand for real money has been masterfully managed, considering that inflation has not run rampant due to a surplus of fake money, created by the massive volume of credit, has not created a gross surplus that skews interest rates.
However, this is itself a problem: the supply and demand of money would fluctuate left to its own devices. Keeping interest rates low enables banks to lend more money at lower rates to unqualified borrowers.
It has been speculated that less credit would have been extended if interest rates were higher - but this is an assumption. It seems likely that almost as much credit would have been extended at higher interest rates, or that the interest in investors in making a higher return on riskier loans would have counterbalanced the scarcity of credit.
But given what actually happened, rather than what might have happened if the central banks raised interest rates, it is entirely fair to suggest that the central banking system's practices were a significant contributor to the precipitating crisis.
The global context
Globalization and the resulting trade deficits also had a significant impact on the economies of developed nations, which had outsourced much of their industrial production to other countries, particularly China and other parts of Asia, which earned significant trade surpluses by selling manufactured goods to developed nations. The developed nations had correspondingly high trade deficits that, coupled with a sharp rise in oil prices, resulted in significant trade imbalances.
Western governments seemed complacent about the situation, and did not take action to replace the demand being sucked out of their economies to purchase foreign goods with goods that could be offered in trade. There is a convincing argument that their economies would have been better poised to weather the deflation of the bubble had they done so.
Very low interest rates, some less than 1%, should have been sufficient signal of a lack of domestic investment - as launching new businesses or expanding existing ones would increased the demand for money, hence interest rates. Not to mention the many other metrics that consider domestic income, employment, and productivity had all been looking flat for years. As such, "it was a no-brainer" that domestic production was a serious and growing problem.
Instead, the US government felt the best solution was to keep people spending, by imposing a policy of low interest rates and the availability of credit to creditworthy borrowers - even knowing that a significant portion of borrowed funds would lead to the further purchase of foreign rather than domestic goods.
As such, while Americans accumulated debt, the Chinese accumulated savings, further exacerbating the imbalance of trade and the weakening of western economies.
Regulatory somnolence
The position of regulatory agencies during the crisis is described as "supine." There was regulation aplenty, and regulators were ensuring that banks remained in compliance with the letter of the existing law, but no effort was made to address the substance of what banks were doing, or to close the dangerous loopholes they were exploiting.
Incredibly, the regulatory adjustments that were made created additional loopholes, enabling banks to reduce their capital requirements and move questionable assets off the balance sheet or to subsidiaries - such that the bank's own sheets were clean, but there were still considerable liabilities for the bank when its subsidiaries failed.
There is ample evidence that the British authorities were in close touch with the problems, but decided to do nothing about them in order to maintain the competitive position of their domestic markets against foreign markets that employed highly questionable activities. As such, the UK explicitly followed a policy of "light touch" regulation - in effect, to allow its institutions to run rampant.
Britain was not alone in this, and the author considers the regulation of financial markets to have been in the nature of "a sick joke."
Private complacency
The utter failure of oversight was not confined to the public sector, and a great deal of blames falls to the private sector - the banks, investment companies, and the auditors who are supposed to serve the investing public by assessing risk.
Moody's, Standard and Poors, and other such firms were issuing their highest AAA rating with a rubber stamp to incredibly risky securities, which enabled banks and other institutional investors who relied upon their ratings to buy and hold such investments with a false sense of securities.
They claimed not to have seen it coming, and that they were taken in, but the author disparages this: ratings agencies receive a bulk of their income from the banks and institutions they claim to be objectively rating. While there is no overt proof of malfeasance, there is ample motive for it.
But even the armies of independent market analysts, nor even the financial press, perceive the perils of excessive debt. In fact, the financial press "seemed to be cheering on the party on." Resulting in a global mass delusion about the sources of prosperity, in much the same way as Galbraith had described the situation of America in the 1920s.
Was it an accident?
It is claimed that the disaster occurred as a result of a single event that pushed the system over the edge - namely, the collapse of Lehman Brothers in September 2008. It is commonly reckoned that if the firm had not been allowed to bust, the crisis would have been relatively minor and the consequences less devastating.
The author rejects this hypothesis. The firm's collapse was a milestone in the chain of events that led to disaster, but it was not the cause. The bankruptcy or solvency of a single firm would not have addressed the fundamental problems: inflated asset values, the extension of credit to unreliable borrowers, etc. would all have remained had this one firm survived.
If it weren't Lehman, it would have been another major firm that served as harbinger of the global collapse. The problems were systemic, and world governments did not have the resources to bail out every bank that failed - some would have to be let go, just as had happened in the savings and loan crisis two decades prior.
Was it the bean counters' fault?
Some commentators argued that, in spite of the factors that created the issue, the accountants, auditors, underwriters, and other financial professions had ample evidence of the problem and were derelict in their duties to raise a red flag before the situation reached critical mass.
The author suggests that there is some merit to this, but not much. The suggestion that a problem so complex and so severe could have been resolved by people whose profession it is to account and observe seems overly simplistic. In effect, accountants can point out situations and provide advice, but if their analysis and advice are ignored, and when the very regulatory agencies to which they would report malfeasance are entirely indifferent, they are without recourse.
Moreover, the argument is based entirely on subjective factors. In any given financial situation, there are equally qualified professionals on both sides of the argument. Numbers may be objective, but the numbers alone do not demonstrate conclusions - they do, however, provide support for the conclusions others draw.
Ironically enough, the Japanese financial crisis of the 1990s was attributed to exactly the opposite argument: that accountants were being too skittish and too cautious, and created economic stagnation by advising overly conservative investment and overly restrictive lending criteria.
Was "subprime" lending the root cause?
Some critics have also suggested that regulators, particularly in the US government, placed enormous pressure on financial institutions to extend credit to unqualified borrowers - and had this not occurred the crisis would not have occurred.
True enough, subprime lending was at the heart of the crisis, as the entirety of losses can accurately be laid upon debts that would not be paid. However, subprime lending was merely an "egregious manifestation" of a much more widespread phenomenon of excessive lending to all borrowers, even qualified ones, particularly for real estate purchases.
That is to say that builders, landowners, and real estate speculators were able to receive financing to build an enormous inventory, and an enormous amount of consumer lending was necessary to enable them to sell that inventory and repay the loans by which the buildup was financed. If consumer lending had been restricted, the loss would still have occurred, albeit in a lesser degree, on those commercial loans.
Moreover, mortgage loaning was merely a part of a more general acceptance of risk throughout the financial system. Credit was freely available in many forms to consumers.
It was also available to companies and institutions, in the form of junk bonds that were regarded as legitimate due to conservative interest rates. One example are bonds issued by emerging market governments. Ten years previously, investors demanded 12% over market rates to purchase these issues, but by 2007, the unstable governments of third-world nations such as Panama and Morocco were able to obtain credit at a premium of less than 2%.
Ultimately, the author concludes that if the crisis had not started with subprime mortgages, it would likely have taken root in another subsector of the financial markets. In all credit markets, banks were taking on a great deal of risk loaning to dodgy borrowers of all shapes and sizes.
Was the disaster unpredicted?
Given that all the factors were lining up for a financial catastrophe, there is an obvious question to ask: why didn't anyone see this coming?
The fact is, many did see it coming, but the warnings went unheeded by firms and investors that were making substantial profits and sought to do so for as long as possible. It's likely that they recognized disaster was coming, but didn't want to be the first to leave the party, and it became a game of brinksmanship in which many, if not most, went over the brink.
The author was among scores of economists and analyst who gave strong and stem warning, backed by overwhelming evidence, and all to no avail - and whose arguments were dismissed without regard by profit-seeking institutions that provided no credible argument to the contrary. They preferred not to think about it, and pretend it wouldn't happen. And so it did.
The gallery of villains
The author also suggests that economists are ultimately responsible, as the ideas they promulgated about the way in which markets and monetary systems work came to dominate policy thinking, not just in the classrooms of academia but also in corporations, regulatory agencies, governments, and central banks - as well as the mind of the common man in his role as a consumer, debtor, investor, and voter.
The Myth of Efficient Markets
The author takes aim in particular at the University of Chicago and its radical take on free-market economics: the belief that markets are efficient and will take care of themselves if you simply leave them alone.
The theory of efficient markets maintains that the disparity between the actual value of any item and the price that is paid for it arises from the estimation of the seller and buyer (primarily the buyer, whose consent to pay sets a price), and that if both parties are reasonably well informed, the price will be within a factor of two of its actual value (it will be priced between extremes of half to double its actual value).
On the surface, this seems entirely reasonable - but taken to its extreme, it leads to the misconception that all markets are efficient at all times and that price and value are very closely correlated. This hypothesis came to be accepted as established fact, and led to an "absurd reverence" for markets and their assessments of value.
Yet "the markets" is a vague abstraction of all people who buy and sell all goods, whether they are savvy or gormless. They include the most crooked sellers and the most gullible buyers, and a great many people involved in market are clever, quick, and cunning in finding ways to maximize their personal profit by seeking victims to deceive.
Markets are also subject to mass psychology: crowds seldom act rationally and can behave in extremely stupid ways. The efficient markets theory depends on the majority of participants in a market to act rationally and make independent assessments, such that they are not subject to mass hysteria.
Said another way, crises do not occur when the majority of the people in a market act rationally and stand their ground rather than following a small number of irrational individuals who charge toward a cliff. But where that is not the case, and most people in a market are irrational, the actions of a few cause many to follow in disastrous situations.
Political Influence
Much has been made of the pressure that government had put upon the private sector to facilitate and encourage irresponsible behavior by advocating the "right" of creditworthy borrowers in exorbitant amounts at generous rates, legitimatizing specious securitization of debentures, and ignoring the mounting evidence of fiscal insecurity.
However, political power is a two-way street, and suggesting that government is sole to blame overlooks the fact that tremendous influence over politicians is held by their contributors and financial reporters. Consider that over a ten-year period, the top 25 firms in subprime mortgages contributed about $370 million on lobbying and campaign donations to ward off tighter regulation of their industry.
As such, industry leaders claiming to have been pressured by government are likened to ventriloquists who claim to have been victimized by their own mannequins.
President Clinton in the US and Prime Minister Blair in the UK, two allegedly left-leaning politicians, were deep in the pockets of the banking and financial industry, and appointed many senior bankers and financiers to prominent positions in their governments.
Consider the example of Goldman Sachs, which has furnished two treasury secretaries, a chief economist, a president of the New York Federal Reserve, and a vice-chairman of the Federal Reserve committee that sets interest rates. Goldman alumni occupy many positions of great power and influence in governments around the world.
Is it any wonder, then, that the banking and finance industries have been very well treated by governments led by the politicians they purchased?
A Veneer of Success
There was also a broader reason for the acceptance of the market's behavior by both regulators and ordinary people: they appeared to be working very well.
While the western economies seemed to suffer crises on occasions, it had managed to survive and, prior to the collapse, there was a sense that things were going very well. The decade of the 1990s in particular was one in which there was a tremendous economic growth fueled by debt-fueled spending.
People on the lowest levels of society enjoyed a great deal of material wealth (things bought on credit they should not have been issued), the commercial sector enjoyed high demand for products and services, and the finance sector was making excellent profit.
In effect, no-one thought there was a problem because everything they saw seemed to be going very well. It wasn't until the bill came due and no-one had the money to pay that anyone suspected there might be a problem.
From causes to consequences
The author states his intent to leave off the causes - it's important to have a clear picture of how the cataclysm occurred, but far more important to understand the present situation and consider the challenges and opportunities that lie ahead.